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  Social Security  Financing shortfalls Defined Benefit Pensions  Defined Benefit Pensions  Shut down/freezing trend Defined Contribution Plans  Defined Contribution Plans  Behavior & low balances

Solution: Working Longer? No easy solution to pension problems, difficult to increase taxes or cut benefits No easy solution to pension problems, difficult to increase taxes or cut benefits Working longer can look appealing: Working longer can look appealing: Increased longevity provides a rationale for longer careers, can be seen as “fair” Increased longevity provides a rationale for longer careers, can be seen as “fair” Increases payroll and income tax revenues Increases payroll and income tax revenues Reduces public expenditures (if NRA increase) Reduces public expenditures (if NRA increase) Help preserve individual retirement income Help preserve individual retirement income

Prior Studies and Limitations Prior studies: Assuming a few more years of work can improve pension outlook significantly 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 This paper: Identifies 3 issues/ limitations that can reduce the benefits associated with working longer

Issue #1. Omitted Cost Bias Working longer has a disutility cost Working longer has a disutility cost Cost is abstract and not captured by traditional pension measures (retirement income, funding) Cost is abstract and not captured by traditional pension measures (retirement income, funding) Illusion that “free money” is added to the system Illusion that “free money” is added to the system

Issue #2. Workers have to be willing to delay retirement Retirement age not set directly by policy Retirement age not set directly by policy People will work longer if it maximizes their utility People will work longer if it maximizes their utility Pension reductions would make it optimal to work longer Pension reductions would make it optimal to work longer Additional labor income will replace less than 100% of lost pension income Additional labor income will replace less than 100% of lost pension income

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

Model 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: Worker typically retiring endogenously If does not work longer If works longer (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: Marginal Benefit (MB) vs. Marginal Cost (MC) MC MB Worker retiring endogenously Worker retiring exogenously Wealth (including pensions) Low potential welfare gains Higher potential welfare gains

Worker typically retiring exogenously Case where ability to work longer is increased by a year If 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 longer (increases work by 0.9 year)

Summary of Results Benefits of working longer: Benefits of working longer: Replace a portion (not all) of retirement income lost due to pension reductions 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 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 Real potential for welfare gains lies in removing constraints to work and reducing disutility cost of work

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