The effects of rare economic disasters on investment decisions and pension funds

This paper attempts to develop an insight on how economic disasters affect long horizon investment and saving decisions of individuals and what the optimal response of social security should be to counterbalance such major economic shocks. For this purpose, Idevelop a two overlapping generations model in which asset returns are assumed to be log-normally distributed. I take into account the low probability economic disasters of the 20th Century as they dened in Barro’s (2006) Rare Disasters and Asset Markets in the Twentieth Century seminal contribution. I find that, in the absence of Pay AsYou Go scheme, when the disaster’s probability or size increases, individuals reduce their consumption during the working period of their life while they increase the share of their portfolio they invest on government bonds. Interestingly, I conclude that a change inthe disaster’s probability has more severe eects on individual’s investment and savings decisions than a change in the size of the disaster. The introduction of Pay As You Go system seems to partially cancel out the eects of economic disasters and under particularconditions it can be welfare improving.