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Private Pensions and Public Pension Design
Abstract
Government pension spending in developed countries can be divided into three types: (1) Social Security-style benefits that depend on earnings during working life, (2) subsidies of private pension saving and (3) means-tested transfers to retirees. Using an estimated lifecycle model that accounts for these each of these, as well as endogenous labour supply, private savings and realistic uncertainty, this paper investigates the optimal combination of these three approaches. I show, using an optimal taxation framework, that for countries (such as the US and the UK) that currently provide public pensions that depend on career average earnings, large welfare increases can be obtained by increasing means-tested old-age transfers balancing the budget by (any of) reducing the public pension, increasing taxes or (especially) reducing private pension subsidies. While means-tested public pensions cause distortions, I show that the costs of these are more than offset by the value of the insurance they provide against low lifetime earnings potential, poor investment returns and longevity. The optimality of greater means-tested support is specific to older individuals: I find that means-tested support given to younger households should be much lower than that provided to the elderly. These results imply that governments should provide strong work incentives for the young, but provide pensions with good insurance properties for the old.