Insurance, Efficiency and the Design of Public Pensions

Government pension spending in advanced economies can be divided into three types: (1) Social Security-style benefits that depend on earnings during working life, (2) subsidies of private pension saving and (3) means-tested income floors provided to the elderly. Using an estimated lifecycle model that accounts for each of these, as well as endogenous labour supply, private savings and realistic uncertainty, this paper investigates the optimal combination of the three approaches. For countries (such as the US and the UK) that currently provide public pensions that depend on career-average earnings, I show that large welfare gains can be obtained by increases in the level of means-tested old-age income floors that are funded by any of reducing public pensions, increasing taxes or (especially) reducing private pension subsidies. While means-tested transfers cause costly distortions, these are more than offset by the value of the insurance they provide against low lifetime earnings potential. The optimality of greater means-tested support is specific to older individuals: I find that such support to younger households should be at a much lower level than that to the elderly. These results imply that governments should provide strong work incentives for the young, but provide pensions with good insurance properties for the old.