On intergenerational risk sharing within social security schemes

Abstract

Pay-as-you-go (PAYG) schemes entail beneficial risk sharing and diversification features in multi-pillar pension systems. Depending on the pension formula these features vary, however, significantly for different types of PAYG schemes. We derive individually most-preferred PAYG rules, represented by a risk-sharing parameter, for young and old members of a society. Preferences depend on the correlation between the risks of the PAYG scheme and the return risk of a funded scheme and on expectations about the durability of the pension rule. We find that the generations' interests with respect to the optimal PAYG rule typically do not fully clash, in particular if future economic conditions are expected to be similar to today's. We discuss the implications of these findings for the political economy of pension systems, offering an explanation why one typically observes “mixed” PAYG rules in reality.