Price and income incentives in early retirement: a
preliminary analysis of a Dutch pension reform
Peter Kooiman, Rob Euwals, Martijn van de Ven, Daniël van Vuuren
CPB Netherlands Bureau for Economic Policy Analysis
Van Stolkweg 14
P.O.Box 80510
2508 GM The Hague, the Netherlands
p.kooiman@cpb.nl
Draft, June 2004
Abstract
This paper discusses two recent reforms of the early retirement pension system in the Netherlands. The
first is the gradual shift from pay-as-you-go financing to pre-funding, the second the abolishment of
fiscal support for early retirement saving. It is argued that the first reform will have a considerable impact
on the retirement age since it entails a drastic change in the price of retiring. The effect of the second
reform is likely to be much smaller for several reasons. Abolishing the tax subsidy on occupational
pension savings increases the tax burden on labour, and thereby tends to decrease labour supply. When
the former subsidy is returned to workers as a general labour income tax cut the policy can largely be
counteracted either by raising collectively agreed pension premiums or by increased private savings.
1
1
1. Introduction
In the seventies of the past century early retirement programs have deliberately been created for
employees in most sectors of the Dutch economy. At that time this policy seemed to represent a win-win
strategy. Older workers were allowed to leave the labour market at generous conditions, which certainly
did not reduce their wellbeing. This led to the creation of job openings for young entrants to the labour
market, thus preventing them to develop into a lost generation in the fairly grim economic conditions that
prevailed at that time. The attachment to the labour market would allow them to develop their human
capital, thereby increasing their expected lifetime wealth.
The program appeared to be very successful, participation rates of older workers dropping rapidly since
the seventies. However, with the benefit of hindsight, it is clear by now that the short term gains carry a
considerable price in the longer run. Indeed, it is now a stated policy goal to increase participation of the
elderly again in view of the upcoming ageing of the population in the OECD area. It is not very easy,
though, to reverse the past trend into early retirement. Meanwhile it has developed into a standard for the
life course of the current working population. Such cultural habit formation is reinforced by the
considerable post second world-war economic growth. Getting richer all the time we can also afford to
work less.
The only feasible way to induce older people to postpone retirement is to (re-)create proper incentives.
Restricting ourselves to the economic point of view, two natural candidates are price incentives and
income incentives. The first refers to the financial reward for continuing work, the second to the amount
of financial resources that people have to support them in case of retirement. When deciding about early
retirement, workers in fact decide about the purchase of a considerable extra amount of future leisure; its
price is labour income foregone minus implicit taxes embedded in the prevailing pension system.
Increasing this price, and reducing available resources, i.e. older workers wealth, could help to reduce
consumption of this “commodity”.
Recent Dutch history illustrates both lines of attack. Since the mid-nineties of the past century early
retirement programs are gradually being converted from Pay-As-You-GO financing (PAYGO) to prefunding. As a corollary to this conversion the actuarial unfairness of the scheme will be drastically
reduced. Equivalently, the price of extra leisure through early retirement will drastically increase, thus
putting a much stronger price incentive for continuing work in place again. As far as the income
incentive is concerned, Dutch government has announced a proposal to stop all fiscal support for early
retirement savings from 2006 on. By abolishing the existing tax subsidy on early retirement savings one
hopes to decrease the amount of net early retirement wealth accumulated by workers. With less pension
wealth available, workers might be forced or induced to postpone retirement, i.e. work longer.
2
In this paper we discuss the likely effects of both price and income measures on retirement age. We will
not report firm empirical evidence, since empirical work is still underway (price incentives) or cannot be
done due to the fact that the policy has not been implemented yet (income incentives). Arguments
advanced are therefore mainly analytical in nature, although some statistics are provided as illustrations.
The set up of the paper is as follows. Section 2 gives a brief overview of the history and structure of the
Dutch early retirement provisions. Section 3 discusses the transformation from PAYGO financing to prefunding of the early retirement scheme, and the associated drastic change in the degree of actuarial
(un)fairness of the system. Section 4 analyses the likely outcome of the announced policy to abolish the
favourable tax treatment of early retirement savings. Section 5, finally evaluates the two policies.
2. Some history
Dutch pension arrangements consist of both old age pension provisions and early retirement schemes.
