Pension plans and retirement incentives

The object of this paper is to examine the impact of type of pension scheme on retirement behaviour. The well-documented decline in the labour-force participation of older women and older men (in particular) is common to most industrialised countries. The proportion of men aged 55 to 64 in employment fell between 1980 and 1996 in all 17 OECD countries for which data are available, by an average of more than ten percentage points. The average employment rate of men in this age group in 1996 was a little under 60 per cent. The reasons for this are complex, but probably involve both a demand effect — high and persistent unemployment, especially in Europe — and a supply effect — pension benefits and the value of other savings have increased. It is desirable to encourage people to retire later to counterbalance the effect of population ageing on the ratio of workers to dependants. Some have argued that this can be achieved with ‘parametric reforms’, tinkering with the rules of existing public defined-benefit schemes. Many countries, however, have introduced or proposed more radical reforms emphasising the role of privately managed defined-contribution pensions. An obvious question is how these regimes are likely to affect retirement behaviour. The paper presents a model of a simple (defined contribution) pension plan and looks at the optimal retirement date, which is found to depend on prospective earnings and the evolution of the accumulated pension fund, which, in principle, are separable. The paper also looks at defined-benefit pension schemes, which are the norm in public and much private provision. Here there are significant interactions and complications. The pension formula is often non-linear, with accrual rates that vary with the number of years of contributions and formulae that depend on a limited number of ‘best’ or ‘final’ years of earnings. There are also ‘spikes’ when early retirement is first permitted, at the standard retirement age etc. Pensions can be actuarially adjusted, depending on the year at which benefits are first drawn. We show that the incentives in a defined-benefit scheme are very different from the defined-contribution retirement saving plan.