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Aggregate Risk, Political Constraints and Social Security Design

  • D'Amato, Marcello
  • Galasso, Vincenzo

In a stochastic environment, with political constraints, we analyse the behavior of a fully funded system, whose portfolio is composed of a risk free and a risky asset. When an aggregate negative shock hits, a large share of the wealth of the elderly is wiped out and office-seeking policy-makers ‘bail them out,’ by instituting a long-lasting PAYG system. Under these political constraints, a fully funded system suffers from a moral hazard problem, since agents have an incentive to choose a riskier portfolio, which increases the wealth loss associated with the bad state. The introduction of a mixed system reduces the riskiness of the portfolio, which remains however higher than in the case of no policy-maker’s intervention. Furthermore, the early adoption of a mixed system, previous to the occurrence of a negative shock, eliminates the policy-maker’s incentive to intervene, albeit at a high cost. In fact, its unfunded pillar would be larger than the PAYG system introduced in the case of a bad shock. In our dynamically efficient economy, this would amount to impose an extra loss on all future generations.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3330.

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Date of creation: Apr 2002
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Handle: RePEc:cpr:ceprdp:3330
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