How automatic adjustment factors affect the internal rate of return of PAYG pension systems

Abstract

AbstractIn this paper we analyze automatic adjustment factors that can be used to keep the budget of a PAYG pension system balanced when cohort sizes fluctuate. The adjustment factors are defined in a way that is similar to their real-world counterparts and they differ in the relative weight they put on changes in the contribution rate and in the pension level. We show how the internal rate of return of the PAYG system depends on the fluctuations in cohort size and on the choice of the adjustment regime. We find that fluctuations in the cohort size have the smallest impact on the internal rate of return if the relative weight of the adjustment parameters directly corresponds to the length of the retirement period relative to the length of the working period. For reasonable numerical values, this weight is close to the actual choice in the German system.