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Pension Reductions: Can Welfare be Preserved by Delaying Retirement?. Marie-Eve Lachance San Diego State University ARIA Annual Meeting, August 7 th , 2007. Pension Reductions. Social Security  Financing shortfalls Defined Benefit Pensions  Shut down/freezing trend

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pension reductions can welfare be preserved by delaying retirement

Pension Reductions:Can Welfare be Preserved by Delaying Retirement?

Marie-Eve Lachance

San Diego State University

ARIA Annual Meeting, August 7th, 2007

pension reductions
Pension Reductions
  • Social Security 

Financing shortfalls

  • Defined Benefit Pensions 

Shut down/freezing trend

  • Defined Contribution Plans 

Behavior & low balances

DB

solution working longer
Solution: Working Longer?
  • No easy solution to pension problems, difficult to increase taxes or cut benefits
  • Working longer can look appealing:
    • Increased longevity provides a rationale for longer careers, can be seen as “fair”
    • Increases payroll and income tax revenues
    • Reduces public expenditures (if NRA increase)
    • Help preserve individual retirement income
prior studies and limitations
Prior Studies and Limitations
  • Prior studies: Assuming a few more years of work can improve pension outlook significantly
  • This paper: Identifies 3 issues/ limitations that can reduce the benefits associated with working longer
issue 1 omitted cost bias
Issue #1. Omitted Cost Bias
  • Working longer has a disutility cost
  • Cost is abstract and not captured by traditional pension measures (retirement income, funding)
  • Illusion that “free money” is added to the system
issue 2 workers have to be willing to delay retirement
Issue #2. Workers have to be willing to delay retirement
  • Retirement age not set directly by policy
  • People will work longer if it maximizes their utility
  • Pension reductions would make it optimal to work longer
  • Additional labor income will replace less than 100% of lost pension income
model overview
Model Overview

Impact on welfare

(wealth-equivalent)

Pension reduction

Delay in retirement

  • 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 worker typically retiring endogenously
Illustration:Worker typically retiring endogenously

If works longer

(increases work by 1 year)

If does not work longer

$23,897

$17,013

$16,698

-

=

$315

Welfare loss

Income increase

Leisure utility cost

Net welfare gain

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

working an additional period marginal benefit mb vs marginal cost mc
Working an Additional Period:Marginal Benefit (MB) vs. Marginal Cost (MC)

Higher potential welfare gains

Low potential welfare gains

MC

MB

Wealth

(including pensions)

Worker retiring exogenously

Worker retiring endogenously

worker typically retiring exogenously case where ability to work longer is increased by a year
Worker typically retiring exogenouslyCase where ability to work longer is increased by a year

If works longer

(increases work by 0.9 year)

If does not work longer

$24,745

$19,709

$15,868

-

=

$3,841

Welfare loss

Income increase

Leisure utility cost

Net welfare gain

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

summary of results
Summary of Results
  • Benefits of working longer:
    • Replace a portion (not all) of retirement income lost due to pension reductions
    • For those who are able to delay retirement, value of additional income almost completely offset by disutility cost of additional work
    • Real potential for welfare gains lies in removing constraints to work and reducing disutility cost of work
application combination approach
Application: 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

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