Japan now faces a serious problem because of longer life expectancy and lower fertility in an aging society. Using a simple theoretical framework of two-period overlapping generations, this section illustrates the potential conflicts among generations resulting from the 2004 pension reform in an aging Japan. The reform may be regarded as a gradual change from a defined-benefit (DB) system to a defined-contribution (DC) system. With regard to the pension system in Japan, see the case study of this chapter, Appendix A.

The budget constraint in the pay-as-you-go system is given as

where L_{t} is the number of people in generation t, b_{t} is the per capita contribution when young in period t, and 0_{t} is the per capita benefit when old in period t. In the DC system, b_{t} = b, while in the DB system 0_{t} = 0_{t} = в. Here, b and в are exogenously given as fixed levels of contribution and benefit respectively.

The net benefit of generation t is defined as

where, for simplicity, the discount rate is assumed to be zero.

Considering the above budget constraint, in the DB system the net benefit of generation t is written as

In the DC system, we have

As the time path of population size, let us assume that, from time 1 to time 6,

Namely, L = 1 is the initial equilibrium level of population and L = 0.5 is the new equilibrium level of population. During the move from L = 1 to L = 0.5, the population temporarily rises. Generation 3 is a baby boom generation and, beginning with time period 5, population growth is negative. This may well reflect Japan’s actual and future demographic changes after the Second World War.