On the optimality of social security instruments

Abstract Public pension and public health care policies – collectively referred to here as social security policies – are costly and increasingly challenged by demographic shifts. Using a two‐period overlapping generations model in which health investment affects both mortality and morbidity, we analytically study the optimal design of social security. Our model incorporates three market imperfections: an intergenerational externality, a constraint on saving for future consumption, and incomplete insurance markets. It also considers three policy instruments: subsidies for health investment, subsidies for health expenditures, and a pay‐as‐you‐go pension replacement rate. We analyze how the imperfections, along with evolving trends in mortality and morbidity, shape the optimal set‐up of social security policies. Our findings show that there is no universal design for optimal social security: the effectiveness of each instrument depends on the others and on market conditions, with stronger prevention policies emerging as key in aging societies and in systems with less generous pensions.