Coping With Demographic Change: Macroeconomic Performance And Welfare Inequality Effects Of Public Pension Reform

Demographic change forces governments in all OECD countries to reform the public pension system. Increased sensitivity to rising inequality in society has made the challenge for policy makers only greater. In this paper we evaluate alternative reform scenarios. We employ an overlapping generations model for an open economy with endogenous hours worked, human and physical capital, output, and welfare. Within each generation we distinguish individuals with high, medium or low ability to build human capital. Frequently adopted reforms in many countries such as an increase of the normal retirement age or a reduction in the pension benefit replacement rate can guarantee the financial sustainability of the system, but they fail when the objective is also to improve macroeconomic performance and aggregate welfare without raising intergenerational or intragenerational welfare inequality. Our results prefer a reform which combines an increase of the retirement age with an intelligent design of the linkage between the pension benefit and earlier labour earnings. First, this design conditions pension benefits on past individual labour income, with a high weight on labour income earned when older and a low weight on labour income earned when young. Second, to avoid rising welfare inequality this linkage is complemented by a strong rise in the benefit replacement rate for low ability individuals (and a reduction for high ability individuals).