Designing the Pension System: Conceptual Framework

Abstract

This paper develops an analytical framework for the design of pension systems, taking the functions of the pension system as the guiding principle. It discusses the economic principles underlying these functions and their implementation in practice. In particular, it distinguishes three functions: facilitating life-cycle financial planning; insuring idiosyncratic risks and sharing macroeconomic risks across generations. The first function concerns consumption smoothing over the life cycle, taking into account individual circumstances and preferences. The second function concerns pooling of intragenerational risks in the face of imperfect insurance markets. The third function concerns intergenerational risk sharing of systemic or ‘macroeconomic’ shocks in the face of incomplete markets. As regards the latter function, the relevant market imperfections are the limited tradability of human capital and the lack of markets to trade risks with future generations.