The transition to a multi-pillar pension system: the inherent socio-economic anomaly

Abstract

Purpose This paper aims to analytically show that in an over-lapping-generation (OLG) model, low earning cohorts bear unwanted risk and absorb higher economic cost than high earning cohorts do. Design/methodology/approach This paper aims to consider the individual's risk appetite, using a simple utility function, based on consumptions and discount rates in each period. This paper calibrates the model according to teh Israeli pension system as a representative of a small open developed organization for economic cooperation and development country. Israel is considered as unique case study in the pension landscape, as it implements almost pure defined contribution pension scheme with continuous trend of pension market capitalization (Giorno and Jacques, 2016). Hence, this study finds Israel suitable for examining the theoretical mix of pension scheme. That model enables exploring combined solutions for adequate old age benefits, involving the first and the second pension pillars, under fiscal constraints. Findings It comes out that for risk-averse individuals, the optimal degree of funding is negatively correlated to asset returns' volatility and positively correlated to earning decile level. The neglect of risk and individual's current earning level will thus overstate the contribution level and funded percentage from total contributions. Moreover, even in an economy with minimum government intervention, and highly developed private pension fund with high average of rate of return, the authors find it is optimal that the pension system contains a sizeable unfunded pillar. This paper innovates by revealing a socio-economic anomaly in design of mix pension systems in favor of high earning cohorts on the expense of economic loss of low earning cohorts. Practical implications The model presented in this paper could be implemented in countries with mix pension systems, as an alternative to public social transfers or means tested, alleviating poverty and inequality in old age. Additionally, this model could raise the public awareness of the financial sustainability of the unfunded pay-as-you-go pillar to diversify financial risk in pension systems, especially for low earning cohort in society. Social implications One area of research that is particularly relevant in this context concerns the issue of alleviating poverty and income inequality. It is often stressed that the prevention of old age poverty is among the central targets of well-designed pension system (Holzmann and Hinz, 2005). The conceptualization of minimum pension guarantee used in this composition allows to clearly capturing the notion of such a poverty and social targets as an integral part of the pension system rolls. Originality/value This paper innovates by revealing a socio-economic anomaly in design of mix pension systems in favor of high earning cohorts on the expense of economic loss of low earning cohorts. That comes to realize through the level of total contribution rates and funded share that are generally optimal for high earning cohorts but not for low earning cohorts. This paper identifies that the effect of anomaly is most significant in a market characterized with high income-inequality level. This paper finds that imposing intra-generational risk sharing instrument in the form of minimum pension guarantee can re-balance pension design among different earning cohorts. This solution demonstrates balancing effect on the entire economy.

Moving toward funded pension scheme: Pure economic argument due to population aging or responsibility abdication of governments?

“…That variety of actors throughout its length and breadth may represents the entire government perspective. By that, we continue Altiparmakov (2018) and Wolf and Ocerin (2021), who suggest that stable pension system must seek for an equilibrium between earning cohorts. Otherwise, the chances are high for pension reforms and reversals (Ortiz et al 2018;Naczyk & Domonkos, 2016).…”

“…Wolf and Caridad (2021) have shown that by shifting to funded pension scheme socio economic anomaly exists because of the high exposure of low earning cohorts to market and credit risk without the ability to hedge themselves. They also claim that the optimal contributions rates are generally close to high earning preferences (see also Wolf and Ocerin, 2021). In that case the funded pension market should be included an 'Externalities', where high earners compensate low earners by risk sharing.…”

“…Rates of returns are uncertain (ex-ante expected utility). GDP per capita growth rate approximates the aggregate wage income, following the same method of Masten and Thorgesen (2004), Wolf and Ocerin (2021). We also assume that the real PAYG rate of return, 𝑔 𝑠+1 , is equal to the growth rate of wages or the change in the GDP per capita.…”

The Expectation for Pension Insurance in Funded Schemes: Theoretical Model and Global Implementation

“…That tendency is crucial when the individuals' accumulations are not high. Using simulations of the utility function, Wolf and Ocerin (2021) found that low-earning cohorts wish to avoid extensive exposure to market risk in their old age benefits.…”

Political Stress and the Sustainability of Funded Pension Schemes: Introduction of a Financial Theory

“…After recognizing the gap between financial positions, this paper offers an equilibrium satisfying multi player game by intra-generational risk sharing. Thus, this paper may be included in the literature on risks in pension schemes (Wolf and Caridad y Ocerin 2021;Wolf and Caridad y Lopez Del Rio 2021a;Chen et al 2014).…”