“Our results indicate that behavioral utility helps explain the ‘glidepath puzzle’”
What is the focus of the paper?
This research focuses on a well-known phenomenon in pension investing, where people tend to reduce the share of equities in their portfolio more quickly than would be optimal according to economic models. The authors refer to this as the ‘glidepath puzzle’. The paper first discusses possible explanations, such as a lower- than-expected equity risk premium. In the analytical part, the researchers look beyond the traditional economic approach and also consider behavior: people appear to be particularly sensitive to perceived losses – a phenomenon known as loss aversion – for example, when their pension value declines compared to the previous year. Finally, the authors examine whether combining economic and behavioral factors, in this case sensitivity to losses, can lead to a better glidepath design that improves participants’ welfare.
What are the key findings?
Loss aversion turns out to be an important explanation for the fact that glidepaths in practice often deviate from what would be optimal according to theory. This is the case in the accumulation phase of the pension and under the assumption of average risk aversion. Additionally, most of the examined glidepaths in the paper turn out to be suboptimal. Furthermore, a trade-off exists between economic utility and psychological costs resulting from loss aversion. Finally, the most important result: when the glidepath is chosen based on behavioral factors, such as loss aversion, as well as economic factors, the expected welfare of participants can increase with at least ten percent.
What are the implications?
- A better understanding of the possible explanations for the ‘glidepath puzzle’ can help policymakers and pension funds make better-informed decisions and develop glidepaths that strike a balance between economic and behavioral realities.
- Glidepaths currently applied in practice often take behavioral factors such as loss aversion into account only implicitly, but could generate substantially greater welfare if these factors were explicitly integrated into the design process.
- The welfare of participants in pension funds can be substantially increased when the glidepath is optimally shaped by taking behavioral factors such as loss aversion into account alongside more traditional economic considerations.