Abstract
When the financial positions of pension funds worsen, regulations prescribe that pension funds reduce the gap between their assets (invested contributions) and their liabilities (accumulated pension promises). This paper quantifies the business cycle effects and distributional implications of various types of restoration policies. We extend a canonical New-Keynesian model with a tractable demographic structure and, as a novelty, a flexible pension fund framework. Fund participants accumulate inflation-indexed or non-indexed benefits and funding adequacy is restored by revaluing previously accumulated pension wealth (Defined Contribution (DC)) or changing the pension fund contribution rate on labor income (Defined Benefit (DB)). Economies with DC pension funds respond similarly to adverse capital quality shocks as economies without pension funds. DB pension funds, however, distort labor supply decisions and exacerbate economic fluctuations. While DB pension funds achieve intergenerational risk-sharing, welfare analyses indicate that the negative effects of the induced distortions are sizeable.
Highlights
The financial positions of pension funds worsened worldwide during the financial crisis of 2008 and the ensuing sovereign debt crisis of 2009
The appeal of inflation-indexed Defined Benefit (DB) pension funds is dampened
This paper has provided an assessment of the business cycle effects and distributional implications of pension fund restoration policy by extending a canonical New-Keynesian dynamic general equilibrium model with a tractable demographic structure and a flexible pension fund framework
Summary
The financial positions of pension funds worsened worldwide during the financial crisis of 2008 and the ensuing sovereign debt crisis of 2009. While DB pension funds (which have been studied in environments without nominal rigidities) are generally considered to be ex ante welfare improving because they bring about intergenerational risk-sharing [see Beetsma and Romp (2016) for an overview] and increase the risk-taking capacity of the economy [Gollier (2008)], our results show that the induced distortions of such systems are sizeable when nominal rigidities are present.
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