Optimal Design of Means Tested Retirement Benefits

The design of welfare benefits is a tricky business. In this respect, James Meade placed particular emphasis on the importance of avoiding excessive distortions to the price of labour. Nevertheless, Meade noted that means testing in the delivery of welfare benefits is likely to be desirable in view of the 'hideously expensive' cost of universal benefits provision Ñ he conjectured that £1 of benefits lost for every £2 of private income earned might be appropriate. In this study we take a fresh look at the role of means testing in the provision of retirement benefits in the United Kingdom. We use an articulated rational agent model of the household to explore the effects on welfare of alternative budgetary neutral pensions arrangements. We find that extensive means testing of retirement benefits is preferred, consistent with the conjectures stated by Meade. Our analysis highlights the importance of taking into account the distortions associated with alternative methods of benefits financing when considering pensions reform.