The statutory old age pension age is 65. At that age all Dutch are entitled to a state pension. In addition
most employees save for supplementary occupational pensions. The state provided 65+ base pension is
financed through a PAYGO system, where those below the age of 65 pay an income related premium
covering the benefits of those above 65. The supplementary occupational pension is a pre-funded system
negotiated between trade unions and employers in collective labour agreements at the firm or the sector
level. Part of the full wage1 is set aside as a mandatory pension premium. These premiums are managed
by over 700 pension funds, operated by employers and employees jointly, or by private life insurance
firms.
Table.1 Types of occupational old age pension schemes (end of 2002)
Number of funds
Number of active
Balance sheet value
members
% of total
Defined benefit
Final wage
49,6
52,4
60,6
Average wage
22,5
35,8
23,3
Other
16,7
8,3
15,2
Defined contribution
8,5
3,4
0,8
Other
2,8
0,2
0,1
Total
100
100
100
Source: Pension and Insurance Supervisory Authority.
Table 1 gives an overview of the different types of pension arrangements by fund, number of active
members and balance sheet value. It shows that most active members of Dutch pension funds are covered
1
In this paper the “full” wage is “current” wage plus “future” wage, where current wage is the wage paid out now, and future wage is the
discounted value of the pension entitlements obtained.
3
by a defined benefit pension scheme. Defined contribution schemes constitute only a minor part. Full old
age pensions used to amount to 70% of the gross wage level reached at the end of the career, often
including indexation to either price or wage inflation as long as fund results were favourable enough.
Unfavourable stock market developments and low interest rates have led to some reductions in the
generosity of the occupational pension provisions in recent years. In particular final pay schemes are
being replaced by average pay schemes. As of January 1st 2004 the two largest pension funds in the
Netherlands, the civil servants pension fund ABP and the health care pension fund PGGM have switched
to an average pay scheme. This further increased the share of average pay schemes.
Early retirement pension schemes have been started since the mid-seventies of the past century. In order
to deliberately create job openings for large numbers of young unemployed generous early retirement
conditions were offered to elderly workers, the so-called VUT-schemes. These operate as a PAYGO
system, where all workers pay for the retirement of older workers. On average, eligibility for the VUT
scheme starts at the age of 60 years, with benefits equal to 80% of the last earned gross wage. Basically
the conditions are such that workers do not incur a loss of wealth when they decide to retire under the
scheme. Not only do they receive a net pension which comes close to their former net wage, but also
their old age pension entitlements continue to grow just as if they kept on working. So the price of extra
years of leisure through retirement comes close to zero. The VUT-scheme has therefore been
characterized as “an offer you can’t refuse” 2 . Not surprisingly the VUT proved to be very successful: the
secular decline of participation rates of 60+ workers started to accelerate, especially in the early eighties
when VUT schemes were introduced on a large scale, see figure 1. Other exit-routes have contributed as
well, in particular the disability and unemployment schemes, which also offered rather easily accessible
and similarly generous income substitution for older workers. Since the mid-nineties activity rates are
increasing again.
Halfway in the nineties of the past century both government and trade unions became concerned about
the adverse incentives and the long run financial sustainability of the prevailing VUT schemes. A general
agreement was reached between government and the so-called social partners (federations of trade
unions and employer organisations) to reform the system. VUT-schemes started to be gradually replaced
by less generous early retirement schemes. Benefits were reduced to 70% of the last earned gross wage,
the eligibility age for a full benefit was raised by on average 1 year, supplementary old age pension
accrual stopped during early retirement, and, most importantly, it was decided to change from the
existing PAYGO financing to a funded system in order to get rid of the strong actuarial non-neutrality of
the existing scheme. To compensate workers who had contributed to the old system, a gradual transition
regime was imposed, safeguarding existing claims. So we are now left with a hybrid system where old
VUT-schemes are gradually being replaced by new so-called pre- pension schemes. Table 2 gives an
2
Lindeboom (1998).
4
overview. These pre-pension schemes still contain a substantial degree of PAYGO financing, that should
gradually decline. After all in the new system it takes 40 years of savings to obtain a full early retirement
claim. According to existing law VUT schemes will no longer be fiscally supported after 2020. In 2003
the cabinet has announced its intention to abolish fiscal support for early retirement savings altogether
from 2006 on. Negotiations with the social partners early 2004 have failed to reach an agreement on this
issue. A proposal will soon be sent to parliament.
