Centre for Market and
Public Organisation
What do DC pensions mean for retirement?
Evidence from the UK
Sarah Smith
CMPO, University of Bristol and IFS
Background
•
UK experiencing shift from DB to DC schemes
–
–
•
•
•
•
Half of all men contracted out of state secondary scheme have a DC scheme
More than half of those currently approaching retirement (50-64)
What does this shift in pension provision mean for the timing of retirement?
Numerous studies have established the importance of pension incentives for retirement
– Pension wealth – positive effect
– Accrual – negative effect
Stock and Wise, 1990; Gruber and Wise, 2004, for international evidence
UK – Blundell, Meghir and Smith, 2002, show that growth of DB occupational schemes
can explain part of shift to early retirement in 1980s and 1990s
This paper
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How do retirement incentives evolve in DC schemes (compared to DB schemes) and
what effect might this have on retirement?
–
•
Absence of strong age-related incentives implies profile of retirements likely to be far smoother
How do individuals respond in practice to incentives in DB and DC schemes?
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–
–
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Model DB and DC pension wealth and accrual for sample of older workers in English
Longitudinal Study of Ageing (ELSA) and estimate effect on probability of retirement
DB wealth has positive and significant effect, but DC pension wealth does not
DB and DC accruals have negative effect, sig only for DC schemes
Results imply that DC schemes result in later retirements
Previous papers
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•
Friedberg and Webb (2005)
Estimate separate wealth effects for SS, DB and DC
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–
•
•
Estimate accrual effects for SS and DB, but not DC schemes
Simulations show that shift to DC schemes results in later retirements
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–
•
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SS and DB have positive and significant effects
DC wealth has positive effect, but insignificant
DB wealth, but zero accruals
DC pension wealth
Coile and Gruber (2006)
Estimate separate wealth and accrual effects for SS, DB and DC
–
–
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SS and DB wealth have positive and significant effects
DC wealth has positive effect, but insignificant
DC accrual has negative effect, significant at 10% level
The UK
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DC pensions took off in 1988 when the government allowed people to contract out of
state secondary pension scheme into DC schemes (previously only DB schemes)
•
For people who have contracted out, the low value of the basic state pension means that
their private scheme is likely to be the main driver of retirement
•
Unique institutional features – compulsory annuitization by age 75
Modelling retirement
60
early retirement age, 60
40
20
30
normal retirement age, 65
20
-20
-10
0
accrual - £000s
0
10
Single period accruals
-20
•
Earliest reduced form models estimated probability of retirement as a function of wealth
and single period accruals (or accruals over a discrete period). Failed to take account of
non-linearities caused by early retirement windows in DB schemes
Option Value model – modelled individual retirement decision as a comparison of PV of
retiring now with PV of retiring at all possible future retirement ages
accrual - £000s
•
50515253545556575859606162636465666768697071727374
50515253545556575859606162636465666768697071727374
Option value model
•
Value of retirement in period r:
r 1
S
s t
s r
Vt (r )    s tU w Ys     s tU r  Bs  r  
U w Ys   Ys  s
•
U r  Bs    kBs    s

Value of postponing retirement until r
r 1
S
s t
s r
S
r 1
Gt (r )    s t Et Ys    s t Et kBs r     s t Et kBs t   Et   s t  s   s 
•

s t

s t
Assuming values for , k,  and that expected random components are equal to zero, the
probability of retirement as a function of G(r*) can be estimated using a probit model
Peak value model
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OV dominated by future earnings
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–
•
•
These are uncertain
They may also capture individual heterogeneity
Coile and Gruber, 2002, proposed simpler Peak Value
Assuming  = k = 1, OV can be re-written as a pure revenue function
Gt (r * )    s t Et Ys    s t Et Bs r *     s t Et Bs t 
r 1
S
S
s t
s r
s t
Peak value
•
•
OV should better reflect underlying incentives, but PV may give better approximation
PV better suited to identifying effects of separate elements of pension system
Accrual – DB and DC schemes compared
Delaying retirement in DB scheme
Delaying retirement in DC scheme
•
Increase value of lump sum and pension
by increasing final salary and years’
service (up to max)
•
•
Entitlement to early retirement
Increase value of pension fund by
receiving additional contributions from
the state/ employer and getting another
year’s return on accumulated fund
•
Loss of pension income (after normal/
early retirement age)
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Loss of one year’s pension (after age
50); change in the annuity rate with age
•
Delay in receiving pension
•
Delay in receiving pension
•
Probability of dying without ever drawing
a pension
•
Probability of dying without ever
drawing a pension
early retirement age, 60
20
60
Defined contribution
10
0
accrual - £000s
20
-20
-10
-10
0
accrual - £000s
0
10
40
20
30
normal retirement age, 65
-20
accrual - £000s
Accrual – DB and DC schemes compared
50515253545556575859606162636465666768697071727374
50515253545556575859606162636465666768697071727374
DB accrual rate = 1/60th
Age-earnings profile estimated using FES data 1968-2002
Nominal discount rate = 5%; inflation rate = 2.5%
Survival rate = CMIB, PNML02
50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74
DC contribution rate set at 13.5% to yield same pension
wealth at age 65; nominal investment returns = 6%
Predicted retirements – for illustration
.3
.2
.1
0
Probability of retirement
.4
Take simulated wealth and peak values, apply previous estimates of pension incentive effects
(Blundell, Meghir and Smith, 2002) and predict retirements under two types of pension
50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73
DB early retirement
DC
What happens in practice?
