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DISCUSSION PAPER PI-0621

Three Retirement Decision Models for Defined Contribution Pension Plan Members: A Simulation Study

Bonnie-Jeanne MacDonald and Andrew J.G. Cairns

Published: Insurance: Mathematics and Economics, 48 (2010) 1-18

This paper examines the hypothetical retirement behavior of defined contribution (DC) pension plan participants. Using a Monte Carlo simulation approach, we compare and discuss three retirement decision models: the two-thirds replacement ratio benchmark model, the optionvalue of continued work model and a newly-developed “one-year” retirement decision model.
Unlike defined benefit (DB) pension plans where economic incentives create spikes in retirement at particular ages, all three retirement decision models suggest that the retirement ages of DC participants are much more smoothly distributed over a wide range of ages. We find that the one-year model possesses several advantages over the other two models when representing the theoretical retirement choice of a DC pension plan participant. First, its underlying theory for retirement decision-making is more feasible given the distinct features and pension drivers of a DC plan. Second, its specifications produce a more logical relationship between an individual’s decision to retire and his/her age and accumulated retirement wealth. Lastly, although the one-year model is less complex than the option-value model as the DC participants’ scope is only one year, the retirement decision is optimal over all future projected years if projections are made using reasonable financial assumptions.