Figure 1 Activity rates, 1970 – 2003
Source: Statistics Netherlands, own calculations
Table.2 Number of VUT and pre-pension benefits
VUT
Pre-pension
1996
148 310
22 800
1997
141 300
28 510
1998
130 870
40 420
1999
123 420
51 650
2000
113 080
65 820
Source: Statistics Netherlands
The role of government in the occupational old age and the early retirement pensions is limited. They are
part of collective labour agreements negotiated by employers and employees. Government involvement
5
comes in at two places only. First, through government ruling the negotiated pension scheme is imposed
on non-organized workers and firms as well covered by a collective labour agreement. Thus, although the
degree of organisation of Dutch workers is less than 25%, more than 90% of all workers face a
mandatory supplementary occupational pension scheme and more than 80% a mandatory 3 early
retirement savings scheme. Second, pension savings receive a favourable tax treatment. This involves
two elements. First income tax is deferred: pension premiums are deductible, withdrawals are being
taxed. The (average) rate of taxation on early retirement allowances is approximately 10%-point lower
than the (marginal) rate at which the premiums are deducted 4. Second, pension assets are exempt from a
yearly 1,2% capital taxation. Jointly the two measures imply that on average about one quarter of a net
full early retirement allowance can be attributed to the favourable tax treatment. So the implicit tax
subsidy amounts to about one third of the net own contribution. As a caveat it has to be added that the
outcome of the underlying present value calculations is quite sensitive to the discount rate employed.
Therefore the fractions mentioned should be taken as indicative only.
3. From PAYGO to pre-funding
The recent change from PAYGO financing to pre-funding not only changed the way early retirement
benefits are being financed. Two additional adjustments were simultaneously made to the system. First,
the size of a full pension claim was somewhat reduced. Civil servants, for instance, were entitled to
benefits equalling 80% of their last earned wage, starting at the age of 60 under the old scheme, whereas
since 1997 the comparable figure is 70% at the age of 62. This change is representative for that in other
sectors of the economy, although the timing may differ. Obviously this reduction in pension claims
entails a loss of the total expected wealth especially for older workers, who are on the eve of retiring. A
transitional regime was imposed to mitigate this effect. Lower pension benefits induce lower premiums,
though, so that young generations of workers do not incur a similar loss.
A second adjustment is the way retirement benefits are being recalculated when retirement is postponed.
Under the old system working one year longer implied that one year of entitlements evaporated. No
actuarial adjustments were being made to the entitlements of subsequent years. Given the generosity of
the old system this entailed a considerable loss of pension wealth for every year that one continued to
work after the eligibility age for early retirement. The pension wealth foregone was of the same order of
magnitude as the proceeds from the extra labour effort. Several studies report implicit tax rates 5 on
continued working in the old system in the order of 70-100%, see e.g. Kapeyn en De Vos (1999),
Lindeboom (1999).
3
Recently the Dutch cabinet has also announced that it will no longer impose collectively negotiated early retirement savings schemes
as mandatory. Individual workers will be offered the possibility to “opt out”. In this paper we neglect this development, and argue as if
early retirement schemes are mandatory (as they have been till today).
4
Own calculations.
5
Loosely speaking the Implicit Tax Rate measures how much of each euro, earned by continuing to work, is implicitly taxed away due to
retirement benefits foregone.
6
Under the new scheme, benefits for subsequent (early and old age) retirement years will be actuarially
recalculated. Figure 2 illustrates the case for a particular civil servant (one of the authors). For different
retirement years it presents both the pre-pension (<65) and old age pension (>65) benefit rates. The prepension entitlement is 70% for four years (61-64). Retiring later (earlier) results in a higher (lower)
benefit rate both before and after the age of 65. Not only because a different number of pre-pension years
has to be covered, but also because an extra year of working leads to extra pension accrual. Fiscal
authorities do not allow a pension to be more than 100% of the last earned wage, so retiring at the age of
63 or 64 gives the maximum benefit of 100%. The pension capital surplus is transferred to the
supplementary occupational old age pension provision. A crude actuarial check has made it clear that the
recalculations of benefits are not entirely fair (especially at the age of 63 and 64), but nevertheless come
close to fairness (especially at ages below 63).
