Participation in Tax-Favored Savings Plans: Are Household Portfolios Optimal?

Since the early nineties, the Dutch tax system allows for a tax-favored form of risk free savings through employer-sponsored savings plans (ESSPs). Under certain conditions and up to a certain amount, the contributions to this plan are tax-deductible, and the returns as well as the withdrawals are tax-free. This makes these plans extremely attractive, with real after-tax returns by far exceeding the returns to other financial assets such as risk free saving accounts or stocks and bonds. Thus basically everybody who has access to this type of savings should participate in them, as soon as they have some financial wealth which they can allocate to their own choice. Moreover, unless their liquid financial wealth is too small, households should typically hold the maximum amounts to which the tax incentives apply. In this paper, we analyse household data on access to and participation in these tax-favored employer sponsored savings plans. In particular, we investigate the relationship between the ownership decision of those who have access to the asset and background characteristics. We find evidence that liquidity contraints play an important role. On the other hand, we also find some evidence of irrational portfolio behavior. In particular, regular smokers too often do not hold the asset. Thus the results of this paper question the assumption of rational financial decision making, which is typically maintained in theoretical as well as empirical work on savings and portfolio choice.