Optimal mix between pay-as-you-go and funding for DC pension schemes in an overlapping generations model

Abstract

Public pension systems are usually pay-as-you-go financed, that is, current contributions cover the pension expenditures. However, some countries combine funding and pay-as-you-go within the first pillar. This article studies a mixed system where a part of the individual’s contribution accrues funded rights whereas the other part accrues pay-as-you-go rights. Diversification conditions between these two financing techniques are derived in a mean–variance framework for two distinct contexts: for a cohort entering the system (named ex-ante case) and for multiple cohorts coexisting at the same period of time (named ex-post case). The diversification benefits in presence of a liquidity constraint which ensures that the income from contributions is sufficient to cover the pension expenditures are also studied. We show that, on the one hand, diversification benefits individuals when the economy is dynamically efficient for the ex-ante case. On the other hand, diversification is unattractive when pay-as-ou-go and funding are positively correlated for the ex-post case.