Abstract
This paper develops an overlapping generations model with stochastic production and incomplete markets to assess whether the introduction of an unfunded social security system can lead to a Pareto improvement, even if the initial equilibrium is neither production-ine±cient in the spirit of Diamond (1965) nor dynamically ine±cient in the spirit of Samuelson (1957). When returns to capital and wages are imperfectly correlated and subject to aggregate shocks, then the consumption variance of all generations can be reduced if private markets or government policies enable them to pool their labor and capital incomes. A social security system that endows retired households with a claim to labor income may serve as an e®ective tool to share aggregate risk between gener
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