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The behavioral justification for public pensions: a survey

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Abstract

Unfunded public pension systems are primarily justified on grounds that many individuals lack sufficient capacity to appropriately save for retirement. We begin with a review of the known principle that a standard life-cycle/permanent-income consumer who discounts the future at an exponential rate can benefit from an unfunded public pension system only if the internal rate of return exceeds the private rate of return. However, a pay-as-you-go program with a below market internal rate can in fact improve lifetime utility if the consumer misestimates social security benefits, uses a hyperbolic discount function rather than the exponential function, uses a short planning horizon, behaves impulsively, or if a fraction of the population do no saving at all. A literature has consequently arisen to study how severe these behavioral defects need to be in order to justify a pay-as-you-go program. We survey this literature, and we conclude that the results are highly mixed as to whether an unfunded public pension that earns a below-market internal rate of return can be justified on grounds of shortsightedness in model economies. The challenge for this literature is that the conclusions crucially depend on the particular values of the preference parameters that are used in the simulation experiments, and these preference parameters are not observable, nor is there much consensus concerning the values that should be used in simulations. In fact, even when the analysis is confined to a small and reasonable space of the unobservable preference parameters, it is possible to reach nearly any policy conclusion. We offer some guidance for future work in this area.

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Notes

  1. Throughout this paper we refer to the terms public pension, social security, and social insurance, to equivalently denote a government-managed retirement support program with compulsory participation.

  2. It should be noted that in addition to a myopia justification (as represented by the character of Jack), Musgrave (1968) also characterizes the possibility of a moral hazard basis for social security in the form of a prudent, yet potentially free-riding, Homer. Musgrave states, “the very guarantee that minimum income payments will be received when needed gives an incentive (under the budgetary system) not to provide for old age and not to insure. Even Homer, though potentially prudent, will try to maximize his consumption over time by creating situations of need” (p.27). Such a moral hazard justification for social security is beyond the scope of this survey, but see Kotlikoff (1987, 1989) and Homburg (2000) for more on this idea. Also, see Blinder (1988) and Boadway and Cuff (2005) for a survey of other possible justifications for social security in addition to that of shortsighted behavior.

  3. There is a significant body of literature suggesting that many individuals do indeed fail to save adequately for retirement (Bernheim et al. 2001; Akerlof 2002; Thaler and Benartzi 2004; and Choi et al. 2006; among many others).

  4. See Speight (1989) and Deaton (1992) for more on the Life-Cycle and Permanent-Income Hypotheses.

  5. This setup for b(t) implies a balanced social security budget. The U.S. system has been collecting surpluses of tax revenues at least since 1983 (Smetters 2004). These surpluses have been lent to the U.S. Treasury at interest (the total sum of which has been labeled the “Social Security Trust Fund”). There is an ongoing debate about whether the Trust Fund can be considered a real asset. For more on this discussion see Elmendorf and Liebman (2000), Smetters (2003, 2004), Diamond and Orszag (2004, 2005), and Diamond (2006).

  6. Feldstein (1985) employs a two-period OLG model and shows that the internal rate of return on unfunded social security equals the rate of real wage growth plus the rate of population growth plus the product of the two rates. The internal rate of return in Eq. 7 cannot be solved explicitly as in the two-period model, but numerical calculations easily show that the internal rate of return is positively related to the rate of real wage growth and to the ratio of workers to retirees (which is positively related to the rate of population growth), and so the setting that we use is qualitatively consistent with Feldstein’s model.

  7. See Huang and Caliendo (2007) for a survey of empirical estimates.

  8. See Laibson (1997) and the references therein.

  9. Recall that in Feldstein’s paper the individual discounts the future in making decisions, but “true” utility is the non-discounted sum of period utility.

  10. For example, the Health and Retirement Study and the Survey of Consumer Finances indicate that nearly 90% of Americans have planning horizons that are at least this short.

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Acknowledgement

We thank Jim Payne for comments and suggestions.

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Authors and Affiliations

  1. Department of Economics, University of New Mexico, Albuquerque, NM, USA

    T. Scott Findley

  2. Department of Economics and Finance, Utah State University, Logan, UT, USA

    Frank N. Caliendo

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  1. T. Scott Findley
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  2. Frank N. Caliendo
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Correspondence to T. Scott Findley.

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Findley, T.S., Caliendo, F.N. The behavioral justification for public pensions: a survey. J Econ Finance 32, 409–425 (2008). https://doi.org/10.1007/s12197-008-9036-4

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