A Worker’s Backpack as an alternative to PAYG pension systems

With ageing population and historical trends of low employment rates, pay-as-you-go (PAYG) pension systems, currently in place in several European countries, imply very large economic and welfare costs in the coming decades, threatening the sustainability of these systems. In an overlapping generations economy with incomplete insurance markets and frictional labour markets, an employment fund, which can be used while unemployed or retired can enhance production efficiency and social welfare. With an appropriate design, the sustainable Backpack employment fund (BP) can greatly outperform – measured by average social welfare in the economy – existing pay-as-you go systems and also Pareto dominate a full privatization of the pension system, as well as a standard fully funded defined contribution pension system. We show this in a calibrated model of the Spanish economy, by comparing steady-state economies after the ongoing demographic transition under these different pension systems and by showing how a front-loaded transition from the PAYG to the BP system, ahead of the ‘ageing transition’, can be Pareto improving (i.e. without losers), while minimizing the cost of the reform.