Optimal Illiquidity

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 percent, and (iii) an account with an early withdrawal penalty of ≈ 10 percent. 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 percent penalty. The socially optimal allocations to these accounts and the predicted equilibrium flows of early withdrawals – “leakage” – also match the U.S. system.