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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 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?

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  1. Pension Reductions:Can Welfare be Preserved by Delaying Retirement? Marie-Eve Lachance San Diego State University ARIA Annual Meeting, August 7th, 2007

  2. Pension Reductions • Social Security  Financing shortfalls • Defined Benefit Pensions  Shut down/freezing trend • Defined Contribution Plans  Behavior & low balances DB

  3. 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

  4. 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

  5. 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

  6. 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

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

  8. 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)

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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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