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•
•
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English Longitudinal Study on Ageing (ELSA)
Panel study of 11,400 individuals aged 50+
Interviewed every two years from 2002; waves 1 and 2 currently available
Detailed information on:
– Pensions – current two and past three schemes
– Other wealth (net financial wealth, owner occupied housing, other physical assets)
– Income, demographics, economic activity, health
•
Here, focus on sub-sample of 1,478 men who are
– Aged 50 – 64 and employed in wave 1
– Survive to wave 2
– Exclude high pension/ non-pension wealth and those who don’t know pension type
•
Model retirement between W1 and W2 as a function of (modelled) DB, DC, state
pension wealth and accrual
Ignore possible selection effects into pension type
•
Modelling pension wealth
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•
•
•
•
•
•
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DB pension
Wealth based on self-reported years in the scheme (or, if missing, years with employer)
and self-reported scheme accrual rate.
Assume uprating in line with 2.5% inflation and 50% survivor benefits
Future wealth based on accrual rate (up to max years) and constant, nominal earnings.
Early retirement with 4% reduction in pension value for each year
DC pension
Self-reported fund value at wave 1, converted into wealth using the second best
available age-specific annuity rate (FSA).
Future wealth assumes contributions remain at their current rate and the fund attracts a
nominal 5% annual return.
Both use age-specific life expectancies for the cohort from the Government Actuary’s
Department and a 5% nominal discount rate
Modelling pension wealth
•
Two features of UK pension system
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It’s complicated
•
Current DB
26.9%
Current DC, past DC
3.4%
Current DB, past DB
4.7%
Current DB and DC
3.0%
Current DB, past DC
0.8%
Past DB
6.3%
Current DC
34.5%
Past DC
1.9%
Current DC, past DB
9.1%
No private pension
9.4%
Lots of people have DC schemes with very small amounts in them (£’00,000)
Value of DB
pension
Value of DC
pension
Mean
25%
50%
75%
N
2.19
0.74
1.88
3.06
670
0.49
0.07
0.18
0.46
746
Focus on main pension = private pension wealth > state pension wealth
Distribution of pension wealth, by earnings quintile
Mean value (£’00,000)
Proportion with pension
main
main
any
1
2
3
mean of dbpen
4
5
4
1
mean of dcpen
mean of nopen
2
3
mean of dbmain
mean of spmain
DB
DC
No private pension
4
5
mean of dcmain
1
0
0
0
0
.1
.2
1
.2
.4
2
2
.3
.6
3
3
.4
.8
.5
4
any
1
2
3
mean of spval
mean of dcval0
4
5
1
mean of dbval0
2
3
mean of spval
mean of dcval1
State pension
DB
DC
4
5
mean of dbval1
Sample characteristics
DB
DC - employer
DC - individual
State pension
33.8%
3.6%
7.4%
55.3%
Total pension wealth
3.26
2.05
2.22
1.38
State pension wealth (£’00,000)
0.47
0.59
0.45
0.63
DB pension wealth (£’00,000)
2.59
0.07
0.54
0.03
DC pension wealth (£’00,000)
0.03
1.29
1.16
0.10
Financial wealth (£’00,000)
0.45
0.61
0.65
0.39
Total non-pension wealth
(£’00,000)
Age
1.46
3.18
3.11
1.73
55.0
55.2
55.1
56.6
£27,965
£34,357
£41,006
£17,113
Job tenure
16.0
19.6
16.1
10.9
% doing manual work
0.25
0.26
0.35
0.46
% self-employed
0.04
0.02
0.56
0.31
% who retire
0.17
0.09
0.09
0.15
% sample
Gross annual earnings
Regression analysis
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Estimate the following model using a probit regression:
Ri  0  1SPWi   2 DBWi  3 DCWi   4 SPAi  5 DBAi   6 DCAi 
7 NRAi  8 ERAi  9 AGEi  10 ln Yi  11  ln Y   X i '  ui
2
i
R = binary variable if individual has left work by wave 2
SPW = state pension wealth at W1 for everyone
DBW, DCW = DB, DC wealth at W1 for main DB, DC pension
SPA, DBA, DCA = accrual (of total pension wealth) for those with main state, DB, DC pension
NRA, ERA = binary variable if individual reaches normal, early retirement age by W2
Age = linear age term
Y = earnings
X includes log of non-pension wealth, whether the individual is working full-time at W1, whether
the individual is self-employed at W1, whether they are in manual work at W1, their job tenure
at W1 (and its square), whether their spouse is in work at W1, whether they have college
education and indicators for a range of health problems at W1
Plus, dummies for main pension type
•
Estimate pooled model, plus separate regressions for each of three main pension types
Results
Any wealth
Main wealth
Main wealth
Main wealth
Sep accrual
.0362**
(.0095)
-.01773
