Choosing the legal retirement age in presence of unemployment

A general conclusion of the theoretical literature on pensions is, confronted to an increased longevity, to encourage continued activity. This literature however assumes a perfect labour market. The central question addressed in this article is whether it is still desirable to increase the retirement age when individuals face the risk of being unemployed. In this purpose, we study the design of the Pay-As-You-Go pension system, focusing on the determination of the retirement age, in a model where people differ according to age only and face in every period a given probability of becoming unemployed. We first determine the optimal pension system, which consists in a payroll tax rate, a pension benefit level and a retirement age and study its comparative statics with respect to a change of the unemployment rate and the length of life. Our main findings are the following. First, it is optimal to postpone retirement when life expectancy increases. Second, when unemployment benefits are low the optimal retirement age may decrease with the unemployment rate. We then characterize the issue-by-issue voting equilibrium and compare it to the optimal pension scheme. It is shown that the median voter in general chooses a retirement age lower than the optimal one as well as a higher payroll tax rate. JEL classification: H55