Aggregate risk, political constraints and social security design

We analyze the behavior of a fully funded system, whose portfolio is composed of a risk free and a risky asset, in a stochastic environment, in the presence of political constraints. If an aggregate negative shock occurs, a large share of the wealth of the elderly is wiped out. In this case, office-seeking policy-makers act as a lender of last resort, and institute a long-lasting PAYG system. Under these political constraints, a fully funded system suffers from a moral hazard problem, since agents have an incentive to choose a riskier portfolio, which increases the wealth loss associated with the bad state. The introduction of a mixed system reduces the riskiness of the portfolio, which remains however higher than in the case of no political constraints. The early adoption of a mixed system, previous to the occurrence of a negative shock, could prevent the policy-makers from intervening as a lender of last resort, but at a high cost. In fact, its PAYG pillar would be larger than the PAYG system introduced in the case of a bad shock: This would amount to impose an extra loss on all future generations, since in this environment, a PAYG system is dominated, in rate of return, by the risk-free asset.