A Two-Step Mixed Pension System: How to Reinvent Social Security with the Help of Notional Accounts and Term Annuities

Abstract

The change in economic and sociodemographic reality, characterized by a continuous increase in longevity, the consequences of the economic crisis, and the lack of adequate adjustments of social security retirement pension systems everywhere, entails risks for workers and the social security systems themselves. Many reforms of public pension systems have been carried out in recent years, based on modifying system parameters and structural changes. Some reforms aim at increasing capitalization in the determination of the final pension through a life annuity to complement the public retirement pension as a second retirement income. Against the background of the change of agents’ behaviors throughout the life cycle and the presence of an adverse selection problem in the annuities market, we describe in this paper a two-step mixed pension system that tries to solve the pressure that increasing longevity is putting on pension schemes to provide adequate and sustainable pensions for all. In our two-step mixed system, when workers reach their ordinary retirement age they receive a term annuity generated by their previous capitalized savings to be replaced by a social security defined contribution pure life annuity when the so-called grand age is reached. The analysis is carried out from an individual perspective, through the internal rate of return that workers will receive after ordinary retirement in both schemes compared with the one they would get with the same contributions in the current situation. We also analyze some possible transition strategies to the new system.

Keywords: Retirement Planning, Social Security, Retirement Pension Systems

JEL Classification: G10, G11