Pension Reform in the Presence of Financial Market Risk

Abstract

As their populations grow older, the industrial countries face steep increases in public pension costs. If countries change their pension systems in advance of sharply higher pension costs, it is possible to prepare for the added retirement costs by funding a portion of the future liabilities through increased saving. By boosting capital formation and economic growth, higher saving has the potential to increase the incomes - and the welfare - of future workers and retirees.

This paper considers investment accumulation and pension adequacy in light of financial market risk. We examine two alternative reforms of the U.S. pension system that are aimed at pre-funding part of future pension liabilities and increasing national saving. The first policy expands the role of advance funding in the existing Social Security system by moving toward a policy of tax increases that are large enough to maintain close actuarial balance over a 75-year horizon. Under the alternative policy, the traditional Social Security program adopts pay-as-you-go financing after 2033 and a new system of individual investment accounts is adopted to supplement (reduced) pensions under the traditional system. Advance funding takes place in the new individual investment account system.