LONGEVITY AND PUBLIC OLD-AGE PENSIONS

I. INTRODUCTION Conventional economic analysis of intertemporal or intergenerational resource allocation takes longevity as exogenously determined by biological or technological factors. Within this framework, the institution of a mandatory public old-age pensions of a pay-as-you-go type unambiguously reduces capital accumulation. The intuition behind this result is that when the young expect an old-age pension after retirement and at the same time pay an earmarked payroll tax that lowers disposable income, the ability and the incentive to save are reduced. Such a result, however, ignores the possibility that an individual who has a survivorship-contingent title to an old-age pension might use resources to increase the likelihood of survival to acquire the promised pension. The fact that over the past century both longevity and the size of old-age pensions have risen suggests that a more complete model that incorporates longevity as a choice variable may be useful in understanding the simultaneous increase in longevity and old-age pensions. Ehrlich and Chuma (1990) consider the demand for longevity in a world where the certain length of life is a fixed function of health care expenditures, thus making longevity endogenous. In their model, consumers choose the optimal depreciation rate for human capital by choosing the path of health care expenditures. Their work paves the way for consideration of the effect of longevity contingent property rights on behavior. In a more recent paper, Philipson and Becker (1998) build on the work of Ehrlich and Chuma by modeling longevity-contingent claims in the form of old-age pensions. Among other things, they find that an increase in a longevity-contingent old-age pension will induce individuals to live longer. As a result of this longer life, Philipson and Becker question the traditional result that pay-as-you-go old-age pensions always reduce the capital stock because workers who choose greater longevity may also choose to save more during their working years to finance their longer retirement period. In this paper we introduce endogenous and uncertain lifetime into a two-period overlapping generations (OLG) model. We depart from the traditional Diamond-type OLG model by measuring longevity as the probability of survival into the second period and by allowing individuals to affect their survival probability through spending on longevity extending activities. Within this framework, we examine the effects of a pay-as-you-go old-age pension on longevity and capital accumulation under two polar assumptions concerning the existence and absence of a fair intragenerational annuity market. In either case, the longevity effect of an increase in the old-age pension is neutral while the capital stock effect is strictly negative if the interest rate and population growth rate are equal (e.g, if the economy is on a golden rule path). Surprisingly, increasing the old-age pension produces both a negative longevity and savings effect for the more relevant case where the interest rate is larger than the population growth rate. That an increase in the old-age pension produces a negative capital stock effect is anticipated, but the neutral or negative effect on longevity is counterintuitive. It is counterintuitive because the empirical evidence seems to show lockstep increases in both longevity and government-provided retirement benefits in the form of pensions and heath care benefits. Furthermore, longevity insurance conjures up the moral hazard problem where increased utilization is expected. With government provision, the funding pool expands with use; the cost being borne by workers. The fact that the workers bear the burden of increasing the old-age pension helps explain the longevity results we obtain. When the population grows at the same rate as the return on capital, an increase in the pension is offset by a dollar-for-dollar reduction in private savings, leaving second period consumption unchanged. …