Earnings Test, Non-actuarial Adjustments and Flexible Retirement

In response to the challenges of increasing longevity, an obvious policy response is to gradually increase the statutory eligibility age for public pension benefits and to shut down pathways to early retirement such as special rules for women. This is, however, very unpopular. As an alternative, many countries have introduced “flexibility reforms” which allow combining part-time work and partial retirement. A key measure of these reforms is the abolishment of earnings tests. It is claimed that these reforms increase labor supply and therefore, also the sustainability of pension systems. We show that these claims may not be true in the circumstances of most European countries. To this end, we employ a life-cycle model of consumption and labor supply where the choices of labor force exit and benefit claiming age are endogenous and potentially separate. Earnings tests force workers to exit the labor market when claiming a pension. After abolishing the earnings test, workers can claim their benefits and can keep on working, potentially increasing labor supply. Our key result is that the difference between exit and claiming age strongly depends on the actuarial neutrality of the pension system and can become very large. Abolishing an earnings test as part of a “flexibility reform” may therefore create more labor supply but at the same time, reduce the average claiming age when adjustments remain less than actuarial, thereby worsening rather than improving the sustainability of public pension systems.