Public pension reform and welfare in an economy with adverse selection

The welfare consequences of the recent major proposals for public pension reform, prefunding, coverage reduction, and privatization, are analyzed, taking account of adverse selection in annuity markets. Prefunding is shown to reduce the premium for private annuities and improve the welfare of every individual if the economic growth rate is lower than the interest rate. A higher replacement ratio is shown to increase the premium for private annuities and reinforce the relative cost advantage of public pensions. The analytical results give an economic rationale to maintaining a large pay-as-you-go program even in the situation of the economic growth rate being lower than the interest rate. Also examined are the welfare effects when incorporating the amortization of the unfunded pension debt, as well as the necessity of imposing a minimum coverage regulation on private annuity contracts when privatizing the public program.