Uncertain Incomes, Pay-as-you-go Systems, and Diversification

This paper analyzes the efficiency of pay-as-you-go pension systems in a small open economy with stochastic wages and interest rates. Applying the criterion of conditional Pareto-optimality it is shown that the introduction as well as the extension of an existing pay-as-you-go system can be Pareto-improving even though its expected rate of return is below the expected interest rate. This result is only based on efficiency grounds and not due to any intergenerational risk sharing. It follows from the fact that a pay-as-you-go system acts as a means of diversification by reducing the overall risk of individual saving portfolios