Intergenerational risk sharing and labour supply in collective funded pension schemes with defined benefits

In many countries, collective funded pension schemes with defined benefits (DB) are being replaced by individual schemes with defined contributions. Collective funded DB pensions may indeed reduce social welfare. This will be the case when the schemes feature income-relatedcontributions that distort the labour-leisure decision. However, these schemes also share risks between generations. This adds to welfare if these risks cannot be traded on capital markets.This paper compares the welfare gains from intergenerational risk sharing with the welfare losses that are due to labour market distortions. We adopt a two-period overlapping-generationsmodel for a small open economy with risky returns to equity holdings. We derive analytically that the gains dominate the losses for the case of Cobb-Douglas preferences between labour andleisure. Numerical simulations for the more general CES case confirm these findings which also withstand a number of other model modifications, like the introduction of a short-sale constraintfor households and the inclusion of a labour income tax. These results suggest that collective funded schemes with well-organized risk sharing are preferable over individual schemes, even iflabour market distortions are taken into account.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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