Pension plans as a spur to labor force withdrawal Essay

To what extent may pension plans decrease labor force participation
among older workers? In a study undertaken for the National Bureau of
Economic Research, economists at several universities probe the possible
effect of defined-benefit pension plans on labor force behavior. Their
objective, according to David A. Wise, author of the study, is “to
demonstrate the order of magnitude of the potential incentive effective
of these plans without attempting to present empirical estimates of the
impacts, but suggesting the response of workers to pension plan
characteristics could be substantial.”



The economists consider the case of a 30-year-old worker in a
“typical plan.” the plan calculates normal retirement
benefits as 1 percent of average earnings over the last 5 years of
service multiplied by years of service. Benefits are reduced by 3
percent for each year that early retirement at age 55 precedes normal
retirement at age 65. “Cliff vesting” occurs after 10 years,
meaning the employee accrues no credits until meeting the service
requirement. “The annual increment to pension wealth” is
calculated as a percentage of the wage rate. “Underlying the
calculations is a representative lifetime age-earnings profile that
assumes substantial growth in real wage rates between agess 30 and 50
and very little growth from 50 to 65.”



Under three accrual patterns based on wage inflation of 6 percent
and nominal interest rates of 3.6, and 9 percent, pension wealth
increases by from 4 to 14 percent of wages earnings when vesting begins.
The rate of accrual increases “slowly at first and then rather
sharply until the age of early retirement.” At the age of early
retirement, the accrual rate drops sharply. This is because annual
benefits are not reduced enough to offset the increase in the number of
years the worker would receive benefits if he or she chooses early
retirement.



For a plan without an early retirement option, or one “that
uses an actuarially fair, early retirement reduction formula,”
benefits continue to increase to age 65.



The study emphasizes the importance of interest rates. It points
out that “if interest rates are high relative to the rate of
inflation, the accrual after age 55 can indeed be negative. In this
case pension wealth could actually decline with additional years of
work.”



Wise’s report is based on the introductory chapter of an NBER volume, “Pensions, Labor and Individual Choice,” to be
published by the University of Chicago Press.

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