(.0356)
.0531
(.0469)
-.1011
(.1271)
-.2351
(.2071)
.0503
(.1035)
.0374**
(.0095)
-.0213
(.0467)
.0516
(.0467)
-.1042
(.1269)
-.2344
(.2071)
.0544
(.1036)
.0361**
(.0094)
-.0216
(.0484)
.0463
(.0476)
.0366**
(.0094)
-.0224
(.0497)
.0572
(.0478)
.0380**
(.0103)
-.0363
(.0440)
.0511
(.0478)
-.0018
(.0023)
-.0148**
(.0070)
.0003
(.0016)
-.0087*
(.0051)
-.2330
(.1611)
-.0020
(.0040)
.0091
(.0055)
.2251
(.1611)
.0020
(.0047)
1395
-469.68
DB wealth
(£’00,000)
DC wealth
(£’00,000)
SP wealth
(£’00,000)
DB peak
(£’000)
DC peak
(£’000)
SP peak
(£’000)
DB acc2005
(£’000)
DC acc2005
(£’000)
SP acc2005
(£’000)
DB acc2004
(£’000)
DC acc2004
(£’000)
SP acc2004
(£’000)
N
1395
Log likelihood
-472.38
1395
1395
-.0075
(.0050)
-.0227*
(.0127)
.0008
(.0040)
.0071
(.0052)
.0116
(.0135)
-.0006
(.0041)
1395
-471.92
-469.98
-467.72
Results
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•
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Wealth
DB pension wealth enters positively and significantly in all specifications
State pension wealth enters positively and significantly in single regression
DC pension wealth enters negatively and insignificantly in all specifications
Including DB and DC wealth only for main pension results in slightly better fit than
including for all, but little effect on the results
•
•
Accrual
DB pension accrual has expected (negative) sign, but is insignificant in most
specifications. Not capturing full range of early retirement incentives?
State pension accrual is insignificant, but little variation across individuals
DC pension accrual has expected (negative) sign and is significant in most
specifications. Variation across individuals reflects contribution rates. Endogenous?
Single period accruals result in slightly better fit than peak value
•
•
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Why no DC wealth effect?
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Researchers are better at modelling (formulaic) DB pension wealth?
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But DC pension wealth comes from individuals’ reported values
•
Individuals have better understanding of what DB pension wealth means for retirement
income?
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DC pension wealth has very different risk properties to DB pension wealth?
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•
DC pension wealth may be endogenous for some?
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Jan 2003 onwards, period of rising stock market, but after-effects of earlier crash
But bias should go the other way
DC pensions are more flexible and imply a less close relationship between retirement
and pensions?
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–
Part of accrual in DC scheme is independent of working
Individual can draw a DC pension and work
Retirement and pension receipt
employer pension
0
.2
Density
.4
.6
personal pension
-5
0
5
-5
0
Difference between age started to draw a pension and age stopped work
Graphs by pen
Source: British Household Panel Survey
5
0
.1
.2
.3
.4
.5
.6
What does this mean for retirement?
Predicted retirement hazards
50
51
52
53
54
55
56
DB predictions
57
58
59
60
61
62
DC predictions
DC pensions associated with later retirement….
63
64
0
0
.1
.1
.2
.2
.3
.3
.4
.4
.5
.5
.6
.6
What does this mean for retirement?
Predicted retirement hazards
50 51 52 53 54 55 56 57 58 59 60 61 62 63 64
DB predictions
DC wealth, DB paras
DC predictions
50 51 52 53 54 55 56 57 58 59 60 61 62 63 64
DB predictions
DB wealth, DC paras
DC predictions
… this has little to do with lower levels of wealth, but largely driven by differential response to pension incentives
Conclusions
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Shift from DB to DC schemes has implications for the timing of retirement
•
•
DB schemes:
Provided a tool for employers to manage labour market exits (through early retirement
windows). Strong age-related incentives and clustering of retirements
•
•
•
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DC schemes:
Age profile of retirements is (likely to be) smoother.
Estimates suggest weaker link between wealth and retirement, consistent with greater
flexibility. But accruals (contributions?) still appear to be important.
Results suggest that DC schemes result in later retirements.
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Important unresolved issues include
–
–
Selection into pension type
Endogeneity of pension wealth and contributions