Figure 2: actuarial adjustments of pension benefits at the civil servants pension fund
Source: private communication
Under actuarial fairness the implicit tax rate is zero by definition. Implicit tax rates may even be negative
now due to the fact that extra old age pension accrual is cheap for old workers. Actuarial calculations
show that the usual flat rate of old age pension premiums for all workers implies a subsidy in the order of
20% of the gross wage to old workers, paid for by young workers. An extra year of work entails an extra
year of collecting this subsidy. The dramatic change in implicit tax rates, from virtually 100% in the old
scheme to probably even negative values now, is likely to have a considerable effect on participation.
Opting for early retirement is very costly now indeed, as compared to the old scheme, where it was
almost free. As an example consider a standard income earner (gross income euro 29 000 per year, close
7
to modal). Assuming an implicit tax rate of zero, the net price of an extra year of leisure through early
retirement is about 19 000 Euro. This is equivalent to twice the full user cost of owning and using a new
luxury mid-size car, 18 000 km of mileage included.
The transition from PAYGO to pre-funded schemes does not take place simultaneously at the same time
in all sectors. This offers a way to estimate the impact of this transition through so-called difference-indifference estimation, applied to longitudinal micro-data on the income of elderly employees. A first
analysis6 indicates that the transition at the civil servants pension fund ABP has resulted in an average
postponement of early retirement by 8 months. For the largest part, this seems to be due to a price effect
implied by the introduction of actuarial adjustments in the new scheme. The income effect – lower
pension wealth – only seems to matter for low income employees.
Still, the decline in the use of the early retirement exit route is somewhat lower than might be expected.
This could be a result of habit formation, which could imply that long-term effects have greater
magnitude than the effects currently witnessed. After all it takes time for workers to realize that the
financial conditions have changed so profoundly. Also the change to (approximate) actuarial neutrality of
the early retirement provisions has certainly not been completed yet. So we may witness a further rise of
the early retirement age, even without the policy intervention that we discuss in the next section.
4. Abolishing fiscal support for early retirement saving
In this section we discuss the role of the favourable tax treatment of early retirement savings. As stated in
section 2 this treatment amounts to a subsidy in the order of one third of the net value of such savings.
Abolishing these subsidies, as announced by the Dutch cabinet, entails a loss of 25% of future early
retirement pension wealth, all other things being equal. Through the income effect this might induce
workers to postpone retirement.
The analysis is complicated, though, by several aspects. First, pension savings are mandatory, so that
customary behavioural reactions of individual optimizing agents might not be relevant. Second, it should
be noted that in a mandatory occupational scheme the tax subsidy on pension savings is effectively a
subsidy on labour. Indeed, the full wage received as a reward for delivering work effort consists of
current wage income plus deferred pension income properly discounted. The size of the deferred income
component depends on the size of the subsidy. Removing the subsidy therefore decreases the full wage,
i.e. corresponds to an increase of the (tax) burden on labour. So price effects come in again, and labour
supply is likely to be influenced, not only of the targeted elderly but also of younger workers. In
studying the labour supply effect of the tax subsidy on early retirement savings we therefore have to
consider both young and old workers. Third, from the point of view of the government, skipping a
6
CPB will publish further results of this micro data study later this year.
8
subsidy creates funds that can be used for other purposes, which, in turn might influence labour supply as
well. In particular these funds could be used to reduce the burden on labour by decreasing some general
labour related tax. Fourth, individual workers might react by increasing their free supplementary savings,
in order to compensate for the reduction in mandatory pension savings. To the extent that they do so it
will reduce the effect of the announced policy.
To cope with these complications we take the following approach. To get a fair assessment of the
announced policy we will consider a balanced budget scenario, combining the abolishment of the tax
subsidy on early retirement savings with a compensating general tax cut on labour income. Given such a
policy, social partners subsequently determine their policy with respect to the amount of mandatory early
retirement savings. Finally, individual workers react, eventually adapting their labour supply and their
rate of free savings.
We have no strong economic theory about the optimal reaction of the social partners involved in
negotiating the collective labour agreements. Within limits set by fiscal law they are free to choose the
amount of mandatory savings for future pensions. Employers are likely to be largely indifferent as long
as total wage costs do not increase. In addition, they have an incentive to foster early retirement saving
since it insures them to some extent against the risk of being stuck with old workers with sticky wages
and declining productivity, which they would prefer to get rid off. A suitable retirement provision might
increase work force flexibility. In the long run, labour unions are likely to mirror worker preferences,
although as a principle agent they are expected to add their own perspectives, especially when workers
are myopic or have hyperbolic preferences over their lifetime.
