How Should Pension Benefits Be Lin ked to Contributions in Pay-as-you-go Pension Systems?
Abstract:
I compare in terms of macr
oeconomic 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 be
nefits are based on previous accrued contributions and iii) a defined benef
it (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 im
plicit tax on continuing to work after the early retirement age that distor
ts labor supply at the extensive margin substantially. This outweighs the i
nsurance against idiosyncratic shocks provided by the fact that the replace
ment rate decreases with average lifetime earnings under the current US pen
sion system. Overall, the steady state of the economy with the US pension s
ystem is the worst performing in terms of welfare. Welfare is the highest i
n the steady state with the FL pension system due to the better insurance p
rovided 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 prov
ides 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 si
milar in terms of macroeconomic outcomes and welfare. However, the DB syste
m provides a slightly higher labor supply, less insurance against shocks an
d a slightly higher welfare than the NDC system.