Optimal Design and Regulation of Funded Pension Schemes

Abstract

This paper reviews the literature on the optimal design and regulation of funded pension schemes. We first characterize optimal saving and investment over an individual’s life cycle. Within a stylized modeling framework, we explore optimal individual saving and investing behavior. Subsequently, various extensions of the model are considered, such as additional financial risk factors, stochastic human capital and more elaborate individual preferences. We then turn to the literature on intergenerational risk sharing, which suggests that a long-lived entity such as a pension fund or the government can yield ex-ante welfare gains by allowing non-overlapping generations to trade risk. The scope for this type of intergenerational risk sharing, however, is limited by the ability to commit generations to the contract. These commitment problems raise concerns with respect to sustainability and intergenerational fairness. We explore the role of solvency regulations to address these concerns about intergenerational fairness and discontinuity risk.

Keywords: Saving, investment, life cycle, pension schemes, risk sharing, commitment problem, discontinuity risk

JEL Classification: D91, G11, G23