How Does Pension Reform Affect Savings and Welfare
This paper explores the effects of pension reform on precautionary savings, wealth accumulation and welfare. The impact of pension programs on income uncertainty through life has been largely ignored in the literature of precautionary savings and pension reform. This paper uses dynamic programming techniques to solve for the optimal consumption of a worker that faces uncertainty on labor and retirement income. Subsequently, with parameter values for the U.S., I study the impact of two policies on workers with different on educational levels. One is the elimination of redistribution in the current benefits formula. The second is the change from system defined in benefits (DB) to one defined in contributions (DC). In the first case, results show that redistribution is valued positively by all types of agents, even by those who expect losses from it, given their expected income. As a consequence, workers increase their savings to prepare for the increased uncertainty. The increase in aggregate savings is in the order of 4%. The second case has the opposite consequences. Welfare increases with the adoption of the DC system because it has superior insurance properties. The advantage consists in that periods on which the variance of income is lower receive a higher weight in the calculation of benefits. Precautionary savings are reduced with a fall in aggregate savings of 1.4%.
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