On the Complementarity of Public and Private Pensions: Equity, Efficiency, and Optimal Design

This paper studies whether shifting retirement financing from public to mandatory private pensions can deliver Pareto improvements across generations when the implicit return on public pensions is persistently below the market return on capital. We develop a dynamic general equilibrium overlapping-generations model with heterogeneous households facing idiosyncratic earnings risk, endogenous labor supply and retirement, and a mixed public–private pension system. Calibrated to Australia – where strict means testing creates strong complementarity between public and private pensions – the model shows that higher private contributions raise aggregate wealth and future welfare but impose transitional welfare costs on current workers. The optimal contribution rate is around 14 percent of gross wages, yielding efficiency gains of 0.23 percent of lifetime consumption through reduced public pension eligibility and lower distortionary taxation. When combined with compensating transfers, the reform delivers a Pareto improvement across generations. In contrast, in systems with weaker or no means testing – such as pension designs comparable to those in the Netherlands and the United States – these gains diminish or turn negative, indicating that the linkage between private wealth and public pension entitlements is central to the scope for Pareto-improving reform.