Pension reform in an OLG model with heterogeneous abilities

Abstract We study the effects of pension reform on hours worked, human capital, income and welfare in an open economy populated by four overlapping generations: three active generations (the young, the middle aged and the older) and one generation of retired. Within each generation we distinguish individuals with high, medium or low ability to build human capital. Our simulation results prefer a pay-as-you-go pension system with a particular earnings-related linkage above a fully-funded private system. This pay-as-you-go system conditions pension benefits on past individual labor income, with a high weight on labor income earned when older and a low weight on labor income earned when young. Uncorrected, however, such a system implies welfare losses for current low-ability generations and rising inequality. Complementing or replacing it by basic and/or minimum pension components is negative for aggregate employment and welfare. Better is to maintain the tight link between individual labor income and the pension also for low-ability individuals, but to strongly raise their replacement rate. An additional correction improving the welfare of low-ability individuals would be to maintain for these individuals equal weights on past labor income.