Labor Income and the Design of Default Portfolios in Mandatory Pension Systems: An Application to Chile

Governments often impose choices regarding the levels of savings and the composition of the portfolio of assets in mandatory pension systems; either the share of pay-as-you-go vs. financial assets or the structure of default portfolios to which a majority of workers stick. Yet, it is well known that the optimal savings rate and the structure of the portfolio of assets depend on individual preferences and the properties of human capital. For example, workers whose labor income is very volatile or is highly correlated with the returns on risky financial assets should tilt their portfolios towards safe assets early in life. In this paper we explore the potential welfare gains derived from incorporating this basic principle into the design of the default portfolios offered by DC pension plans, based on the case of the Chilean pension system. We estimate the properties of labor earnings for several representative individuals, simulate their optimal life-cycle portfolio choices and compare with the current institutional defaults. We find very sizable welfare improvements for several of the groups of workers studied. The results suggest that policymakers should take into account education and occupation when defining portfolio defaults. These principles apply more generally to the choice between pay-as-you-go vs. financial assets – and we argue – could improve incentive for some groups to contribute.