Effects of pension system reform on individuals' decisions

In 1981 Chile was the first country in the world to privitise its pension system moving from a pay-as-you-go scheme (PAYG) to a Defined Contributions (DC) scheme. Individuals in the labour market at the time of the reform were given the choice to either stay in the PAYG system or to opt-out to the DC scheme. New entrants must join the DC system. Exploiting the wide differences in pension formulas across schemes, I firstly find that the reform significantly increased expected pension wealth for most of those who opted-out. I then investigate the extent to which households substitute this increase by decreasing accumulation of other wealth. As the decision to either stay or to opt-out was not random, I gain identification through an instrumental variable approach. I find a pension offset of around 30%. Among the possible reasons for the incomplete offset are imperfect information, the desire to compensate for new risks faced and habit formation. Lastly, through a non-linear random effects dynamic model that allows for state dependence and unobserved heterogeneity, I estimate the effect of pension system design on individuals' formal/informal labour market decisions. Results indicate that individuals in the DC scheme are 23% more likely to be formal than those in the PAYG scheme at any one period. Further, simulations show that the boost in formality caused by the reform lasts throughout the life cycle. State dependence is even more important indicating that labour market past decisions do affect future ones. The unobserved heterogeneity is also high and significant but it is only a fifth of the state dependence. The results on state dependence and initial condition suggest that there is scope for public policy to affect formality decisions