Means-testing retirement benefits in the UK: Is it efficient?

We construct a dynamic stochastic general equilibrium model with overlapping generations in order to analyze the optimality of means-testing pension benefits in the UK. While previous studies only consider the long-run welfare effects of alternative policy reforms, we compute the full transition paths and separate aggregate efficiency effects by means of compensating transfers.We first demonstrate that it is qualitatively important to consider transitional cohorts and aggregate efficiency instead of long-run welfare, since the latter approach understates the dramaticsavings distortions arising from means-testing. Our findings indicate that the introduction of the pension credit (PC) was efficiency deteriorating. In order to reduce distortions induced by theUK pension system, benefits should be strictly means-tested against second pillar pension income only and not against private wealth.