How Should Pension Benefits Be Linked to Contributions in Pay-as-you-go Pension Systems?

Abstract:
I compare in terms of macroeconomic outcomes and welfare the current US pension system with the three most widespread types of pension benefit arrangements: i) a flat benefit (FL) system that pays the same pension regardless of the amount of previous contributions, ii) a notional defined contribution (NDC) system in which benefits are based on previous accrued contributions and iii) a defined benefit (DB) system in which pensions are a constant replacement rate times the average life-time earnings. I show that the current US system imposes an implicit tax on continuing to work after the early retirement age that distorts labor supply at the extensive margin substantially. This outweighs the insurance against idiosyncratic shocks provided by the fact that the replacement rate decreases with average lifetime earnings under the current US pension system. Overall, the steady state of the economy with the US pension system is the worst performing in terms of welfare. Welfare is the highest in the steady state with the FL pension system due to the better insurance provided by the system, although labor supply distortions are higher, mainly at the intensive margin. In the case of a higher contribution rate such as the one prevailing in the Italian pension system, the FL system still provides the highest welfare, but the difference compared to the NDC and the DB system is considerably smaller. This is because a higher contribution rate imposes higher labor supply distortions. The NDC and the DB systems are similar in terms of macroeconomic outcomes and welfare. However, the DB system provides a slightly higher labor supply, less insurance against shocks and a slightly higher welfare than the NDC system.