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Should Private Pensions Be Indexed?

  • Martin Feldstein

The analysis in this paper was motivated by the apparent puzzle that, despite substantial uncertainty about future inflation rates, private pensions are almost universally unindexed. Moreover, although a variable annuity invested in short-term money market instruments provides a good inflation hedge, almost all private pensions provide a fixed annuity. The results of the analysis indicate that the existence of unindexed pensions and fixed annuities is not at all surprising. Even without Social Security, it may be optimal to have a completely unindexed private pension and it is generally not optimal to have a completely indexed pension. The availability of an optimal (or greater than optimal) amount of Social Security generally reduces the desired degree of indexing and, under a variety of conditions, makes it optimal to have no indexing at all in the private pension. Because unexpected changes in the price level do not alter the value of Social Security pensions, the existence of inflation uncertainty makes a Social Security pension optimal when it would not otherwise be and an increase in inflation uncertainty is likely to increase the optimal reliance on Social Security. But despite these conclusions, the analysis shows that including some Social Security in an overall pension program is necessarily optimal only when both money market instruments and Social Security have rates of return that are known with certainty. When the real yield on money market instruments is uncertain, the optimal pension arrangement may be a partially indexed private pension even though Social Security is risk-free and has a return that is higher than the expected rate on the money market instruments. Similarly, when Social Security is risky, the optimal arrangement my be to exclude Social Security and to use a partially indexed private pension. In all cases, an individual who has a low enough degree of risk aversion will prefer no Social Security and a completely unindexed private pension.

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File URL: http://www.nber.org/papers/w0787.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0787.

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Date of creation: Oct 1981
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Publication status: published as Feldstein, Martin. "Should Private Pensions Be Indexed?" Financial Aspectsof the U.S. Pension System, edited by Zvi Bodie and John B. Shoven. Chicago: UCP, (1983), pp. 211-230.
Handle: RePEc:nbr:nberwo:0787
Note: PE
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  1. Feldstein, Martin, 1980. "Inflation and the Stock Market," American Economic Review, American Economic Association, vol. 70(5), pages 839-47, December.
  2. Martin Feldstein, 1981. "Private Pensions as Corporate Debt," NBER Working Papers 0703, National Bureau of Economic Research, Inc.
  3. Zvi Bodie, 1979. "Inflation Risk and Capital Market Equilibrium," NBER Working Papers 0373, National Bureau of Economic Research, Inc.
  4. Patric H. Hendershott & Sheng Cheng Hu, 1979. "Inflation and the Benefits from Owner-Occupied Housing," NBER Working Papers 0383, National Bureau of Economic Research, Inc.
  5. Mishkin, Frederic S, 1982. " Monetary Policy and Short-Term Interest Rates: An Efficient Markets-Rational Expectations Approach," Journal of Finance, American Finance Association, vol. 37(1), pages 63-72, March.
  6. Zvi Bodie, 1980. "Purchasing-Power Annuities: Financial Innovation for Stable Real Retirement Income in an Inflationary Environment," NBER Working Papers 0442, National Bureau of Economic Research, Inc.
  7. Jeremy I. Bulow, 1981. "Tax Aspects of Corporate Pension Funding Policy," NBER Working Papers 0724, National Bureau of Economic Research, Inc.
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