Pension reform in a worst case scenario: public finance versus political feasibility

Abstract

AbstractThis paper uses a quantitative overlapping generation model to suggest a pension reform able to sustain a retirement system, in the face of deep demographic changes. We derive the reform design from an optimization program that selects one or more policy instruments – and their values – among a predefined set, to minimize the welfare loss of the median voter while keeping sound public finances, sustaining gross domestic product growth and considering the welfare of the newborn generation. We calibrate the model to the Luxembourg economy. The European Commission (2012) forecasts that, among all euro area countries, Luxembourg will experience the largest increase in pension costs between now and 2060. Our simulations show that a single instrument reform would imply severe backlashes on the rest of the economy. The suggested pension reform instead consists of a policy mix including taxation, benefits and the effective retirement age. We stress the need to design pension reforms based on optimization programs that lead to the achievement of desired targets. Indeed, the reform implemented by the Luxembourg government in 2013, which does not result from an optimization program, will not keep public finances sound over the medium term.