The Financial Systems of Industrial Countries by Riccardo De Bonis & Alberto Franco Pozzolo

Author:Riccardo De Bonis & Alberto Franco Pozzolo
Language: eng
Format: epub
Publisher: Springer Berlin Heidelberg, Berlin, Heidelberg

5.2 Why Introduce Future Pensions into the System of Accounts?

5.2.1 The Role of Pension Liabilities in the Literature on Household Savings

The main reference to pension liabilities can be found in two branches of the economic literature: the work on household savings and the studies on the sustainability of public finances. In this paper, we keep this distinction, although some papers (and authors) may fall across the two fields. The theoretical framework used to investigate the relationship between pension wealth and household savings is the lifecycle model. The starting point for our purposes can be pinpointed in Feldstein’s work since the late 1960s. Investigating the effects and properties of social security, Feldstein realized that the tests of consumption theory – Friedman’s work on the permanent income hypothesis and Modigliani’s work on lifecycle saving – completely ignored the role of social security even though it had become the major source of retirement income. Moreover, Feldstein noticed that the theory of social security’s effect on saving was more complex than a simple displacement of financial wealth. To the extent that social security induces earlier retirement, it raises the desired level of financial wealth. The net effect of social security on savings, therefore, depends on the balance between two opposite effects: the positive induced retirement effect and the negative wealth displacement effect. It was then clear that the issue could only be settled empirically and that the empirical elements needed to do so should include data on social security “wealth” (the actuarial present value of social security future benefits). Feldstein’s empirical results (updated 22 years later; see Feldstein 1974 and 1996) implied that social security “wealth”, the present actuarial value of future social security benefits, significantly reduced personal savings. The reduction in savings and in the present value of consumption is not the only adverse effect of a pay-as-you-go programme. A second important effect is the distortion of labour supply and of the form in which compensation is paid because of the increase in the marginal tax rate. A third distortion caused by a traditional pay-as-you-go system is the incentive to retire early when an implicit tax results from the loss of benefits caused by delayed retirement. Those elements are also relevant for investigating the welfare implication of the existence, size and financing of social security. In addition, the relationship between pension wealth and household savings is crucial for important policy issues, such as establishing the effects of changes in pension legislation on saving behaviour (Feldstein 2005).

The relationship between pension liabilities and individual consumption can be explained by a simple optimization problem. In the first N-1 periods of their lives, individuals work and receive an exogenous income. In the last period, they retire and receive pension benefits denoted by b. During retirement, in addition to their pension benefits, they can use any savings accumulated during the first periods of their lives. Individuals’ preferences are described by an additively separable utility function. Their optimization problem can be described as:

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