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The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs

The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs. Samson Alva, Norma B. Coe, and Anthony Webb Center for Retirement Research at Boston College Sixth International Longevity Risk and Capital Markets and Solutions Conference Sydney, Australia September 7-8, 2010.

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The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs

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  1. The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs Samson Alva, Norma B. Coe, and Anthony Webb Center for Retirement Research at Boston College Sixth International Longevity Risk and Capital Markets and Solutions ConferenceSydney, Australia September 7-8, 2010

  2. Defined Benefit Pension Plans • Previous research shows that defined benefit (DB) pension plans incorporate age-related incentives that affect the age of retirement. • For example – Friedberg and Webb (2005) estimate employees in DB plans retire two years earlier, on average, than those in DC plans. • May disadvantage employees who would prefer to delay retirement • May impose costs on employers if they result in premature loss of valued employees 2

  3. Deferred Retirement Option Program (DROP) • Some employers have responded by introducing a DROP. • In the typical program we study: • Eligible employees (those who have 10 years’ service and who have attained their Normal Retirement Age) can elect to enter the DROP and remain in it for a maximum of four years. 3

  4. Deferred Retirement Option Program (DROP) (cont’d) • On entry, employees cease to accrue additional pension benefits or pay pension contributions. • During DROP participation, pension benefits are credited to a notional interest-bearing account in the employee’s name. • Balance on the account is paid to the employee in a lump sum on eventual retirement. 4

  5. Possible Effects • Employees might enter the program at the age they would otherwise have retired. • In that case, the program will be cost neutral, provided the interest rate on the DROP account equals the interest rate the employer can earn on the deferred pension benefits. • We might then want to know who delays – are these workers more or less valuable to the employer than their putative replacements? 5

  6. Possible Effects(cont’d) • Employees might retire at the same age as before, but spend the last few years of their career in the DROP. • Will only do this if it is to their financial advantage (and to the financial disadvantage of their employer!) 6

  7. Questions We Examine • Using individual level data provided by a large public sector employer, we estimate: • Impact of the DROP on the age of retirement • Cost of program to the employer • Whether highly valued employees are particularly likely to be induced by the program to delay retirement 7

  8. Overview of Pension Plan Rules Police and fire Police and fire % % % % Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College. 8

  9. How Does the DROP Affect Pension Wealth Accrual and the Incentive to Retire? Calculate expected present value of pension wealth by age assuming DROP is unavailable. Then recalculate program assuming: • DROP is available • Employees makes optimal use of it Assume 2.5% inflation, 1.1% real wage growth, 3.0% real interest rate, population average mortality for the relevant birth cohort 9

  10. Pension Wealth Accrual Male Born in 1970 Commencing Employment in 2000 at $40,000 Starting Salary Real Discount Rate: 3%, Inflation: 2.5%, Real Wage Growth: 1.1% Wealth in year 2009 dollars, discounted to age 50, in thousands Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College. 10

  11. Dataset • Large municipal employer • 63,558 employees in pensionable occupations between 1990 and 2008 • After sample attrition: Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College. 11

  12. Relative to the population, City employees are older and more likely to work in a blue collar job, have less education and longer tenure, and be members of a minority group. Characteristics of Workers in City Pension Plan • Fire and police officers are predominately male. 12

  13. Estimation Strategy • Estimate probit model to calculate effect of DROP on retirement hazard • Estimate counterfactual retirement age for DROP-eligible employees • Compare pension wealth of DROP-eligible employees at actual vs. counterfactual retirement age • Sum to arrive at overall cost 13

  14. Estimation Strategy (cont’d) • Probit model – pooled person-year observations • LHS variable binary indicator for whether the individual left voluntarily at age t or continued to work for the employer • Estimate on everyone, on fire, police, and municipal employees separately • Control for education, occupation, ethnicity, salary, years of service • Plus full set of age dummies 14

  15. Estimation Strategy – Pension-Related Variables • Difference between current and peak wealth/earnings • Difference between current and peak pension wealth/earnings • squared • At peak pension wealth • One, two, three, four, five, six, seven, or more years past peak • At early retirement age • At normal retirement age • After normal retirement age • Pension wealth/earnings 15

  16. Estimation Strategy – DROP-Related Variables • DROP eligibility interacted with: • Not-yet-attained peak pension wealth • At peak pension wealth • One, two, three, four, five, six, seven, or more years past peak • Hypothesis – DROP will discourage retirement before peak and less than four years past peak. People incented to continue working will retire four or more years after the peak. 16

  17. Regression Results: Selected Pension-Related Variables * Statistically significant at the 10 percent level; ** Statistically significant at the 5 percent level; *** Statistically significant at the 1 percent level. Source: Alva, Samson, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College. 17

  18. Regression Results: DROP Eligibility Interacted with Pension-Related Variables *Statistically significant at the 10 percent level; ** Statistically significant at the 5 percent level; *** Statistically significant at the 1 percent level. Source: Alva, Samson, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston College. 18

  19. Estimating Counterfactual Retirement Age • At 3% real interest rate and 1.1% real salary growth, program delays retirement by: • But people stay in the program for a median of four years • So people enter the program at substantially younger ages than those at which they would otherwise have retired 19

  20. Calculate Mean Cost Per Participant • At 3% real interest rate and 1.1% real salary growth, and STRIP interest rates 20

  21. Costs are Actually HIGHER at Higher Assumed Interest Rates • Why? • Program accelerates payment to pension benefits. 21

  22. Are High Quality Workers Disproportionately Likely to Delay as a Result of the Program? • Performance assessments not available for most employees • Infer performance from salary increase relative to average for age and year • Interact eligibility with “high quality” • Program disproportionately affects high quality fire officers, but high quality police officers are less affected. • Why? Outside options? 22

  23. Conclusion • Defined benefit pension plans incorporate strong age-related variations in pension wealth accrual. • These variations in pension wealth accrual influence retirement behavior. • DROP changes both incentives and behavior, and can be very expensive for the employer. 23

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