A Theory of Contribution Density and Implications for Pension Design

The adequacy of contributory pensions for the middle classes depends on density of contribution. Density can be far below 100% because the State is unable or unwilling to impose the mandate to contribute on all jobs, especially on poor workers such as many in self-employment and small firms. The paper presents a model where individuals choose whether to bundle saving for old age in a covered job or to save independently while choosing an uncovered job. The determinants of the effective rate of return offered by the contributory pension plan include the earnings differential. This return is then compared with the returns offered by pure saving in the financial market, to determine the equilibrium density of contribution. The paper also applies the model to assess two standard designs for noncontributory subsidies for the old poor. It finds that these standard designs crowd out contributory pensions for the middle classes by reducing density. The paper also considers two second-generation designs for noncontributory subsidies and other approaches to raise density. This model also allows optimization of the combined “multipillar” structure, where participants get noncontributory pensions and also contributory pensions based on both mandates and fiscal incentives.