Abstract
Ageing population and economic crisis have placed pay-as-you-go pension systems in need of mechanisms to ensure its financial stability. In this paper, we consider optimal indexing of pensions as an instrument to cope with the financial imbalances typically found in these systems. Using dynamic programming techniques in a stochastic continuous-time framework, we compute the optimal pension index and portfolio strategy that best target indexing and liquidity objectives determined by the government. A numerical example is provided to illustrate the results.
Highlights
Over the last two decades we have witnessed a far-reaching wave of reforms in Social Security Systems around the world, in developed economies, due to the growing financial imbalances emerging into their systems
General theory on pensions systems tend to formulate models that are in immediate equilibrium in terms of liquidity or solvency
Governments might prefer to borrow funds, in times when the cost of debt is small, and gradually delay the implementation of policies that might hurt the generosity of the pension system
Summary
Over the last two decades we have witnessed a far-reaching wave of reforms in Social Security Systems around the world, in developed economies, due to the growing financial imbalances emerging into their systems. The focus of governments to balance pension systems by controlling pension expenditure has led regulators to replace the usual indexing of pensions to the Consumer Price Index (CPI) for new methodologies These new methods take into account economic and demographic variables to automatically establish a value of existing pensions so that expenditure matches available funds. This is the case of the 2013 Spanish’s pension reform, where each year the value of existing pensions is indexed according to the result of a formula meant to ensure a budget equilibrium (a comprehensive analysis of this aspect of the Spanish reform can be found in Roch et al, 2017).
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