Pension Reductions:Pension Reductions:Can Welfare be Preserved Can Welfare be Preserved by Delaying Retirement?by Delaying Retirement?

Marie-Eve LachanceMarie-Eve Lachance

San Diego State UniversitySan Diego State University

ARIA Annual Meeting, August 7ARIA Annual Meeting, August 7thth, 2007, 2007

Pension ReductionsPension Reductions

Social Security Social Security Financing shortfallsFinancing shortfalls

Defined Benefit Pensions Defined Benefit Pensions Shut down/freezing trendShut down/freezing trend

Defined Contribution Plans Defined Contribution Plans Behavior & low balancesBehavior & low balances

Solution: Working Longer?Solution: Working Longer?

No easy solution to pension problems, No easy solution to pension problems, difficult to increase taxes or cut benefitsdifficult to increase taxes or cut benefits

Working longer can look appealing:Working longer can look appealing:• Increased longevity provides a rationale for Increased longevity provides a rationale for

longer careers, can be seen as “fair”longer careers, can be seen as “fair”• Increases payroll and income tax revenuesIncreases payroll and income tax revenues• Reduces public expenditures (if NRA increase)Reduces public expenditures (if NRA increase)• Help preserve individual retirement incomeHelp preserve individual retirement income

Prior Studies and LimitationsPrior Studies and Limitations

Prior studiesPrior studies: Assuming a few more years : Assuming a few more years of work can improve pension outlook of work can improve pension outlook significantlysignificantly

This paperThis paper: Identifies 3 issues/ limitations : Identifies 3 issues/ limitations that can reduce the benefits associated that can reduce the benefits associated with working longerwith working longer

Issue #1. Omitted Cost BiasIssue #1. Omitted Cost Bias

Working longer has a Working longer has a disutility costdisutility cost

Cost is abstract and not Cost is abstract and not captured by traditional captured by traditional pension measures pension measures (retirement income, (retirement income, funding)funding)

Illusion that “free money” Illusion that “free money” is added to the systemis added to the system

Issue #2. Workers have to be Issue #2. Workers have to be willing to delay retirementwilling to delay retirement

Retirement age not set directly by policyRetirement age not set directly by policy People will work longer if it maximizes People will work longer if it maximizes

their utilitytheir utility Pension reductions would make it optimal Pension reductions would make it optimal

to work longerto work longer Additional labor income will replace less Additional labor income will replace less

than 100% of lost pension incomethan 100% of lost pension income

Issue #3. Workers may not be Issue #3. Workers may not be able to delay retirementable to delay retirement

Model OverviewModel Overview

Pension reduction

Delay in retirement

Impact on welfare

(wealth-equivalent)

• Can take many forms

• For illustrations, use concrete example of increase in NRA from age 65.5 to 67

Evaluate with a life-cycle model which:

• Includes utility from leisure (Issue #1)

• Defines retirement as an endogenous decision (Issue #2), unless an exogenous shock applies first (Issue #3)

Illustration:Illustration:Worker typically retiring endogenouslyWorker typically retiring endogenously

If does not work longerIf does not work longerIf works longerIf works longer

(increases work by 1 year)(increases work by 1 year)

Welfare loss

Net welfare gain

Leisure utility cost

Income increase

$23,897

$17,013 $16,698

$315- =

Impact on welfare of a 1.5-yr increase in the NRA

Working an Additional Period:Working an Additional Period:Marginal Benefit (MB) vs. Marginal Cost (MC)Marginal Benefit (MB) vs. Marginal Cost (MC)

Uti

lity

MCMB

Worker retiring endogenously

Worker retiring exogenously

Wealth(including pensions)

Low potential welfare gains

Higher potential welfare gains

Worker typically retiring exogenouslyWorker typically retiring exogenouslyCase where ability to work longer is increased by a yearCase where ability to work longer is increased by a year

If does not work longerIf does not work longer

Welfare loss

Net welfare gain

Leisure utility cost

Income increase

$24,745

$19,709

$3,841

$15,868

- =

Impact on welfare of a 1.5-yr increase in the NRA

If works longerIf works longer(increases work by 0.9 year)(increases work by 0.9 year)

Summary of ResultsSummary of Results

Benefits of working longer:Benefits of working longer:• Replace a portion (not all) of retirement Replace a portion (not all) of retirement

income lost due to pension reductionsincome lost due to pension reductions• For those who are able to delay retirement, For those who are able to delay retirement,

value of additional income almost completely value of additional income almost completely offset by disutility cost of additional workoffset by disutility cost of additional work

• Real potential for welfare gains lies in Real potential for welfare gains lies in removing constraints to work and reducing removing constraints to work and reducing disutility cost of workdisutility cost of work

Application: Combination ApproachApplication: Combination Approach

Financial incentives:• Reducing benefits level• Increasing retirement age• Increasing penalty/credit for

early/delayed retirement

Non-financial incentives:• Removing external constraints• Reducing disutility of work• Addressing cognitive

limitations

Decrease Social Security benefit payouts

Induce later retirement & increases tax revenues

Reduce individual retirement income

Improve public finances

Improve individual welfare

Impact of income loss can be partly offset by welfare gain