Optimal Defined Contribution Pension Plans: One-size Does Not Fit All

We study the role of defined contribution pension plans for individuals’ welfare and ability to accommodate shocks. Using a rich life-cycle model, we find that common designs, with a fixed contribution rate out of income for all individuals at all times, are unnecessarily rigid. We propose a design where the contribution rate is a function of the individuals’ age and account balance-to-income ratio. Compared to the typical rigid contribution rate, our design leads to the same average replacement rate, 25.6 percent, but reduces the cross-sectional standard deviation from 10.8 to 4.0 percent. Furthermore, our proposed rule provides both liquidity and consumption benefits for the first 17 years. Consumption increases by as much as 4.9 percent. The design implies a welfare gain of 3.3 percent in consumption equivalent relative to the current fixed contribution rate.