Optimal Degree of Funding of Public Sector Pension Plans

Abstract

This paper explores the optimal degree of funding of public sector pension plans. It is assumed that a benevolent social planner decides on the contribution of current taxpayers to the funding of public sector pensions next period, weighing the interests of current and future tax payers. Two elements play a role in the optimal funding decision: the optimal-portfolio choice (i.e. the tradeoff between the expected excess return and the additional risk of funding vis-à-vis pay-as-you-go) and intergenerational redistribution (i.e. whether the current generation of tax payers is willing and capable to prefund the pension obligations of current public sector workers or shifts the burden to future generations via a pay-as-you-go scheme). The optimal degree of funding appears to vary over time, depending not only on the relative weight given to the current generation, risk aversion, and the distribution of financial risk and human capital risk, but also on the actual state of the economy, i.e. on wage income, funding in the past and the realization of the excess return on this funding.

Keywords: public sector pension plans, funding, implicit debt, portfolio approach