The commitment value of funding pensions

- We study time consistent pension contribution rules when governments can renege on past promises.
- Funding public pensions can act as a commitment device.
- Fully funding may be a preferable policy when interest rates are lower than the growth rate of population.
- Second best tax policies are less likely to be reneged on with funded pensions than under a PAYG system.

This paper studies how funding public pensions can improve policy outcomes when short-sighted governments cannot commit. We focus on sustainable plans, where optimal nonlinear pensions are not reneged on by sequential governments. Funding pensions is a commitment mechanism. It implies lower contributions than does the second best policy, which reduces temptation to over-redistribute later and to misuse revealed private information. Funding may be preferable even if the population growth rate is higher than the rate of return on assets. Second best optimal policies are also more likely to be renegotiation proof under fully funded pensions.