Studying the equilibrium of pension designs when shifting to funded pension schemes: economic theory and links to political factors

Abstract

In this paper, we explain the evolution of pension systems due to political pressure. Such pressure has led to pension reversals in recent years in many of the countries of Central East Europe (CEE) and Latin America. We base our theory on exchange options and finance positions. We show that during the transition to a funded pension scheme, high earners benefit from the change, while the low earners' position worsens. This type of unstable position will eventually lead to pension reversals. We suggest the minimum pension guarantee as a mechanism to create a financial equilibrium to stabilize the pension market. Based on the option characteristics, we analyse the boundaries of that equilibrium. We find that high-income inequality and poverty foster the convergence to a mixed pension scheme or the implementation of a minimum pension guarantee. In the second part of this paper, we show how the minimum pension guarantee has accounted for a major part of the pension designs across OECD countries. Funded schemes that did not implement an unfunded mechanism were reversed to put more weight on unfunded pillars. SUPPLEMENTARY INFORMATION: The online version contains supplementary material available at 10.1007/s43546-022-00236-z.