DP3330 Aggregate Risk, Political Constraints and Social Security Design

Author(s): Marcello D'Amato , Vincenzo Galasso

Publication Date: April 2002

Keyword(s): fully funded , political bailout , moral hazard

JEL(s): D72 , H55

Programme Areas: Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP3330.asp

In a stochastic environment, with political constraints, we analyse the behavior of a fully funded system, whose portfolio is composed of a risk free and a risky asset. When an aggregate negative shock hits, a large share of the wealth of the elderly is wiped out and office-seeking policy-makers ‘bail them out,’ by instituting a long-lasting PAYG system. Under these political constraints, a fully funded system suffers from a moral hazard problem, since agents have an incentive to choose a riskier portfolio, which increases the wealth loss associated with the bad state. The introduction of a mixed system reduces the riskiness of the portfolio, which remains however higher than in the case of no policy-maker’s intervention. Furthermore, the early adoption of a mixed system, previous to the occurrence of a negative shock, eliminates the policy-maker’s incentive to intervene, albeit at a high cost. In fact, its unfunded pillar would be larger than the PAYG system introduced in the case of a bad shock. In our dynamically efficient economy, this would amount to impose an extra loss on all future generations.