Designing Mandatory Pension Plans

Abstract

Numerous countries have established mandatory pension savings schemes characterized by a predetermined contribution rate, investment strategy, and retirement payout policy. We set up a life-cycle model in which we can (i) evaluate the lifetime utility of a participating individual for any given mandatory savings scheme and (ii) determine the optimal design of the savings scheme. When the individual is rational and has access to the same investment opportunities as the pension fund, we show that typical pension scheme designs substantially reduce welfare but that an optimal pension design can marginally improve welfare through the more lenient return taxation on pension savings. However, we also find that a well-designed mandatory pension plan can substantially improve the welfare of individuals who either do not privately invest in stocks at all or only in an undiversified stock portfolio, or who procrastinate on retirement savings.

Keywords: retirement savings, life cycle, consumption, investment, non-participation, under-diversification, procrastination

JEL Classification: D91, G11, D14, E21, J32