Assessing Social Security Reforms under Uncertainty

The Thesis analyzes the insurance provided by pension systems against macroeconomic and demographic risks. This purpose is accomplished by simulating individual life-cycle behaviors in a steady-state partial equilibrium model with uncertainty on wages, financial market returns and life expectancy, calibrated so as to reproduce stylized facts of the Italian economy. In particular, stochastic (macroeconomic and demographic) variables, such as wages, financial market returns, social mobility and survival probabilities follow processes that have been estimated based on available data for Italy, mostly over the period 1990-2004. The Thesis is composed of three essays. The first two papers focus on comparing the insurance provided against wage-related risk by a typical Defined Benefit pension system (modeled according to the old Italian pension scheme before the 1992 Amato reform), providing benefits based on the risky wages earned in the last years before retirement on the one hand; and a typical Notional Defined Contribution system (modeled according to the new Italian pension scheme introduced by the 1995 Dini reform), providing benefits based on all working-life contributions, capitalized at a “notional” rate of return i.e. the growth rate of the economy, on the other hand. The first paper considers a model with a representative individual facing uncertainty on aggregate wages and financial market returns as well as mortality risk. The new NDC Italian pension system turns out to improve “ex-ante” individual welfare (namely, individual welfare measured at the beginning of lifetime) with respect to the old DB scheme, from a purely risk-insurance perspective. This relative gain stems from the new regime pooling a longer series of risky wages in computing benefits, thereby yielding a better wage-risk diversification which causes a reduction (in expected terms) in the variance of pensions. The second paper extends the scope of the analysis by considering a model with heterogeneous agents belonging to different social (i.e. labor-income) classes, facing uncertainty on class-specific wages and stochastic intra-generational social mobility during working life, besides riskiness related to financial market returns and life expectancy. In this setting the previous result reverses, in that the new NDC system turns out to decrease welfare in “ex-ante” terms with respect to the old DB system from a purely risk-insurance perspective, for individuals belonging to all social classes. This result is due to the fact that the new pension scheme causes a higher correlation between pensions (the social security “asset”) and working-life wages (deemed as a proxy for “human capital”), thereby increasing the overall uncertainty individuals are confronted with during their whole lifetime. Such effect prevails (therefore yielding a welfare loss) as a substantial part of the overall wage uncertainty stems from stochastic social class mobility. Generally, social security in the model (under both the old and the new system) is slightly desirable only for individuals whose labor income conditions worsen during working life, in terms of individual welfare being measured after agents discover the final social class in which they have ended up. The analysis of the third paper overall investigates the determinants of the individual choice of contributing to supplementary private pension funds, by evaluating the effects of the latest (2004) pension reform in Italy on the behavior of a representative agent facing uncertainty on aggregate wages, financial market returns and life expectancy. The 2004 reform let individuals choose between contributing to two alternative complementary schemes (each in addition to the mandatory contribution to the public social security system), namely the firm-based severance pay scheme (the so-called TFR) on the one hand, and complementary private pension funds on the other hand. Investing in pension funds turns out to be slightly welfare improving with respect to contributing to the severance pay scheme in the model. This result is uniquely due to the fact that pension funds offer a preferred risk-return combination, since individuals in the model generally turn out to prefer receiving the capitalized amount in lump-sum fashion at retirement (as under the severance pay scheme) rather than in the form of annuities from retirement onwards (as under pension funds). The preference towards lump-sum i.e. more liquid retirement assets, despite supplementary private annuities providing insurance against longevity risk (namely the risk of workers outliving their savings after retirement), is due to two main reasons: a) the pre-existence of (sizeable) public annuities, reducing the relative value of additional longevity-risk insurance from private pensions; and b) the convenience of investing considerable resources (out of a lump-sum payout) in rewarding financial markets upon retirement.