Optimal Illiquidity

John Beshears, James Choi, Christopher Clayton, Christopher Harris, David Laibson, Brigitte Madrian

NBER Retirement Research Center Paper No. NB 17-02
Issued in September 2017

We calculate the socially optimal level of illiquidity in a stylized retirement savings

system. We solve the planner’s problem in an economy in which time-inconsistent

households face a tradeoff between commitment and flexibility (Amador, Werning and

Angeletos, 2006). We assume that the planner can set up multiple accounts for

households: a perfectly liquid account and/or partially illiquid retirement savings

accounts with early withdrawal penalties. Revenue from penalties is collected by the

government and redistributed through the tax system. We solve for the socially optimal

values of these penalties, and the socially optimal allocations to these accounts. When

agents have heterogeneous present-biased preferences, the socially optimal system has

three accounts: (i) a liquid account, (ii) an account with an early withdrawal penalty of ≈

100%, and (iii) an account with an early withdrawal penalty of ≈ 10%. With

heterogeneous preferences, the socially optimal retirement savings system in our stylized

model looks surprisingly like the existing U.S. system: (i) a liquid account, (ii) an illiquid

Social Security account (and defined benefit pensions), and (iii) a 401(k)/IRA account

with a 10% penalty. The socially optimal allocations to these accounts and the predicted

equilibrium flows of early withdrawals – “leakage” – also match the U.S. system.

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