WENDY C. GERZOG, University of Baltimore - School of Law
Email: WGERZOG@UBMAIL.UBALT.EDU

Although section 529, under which tax preferred college savings accounts may be established, was enacted to alleviate the large financial burden of paying for a taxpayer's family members' higher education, it has provided taxpayers with the potential for additional income, gift, and estate tax benefits unintended by the very generous statute. The government's advance notice of proposed rule making cites several of those tax avoidance schemes, proposes some solutions, and asks the public for its recommendations to curb those abuses.

ANNAMARIA LUSARDI, Dartmouth College - Department of Economics, National Bureau of Economic Research (NBER)
Email: annamaria.lusardi@dartmouth.edu
PETER TUFANO, Harvard Business School, National Bureau of Economic Research (NBER)
Email: PTUFANO@HBS.EDU

We analyze a national sample of Americans with respect to their debt literacy, financial experiences, and their judgments about the extent of their indebtedness. Debt literacy is measured by questions testing knowledge of fundamental concepts related to debt and by self-assessed financial knowledge. Financial experiences are the participants' reported experiences with traditional borrowing, alternative borrowing, and investing activities. Overindebtedness is a self-reported measure. Overall, we find that debt literacy is low: only about one-third of the population seems to comprehend interest compounding or the workings of credit cards. Even after controlling for demographics, we find a strong relationship between debt literacy and both financial experiences and debt loads. Specifically, individuals with lower levels of debt literacy tend to transact in high-cost manners, incurring higher fees and using high-cost borrowing. In applying our results to credit cards, we estimate that as much as one-third of the charges and fees paid by less knowledgeable individuals can be attributed to ignorance. The less knowledgeable also report that their debt loads are excessive or that they are unable to judge their debt position.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

ANUP K. BASU, Queensland University of Technology
Email: a.basu@qut.edu.au
ALISTAIR BYRNE, University of Edinburgh - Business School
Email: alistair.byrne@ed.ac.uk
MICHAEL E. DREW, Griffith University
Email: michael.drew@griffith.edu.au

Lifecycle funds offered to retirement plan participants gradually reduce their exposure to stocks as they approach the target date of retirement. We show that such deterministic switching rules produce inferior wealth outcomes for the investor compared to strategies that dynamically alter the allocation between growth and conservative assets based on cumulative portfolio performance relative to a set target. The dynamic allocation strategies proposed in this paper exhibit almost stochastic dominance (ASD) over strategies that switch assets unidirectionally without consideration of portfolio performance.

CRAIG COPELAND, Employee Benefit Research Institute (EBRI)
Email: COPELAND@EBRI.ORG

Target-date funds (also called "life-cycle funds") are a type of mutual fund that automatically rebalances its asset allocation following a predetermined pattern over time. They typically rebalance to more conservative and income-producing assets as the participant's target date of retirement approaches. Of the 401(k) plan participants in the EBRI/ICI 401(k) database who were found to be in plans that offered target-date funds, 37 percent had at least some fraction of their account in target-date funds in 2007. Target-date funds held about 7 percent of total assets in 401(k) plans and the use of these funds is expected to increase in the future. The Pension Protection Act of 2006 made it easier for plan sponsors to automatically enroll new workers in a 401(k) plan, and target-date funds were one of the types of approved funds specified for a "default" investment if the participant does not elect a choice.

This paper investigates the percentage of participants investing in target-date funds in 2007 across various demographic characteristics. Furthermore, it determines whether the entire account balance is allocated to target-date funds for those who invest in them. To control for the potential differences that are likely to result from those defaulted into the funds by automatic enrollment versus those actively choosing the funds, those who can be proxied as being auto-enrolled are compared with those who are not proxied as being auto-enrolled. Moreover, equity allocations outside of the target-date funds are studied both at the aggregate level of the target-date year and at the individual target-date fund level. Overall asset allocation to equities is also investigated, by comparing the equity for those who did not use target dates, those who have only some of their assets in target-date funds, and those who have all of their assets in target-date funds.

GREGORIO IMPAVIDO, International Monetary Fund (IMF), World Bank
Email: gimpavido@imf.org
ESPERANZA LASAGABASTER, World Bank
Email: Elasagabaster@worldbank.org
MANUEL GARCIA-HUITRON, World Bank
Email: mgarciahuitron@worldbank.org

The low performance of mandatory DC pensions exposes these industries to reversal risk as it has recently happened in Argentina. This report claims that the design of industrial organizational forms and default investment options are crucial to exploit behavioral biases stemming from consumer inertia and to reduce administrative fees and increase expected gross rates of returns. This report investigates the tradeoffs of policies aimed at offsetting consumer inertia and increasing net rates of returns of mandatory DC plan mangers. Finally, this report puts forward policy recommendations to improve the design of industrial organizational forms and the design of default investment options.

ALISTAIR BYRNE, University of Edinburgh - Business School
Email: alistair.byrne@ed.ac.uk
DAVID P. BLAKE, City University London - Cass Business School - The Pensions Institute
Email: d.blake@city.ac.uk
GRAHAM MANNION, PensionDCisions
Email: graham.mannion@pensiondcisions.com

In this paper we use a private dataset to examine the contribution and investment decisions made by members of a large UK-based DC pension plan. We find that many employees appear to be relatively financially-sophisticated and follow approaches consistent with economic and financial theory in terms of savings rates and investment strategies. However, there are also many less sophisticated employees who stick with plan default arrangements and/or follow simple rules of thumb in saving and investing. The challenge for corporate sponsors of pension funds is in designing pension plans and communication strategies that reduce the chances of these less sophisticated plan members making mistakes. The results in this paper highlight the areas where mistakes are made and the demographic profile of members most in need of help.

GENG LI, Federal Reserve Board
Email: Geng.Li@frb.gov
PAUL A. SMITH, Federal Reserve Board of Governors
Email: paul.a.smith@frb.gov

Despite news reports suggesting a rise in 401(k) borrowing in recent years, we find that the share of eligible households with 401(k) loans in the 2007 Survey of Consumer Finances was about 15 percent, roughly what it has been since 1995. We find that the best predictors of 401(k) borrowing appear to be the presence of liquidity or borrowing constraints and the size of 401(k) balances relative to income. Since the ongoing financial crisis has likely caused these factors to move in opposite directions, the predicted effect of the crisis on 401(k) borrowing is ambiguous. More fundamentally, we find that many loan-eligible households carry relatively expensive consumer debt that could be more economically financed via 401(k) borrowing. In the aggregate, we estimate that such households could have saved as much as $5 billion in 2007 by shifting expensive consumer debt to 401(k) loans. This would translate into annual savings of about $275 per household-roughly 20 percent of their overall interest costs-with larger reductions for households that carry consumer debt at high interest rates or who hold larger 401(k) balances. We posit that households might utilize 401(k) loans less than expected due to risk-aversion, self-control problems, and confusion about the potential gains, and suggest better financial education that clarifies the conditions under which 401(k) borrowing is advantageous. Finally, we note that allowing households to repay 401(k) loans gradually even after separation from their employers could improve household welfare by reducing the risks of 401(k) borrowing.