Trade-Offs in Means Tested Pension Design

Inclusion of means testing into pension programs allows governments to better direct benefits to those most in need and to control funding costs by providing flexibility to control the condition for receiving pension benefits (extensive margin) and the benefit level (intensive margin). We investigate how the presence of the extensive margin influences the trade-off between the desirability of protecting low income of the elderly and the economic costs of distorting incentives to work and save of young individuals. We show that the means test effect via the extensive margin improves the insurance aspect but introduces opposing impacts on incentives, and that potentially leads to the positive welfare outcome depending upon how these effects play out. We also characterize combinations of two policy parameters: maximum pension benefit and taper rate (the rate at which the benefit declines), that balance out the negative incentive effect and the positive insurance effect. JEL Classification: D9, E2, E6, H3, H5, J1.