The economics of pensions

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DOI: 10.1093/oxrep/grj002

NICHOLAS BARR London School of Economics and Political Science PETER DIAMOND Massachusetts Institute of Technology1

This paper sets out the economic analytics of pensions. After introductory discussion, successive sections consider the effects of different pension arrangements on labourmarkets, on national savings and growth, and on the distribution of burdens and benefits. These areas are controversial and politically highly salient. While we are open about expressing our own views, the main purpose of the paper is to set out the analytical process by which we reach them, to enable readers to form their own conclusions.

This paper has a two-fold purpose. Itsets out the economic analytics of pensions without discussion of empirical magnitudes and outside the context of any particular country, with the intention of giving readers a systematic way of thinking about the topic. The paper is also intended as a contribution to a continuing debate, hence part of the discussion rebuts arguments that we regard as false, or equivocal, or true in somecircumstances but not necessarily always. Specifically, we argue that much analysis is incomplete and over-simplified: focusing on one objective while ignoring others;

assuming an idealized economy with well-informed agents and no distortions such as taxes and missing markets; comparing one steady state with another, when the underlying issue is a move from one steady state to a different one; orignoring distributional effects. The opening section sets out some background matters: the objectives of pension systems, types of pension arrangement, and the economics of pensions. Sections II, III, and IV discuss in turn pensions and labour markets (mainly microeconomic), finance and funding (mainly macroeconomic), and distributional issues.

E-mail addresses:; pdiamond@mit.eduThis paper is a shortened version of Barr and Diamond (forthcoming, ch. 2), which has grown out of our participation in a panel examining pension issues in China. We are grateful to other panel members and commentators on that report and for helpful comments on this paper from Christopher Bliss, Robert Hancké, Dieter Helm, David Hendry, Stephen Nickell, and members of the Oxford Review’s editorialboard at a seminar in Oxford.

Oxford Review of Economic Policy vol. 22 no. 1 2006 © The Authors (2006). Published by Oxford University Press. All rights reserved.



(i) The Objectives of Pension Systems From an individual viewpoint, income security in old age requires two types of instruments: a mechanism for consumption smoothing, anda means of insurance. Consumption smoothing People seek to maximize their well-being not at a single point in time, but over time. Someone who saves does so not because extra consumption today has no value, but because he values extra consumption in the future more highly than extra consumption today. A teenager who saves for a flight ticket is making a judgement that she will get more enjoymentfrom the trip than from spending the money now. Similarly, most people hope to live long enough to be able to retire. Thus a central purpose of retirement pensions is consumption smoothing—a process which enables a person to transfer consumption from her productive middle years to her retired years, allowing her to choose her preferred time path of consumption over working and retired life.2Insurance In a model of certainty, individuals save during their working life to finance their retirement. Important in the case of pensions is that people face a range of uncertainties, including how long they are going to live. Thus a pension based on individual saving faces the person with the risk of outliving those savings, or of consuming very little to prevent that happening. Though any one...