June 7, 2010

Intergenerational risk sharing and labour supply in collective funded pension schemes with defined benefits

Collective funded pension schemes with defined benefits (DB) raise welfare through intergenerational risk sharing, but may lower welfare through distortion of the labour-leisure decision. This paper compares the welfare gains with the welfare losses.

In many countries, collective funded pension schemes with defined benefits (DB) are being replaced by individual schemes with defined contributions. Collective funded DB pensions may indeed reduce social welfare when the schemes feature income-related contributions that distort the labour-leisure decision. However, these schemes also share risks between generations and add to welfare if these risks cannot be traded on capital markets. Do the gains outweigh the losses?

For answering this question, we adopt a two-period overlapping-generations model for a small open economy with risky returns to equity holdings. We derive analytically that the gains dominate the losses for the case of Cobb-Douglas preferences between labour and leisure. Numerical simulations for the more general CES case confirm these findings, which also withstand a number of other model modifications (like the introduction of a short-sale constraint for households and the inclusion of a labour income tax). These results suggest that collective funded schemes with well-organized risk sharing are preferable over individual schemes, even if labour market distortions are taken into account.

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Jan Bonenkamp Read more
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