Mandatory savings, informality and liquidity constraints

Using a national representative survey of households from Peru, this paper characterizes workers' decisions to participate in a pension system, which indicates labor formality. Empirical findings show that a worker's income level has a positive impact on his or her likelihood to participate. To account for these findings, a three-period overlapping generations model with liquid and illiquid assets is implemented. In the model, voluntary participation in the pension system is unattractive to individuals with income under a certain threshold. The retention of illiquid assets, such as pension funds, are not optimal given income constraints. Thus, the liquidity constraint set by a pension system with a mandatory savings policy induces these workers to choose informality.