Liquidity in a Socially Optimal Retirement Savings System

Tax-deferred retirement savings accounts in the U.S. (e.g., IRA, 401k, 403(b), Thrift Savings Plan, etc.) are partially illiquid. Withdrawals before age 59½ incur a 10% tax penalty (in addition to income taxes). The 10% early withdrawal penalty was originally legislated in 1974. At that time, the penalty was a source of contention, with the Senate preferring a much higher penalty than the House. To our knowledge, neither economists nor policy makers have engaged in a systematic effort to evaluate the social optimality of the liquidity of the IRA/401k system.

The liquidity of the current system has consequences. For every $1 contributed to the accounts of savers under age 55, $0.45 simultaneously flows out of the 401k/IRA system, not counting loans (Argento et al., 2012). Much of this leakage occurs for socially desirable reasons, like providing liquidity during periods of financial hardship. We seek to: (1) Evaluate the optimality of the illiquidity features in the U.S. retirement savings system using a behavioral model that includes both spending shocks and self-control problems and (2) Derive the socially optimal level of illiquidity in a retirement savings system.

We develop a structural model to study the optimal level of commitment in a retirement savings system. Our setup is based on the model of Amador, Werning, and Angeletos (2006).