Should pensions be progressive?

The present paper quantitatively characterizes the consequences of rising pension progressivity in an overlapping generations model with idiosyncratic income, disability and longevity risk as well as endogenous labor supply at the intensive and extensive margin. Focusing on the German pension system which is purely earnings related, we increase the degree of progressivity and compute the optimal mix between flat and earnings-related pensions. We find that a flat-rate pension share of roughly 30% maximizes aggregate economic efficiency, since improved insurance provision dominates higher labor supply distortions. Disability risk significantly increases the optimal progressivity level, while endogenous retirement has important macroeconomic implications. Since our results are robust for a wide range of parameter specifications, they indicate that at least in Germany a move towards more redistribution within the pension system is efficient. •The paper quantifies the optimal progressivity of the German pension system.•Dynamic simulation model accounts for intensive and extensive labor supply as well as idiosyncratic income and disability risk.•Simulations indicate that the optimal system involves higher progressivity, since insurance benefits over-compensate additional labor market distortions.