Public pensions reforms: Financial and political sustainability

Abstract

One main reason for the unsustainability of future pensions in many European countries is a failure to adapt to very long-term demographic trends. Also, a reform to address financing issues can be an occasion to improve pension design. Sometimes, however, such pension reforms are likely to be overturned when they lead to significant short-term losses in retirement income. We use an overlapping generations economy with incomplete insurance markets to show that, with an appropriate design, sustainable pay-as-you go systems can greatly outperform current outdated pension systems. We show this in a calibrated model of the Spanish economy, since Spain is a fairly extreme case of the aforementioned failures to introduce a dynamic pension design to deal with an ageing population. Moreover, by comparing the effect of its ageing transition under these different pension systems, we also show how a fast transition, from the current to a reformed PAYG system can be Pareto-improving, while minimizing the risk of political reversal.