Transforming public pensions: A mixed scheme with a credit granted by the state

Birth rates have dramatically decreased and, with continuous improvements in life expectancy, pension expenditure is on an irreversibly increasing path. This will raise serious concerns for the sustainability of the public pension systems usually financed on a pay-as-you-go (PAYG) basis where current contributions cover current pension expenditure. In this paper, we propose, as an alternative solution, that the deficit of the scheme is immediately covered by the state but in return the individuals need to invest an amount of money into a fund. This investment is designed so that the individuals can repay to the state the deficit of the PAYG scheme at a particular level of probability and at the same time provides, on expectation, some gains to individuals. Two different strategies of debt repayment depending on the amount invested and the timing of the repayment to the state are analysed. We compare our results with the direct payment of the contribution that makes the system balanced by the individual. If the investment period is long enough, the optimal strategy tends to be a lump sum debt repayment. Directly covering the deficit of the PAYG is the optimal strategy if the investment period is short and the amount invested is relatively small. For shorter investment intervals and higher investment amounts it might be optimal to use a continuous repayment scheme.