Retirement incentives, individual heterogeneity and labour transitions of employed and unemployed workers

In this paper we analyze the sensitivity of the labour market decisions of workers close to retirement with respect to the incentives created by public regulations. We improve upon the extensive prior literature on the effect of pension incentives on retirement in two ways. First, by modeling the transitions between employment, unemployment and retirement in a simultaneous manner, paying special attention to the transition from unemployment to retirement (which is particularly important in Spain). Second, by considering the influence of unobserved heterogeneity in the estimation of the effect of our (carefully constructed) incentive variables. Using administrative data, we find that, when properly defined, economic incentives have a strong impact on labour market decisions in Spain. Unemployment regulations are shown to be particularly influential for retirement behaviour, along with the more traditional determinants linked to the pension system. Pension variables also have a major bearing on both workers’ reemployment decisions and on the strategic actions of employers. The quantitative impact of the incentives, however, is greatly affected by the existence of unobserved heterogeneity among workers. Its omission leads to sizable biases in the assessment of the sensitivity to economic incentives, a finding that has clear consequences for the credibility of any model-based policy analysis. We confirm the importance of this potential problem in one especially interesting instance: the reform of early retirement provisions undertaken in Spain in 2002. We use a difference-in-difference approach to measure the behavioural reaction to this change, finding a large overestimation when unobserved heterogeneity is not taken into account.