On the Intergenerational Pareto Efficiency of Pay-as-you-go Financed Pension Systems

In pay-as-you-go financed pension plans, pension payments to the retired are not drawn from a capital fund accumulated during their working lives but financed directly by the contributions of the current workers/contributors (see e.g. AARON (1982, 7)). As SAMUELSON (1958) and AARON (1966) have shown, this financing method can provide every generation of workers with a better internal rate of return on their contributions than a capital funded system if the sum of the growth rates of the population (Samuelson's "biological rate of interest") and of the income per worker exceeds the rate of interest on productive investment. This so-called "Aaron condition" does not, however, give a complete and final answer to the question of the efficiency of financing methods, or, to put it more precisely, the question under what circumstances an intergenerationally Pareto-·efficient allocation of consumption is reached via one or the other method for financing public pensions. The limitations pertain to three different problems. First, both SAMUELSON [1958] and AARON [1966] assumed exogenous wages and interest rate so that the result stated above strictly applies only to a "small" open economy. Secondly, the comparison referred to a pure funded and a pure pay-as-you-go system with constant contribution rate over time, so that the possibility of reaching a Pareto improvement via mixed systems or fluctuating contribution rates was excluded. Thirdly, both authors considered mature systems, i.e., the windfall benefits to the generation founding a pay-as-you-go system did not play a role in their analysis. The first aspect was taken up by SAMUELSON (1975], who showed in a neoclassical growth model for a closed economy that, in the presence of a pay-as-yougo financed pension system, the economy can reach a steady state with higher