The Life Cycle Model with Recursive Utility: Defined benefit vs defined contribution

We analyze optimal consumption and portfolio choice when the agent takes the market as given, with applications to pension insurance. First, we recall the results for the conventional additive and separable expected utility model. We explain why this model is not viable in a temporal context. As a consequence, when confronted with real data this theory meets with several conflicting implications. Second, we consider recursive utility, which in contrast has an axiomatic underpinning in a temporal context. All the anomalies of the expected utility approach that we are aware of, disappear with recursive utility. This we find striking, as it calls for a shift in paradigm. The alternative theory explains why people prefer stable pension plans, like defined benefit, to a mere mutual fund, it removes anomalies in the conventional, optimal portfolio choice theory when confronted with market data, and it solves the celebrated equity premium puzzle. Since the recursive model fits market data much more convincingly than the conventional model, this leaves more credibility to the former representation, and more weight to recommendations based on it.