Social Security and Inequality over the Life Cycle

This paper examines the consequences of social security reform for the inequality of consumption across individuals. The idea is that inequality is at least in part the result of individual risk in earnings or asset returns, the effects of which accumulate over time to increase inequality within groups of people as they age. Institutions such as social security, that share risk across individuals, will moderate the transmission of individual risk into inequality. We examine how different social security systems, with different degrees of risk sharing, affect consumption inequality. We do so within the framework of the permanent income hypothesis, and also using richer models of consumption that incorporate precautionary saving motives and borrowing restrictions. Our results indicate that systems in which there is less sharing of earnings risk such as systems of individual accounts produce higher consumption inequality both before and after retirement. However, differences across individuals in the rate of return on assets (including social security assets held in individual accounts) produce only modest additional effects on inequality.