Public pensions as optimal social contracts

Abstract A simple overlapping generations model is modified to allow for an externality experienced by the young from consumption by the elderly. This sets up a game between generations in which one generation's strategy may be to save too little and rely on gifts from the young (e.g. public assistance) for retirement income. Social security can therefore be viewed as a Pareto-optimal contract to restore efficient intertemporal allocation. A funded public pension plan corresponds to forced saving but is vulnerable in that the next young generation may stop contributing, rely on its children for retirement assistance and meanwhile reap the consumption externality from the current elderly's social security benefits. This suggests a forced-giving or pay-as-you-go type of compulsory pension plan (such as exists in most nations) which also has the advantage of aiding the initial old generation and therefore generating an immediate consumption externality for the initial young. The approach can also be used to explain other aspects of existing social security.