Macroeconomic and welfare implications of different pension benefit arrangements

We analyze the trade-off among insurance, labor supply and savings incentives arising in the design of pay-as-you-go (PAYG) pension benefits. We consider two extreme types of pension benefits: i) a at benefit (FL) system that pays the same pension regardless of the amount of previous contributions and ii) a notional defined contribution (NDC) system in which benefits are perfectly linked to previous contributions. The FL system promotes lower labor supply, lower consumption inequality and generally crowds out capital less. If the level of pension contributions is low, the FL system brings a higher welfare due to higher consumption insurance. At higher levels of contributions, the NDC system leads to higher welfare due to lower labor supply distortions. General equilibrium effects tilt the welfare result in favor of FL pensions in dynamically efficient economies. The analysis suggests that pension benefit design should depend on the size of the pension system and the size of idiosyncratic risk. The welfare results can explain the contrasting reforms of pension benefits implemented in different countries, as well as the empirical correlations between pension benefit progressivity, on the one hand, and the size of pension systems and idiosyncratic risk, on the other hand.