On the Fairness of Early Retirement Provisions

Declining fertility and increasing longevity have rendered public pension systems in many OECD countries unsustainable and have triggered substantial reforms of these systems. One of the officially declared reform objectives is to raise the average retirement age. Crucial parameters for this endeavor are first the legal retirement age and secondly the early retirement provisions inherent in the public pension system. In this paper we discuss several notions of "fairness" of early retirement provisions in pay-as-you-go financed public pension systems and we claim that the "right" notion of fairness depends upon the objectives pursued in the design of pension systems. We point out the problems attached to the extreme positions "efficiency" and "welfare maximization" and propose a more modest concept of equity called "distributive neutrality", which is based on the notion that the ratio between total benefits and total contributions to the pension system should not depend systematically on the individual’s ability. By applying this concept to the German retirement benefit formula and taking empirically estimated relationships between average annual income, life expectancy and retirement age into account, we show that at the present discount rate of 3.6 per cent per year there is systematic redistribution from low to high earners, which would be attenuated if the discount rate were raised. This seemingly paradoxical finding is due to the fact that in our data set, there is a negative relationship between earnings and retirement age.