Optimal strategies for pay-as-you-go pension finance: A sustainability framework

Humberto Godínez-Olivares,María Del Carmen Boado-Penas,Steven Haberman

doi:10.1016/j.insmatheco.2016.05.001

Humberto Godínez-Olivares, María Del Carmen Boado-Penas + Show 1 more

Open Access

https://doi.org/10.1016/j.insmatheco.2016.05.001

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Abstract

The aim of this paper is to design an automatic balancing mechanism to restore the sustainability of a pay-as-you-go (PAYG) pension system based on changes in its main variables, such as the contribution rate, normal retirement age and indexation of pensions. Using nonlinear optimisation, this mechanism, identifies and applies an optimal path of these variables to a PAYG system in the long run and absorbs fluctuations in longevity, fertility rates, salary growth or any other events in a pension system.

Highlights

Public pension systems are usually financed on a pay-as-you-go (PAYG) basis where pensions for retirees are paid by the contributions of the working-age population
The common trend resulting from these events, that negatively affect the financial health of the systems, is a wave of parametric, or even structural reforms, by changing the formula to calculate the initial pension from a Defined Benefit (DB) PAYG to a Notional Defined Contribution (NDC), with the aim of reducing the expenditure on pensions
The expenditure on pensions is increasing in line with the increase in longevity, the forecasts for the ageing of the baby-boom generation and any other random events that negatively affect to the financial health of the system

Summary

Introduction

Public pension systems are usually financed on a pay-as-you-go (PAYG) basis where pensions for retirees are paid by the contributions of the working-age population. The common trend resulting from these events, that negatively affect the financial health of the systems, is a wave of parametric, or even structural reforms, by changing the formula to calculate the initial pension from a Defined Benefit (DB) PAYG to a Notional Defined Contribution (NDC), with the aim of reducing the expenditure on pensions.3 In this respect, Boado-Penas et al (2008) [9] warn that some politicians, researchers and public opinion mistakenly consider the annual cash-flow deficit or surplus to be an indicator of the pay-as-you-go system’s solvency or sustainability; i.e. they confuse an annual liquidity indicator with a sustainability indicator. The functional objective function is set to guarantee that the net present value of the income from contributions is sufficient to cover the pension expenditure in the long run Following this introduction, the section of the paper describes the methodology to compile the actuarial balance with the aim of assessing the sustainability of the system.

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Conclusion