Lacking a proper theory we will consider three scenarios. In the first scenario, labour unions negotiate a
repair of the early retirement pension provision. Net premiums will increase at the expense of current
wage income, such that net future pension benefits will not decrease (repair-scenario). In the second
scenario labour unions accept the reduction in pension benefits. Net pension premiums paid out of
current income will stay at the same level as before (accept-scenario). In the third scenario labour unions
decide to abolish mandatory early retirement saving altogether. Indeed, when government does no longer
subsidize such savings an important reason to enter into pre-pension schemes disappears (stop-scenario).
For each of the three scenarios we now consider the likely reaction of individual workers, both young
ones and old ones. Due to the balanced budget character of the scenario considered nothing changes
under the repair scenario. The amount of net forced saving is identical to the baseline situation by
assumption. The necessary increase in pension premiums to be paid out of net full labour income is
accompanied by a compensating7 decrease in labour tax, so that net current income does not change. As
7
The balanced budget assumption is macro, so at the micro level some discrepancies may occur. We abstract from such distributional
effects.
9
all prices are the same8 too, no reallocation will occur, i.e. saving, consumption and labour supply will
not change. The decrease in pension saving aimed at by the government policy measure is exactly
counteracted by the increase in the saving negotiated by the social partners, so that the baseline situation
is restored. Notice that this policy ineffectiveness result does not assume rational behaviour on the side of
the individual agents. Their opinion is irrelevant. With social partners counteracting the government
policy the relevant constraints they are faced with do not change at all; they need not even notice that
something has been going on in the institutional setting of their pension provision.
This conclusion does not hold true in the other two scenarios. The crucial feature here is the extent to
which the mandatory pension savings correspond to the autonomous preferences of workers in the
baseline situation. To ease the discussion9 we consider two polar cases. One is an agent that is not at all
(liquidity) constrained by the amount of forced pension savings; the other is totally (liquidity)
constrained. The first one prefers to save even more and supplements the mandatory savings with
additional free savings. The other one prefers not to save at all, his rate of time preference is extremely
high; future income is practically of no value for him. Actual workers are a mixture of the two, both in
person and in distribution. Young workers may be relatively short-sighted, and seriously liquidity
constrained, so that the second model dominates. Old workers are close to retirement, more mature, and
less liquidity constrained so that the first model might be more relevant 10 .
In the accept-scenario the amount of mandatory pension savings decreases. The compensating reduction
in labour income tax allows the non-constrained worker to substitute extra free savings, so that he can
exactly restore the baseline situation11. Since both the full wage and the marginal rate of substitution
between current and future consumption stay unchanged, there is no incentive to change either the supply
of labour or the rate of saving. So again, nothing will change: for non-liquidity constrained rational life
time optimising agents the policy is ineffective under the balanced budget scenario. The crucial
assumption here is that the true full wage rate does not change when the tax subsidy on retirement
savings is replaced by an equivalent general reduction of the tax burden on labour income.
For the liquidity constrained agent the equivalence between pension savings subsidies and labour income
tax does not apply. In the polar case considered here, pension savings have zero utility 12 . The reduction
8
The return on mandatory pension savings has decreased, but this does not induce substitution since the amount of such savings is
exogenous to the agent.
9
In a formal analysis three cases emerge. The tax subsidy on pension savings implies a higher rate of return on such savings than the
market rate of return on non-subsidized savings. Given the amount of forced saving through the mandatory pension system the
individual worker has a marginal internal rate of return, i.e. the rate at which he would be prepared to save more than the forced savings
already in place. This internal rate can be less than the free market rate, between the free market rate and the subsidized rate, or larger
than the subsidized rate. Here we neglect the middle case; including it complicates the argument without significantly changing the
conclusions of the analysis.
10
Econometric analysis shows that the eligibility age does play a significant role in explaining retirement age. This suggests that older
workers may be liquidity constrained to some extent as well.
11
We assume that the rate of return on private savings is equal to the rate of return of the pension fund.
12
In this case pension premiums fully function as a labour income tax.
10
of these savings in the accept-scenario does not entail a welfare loss. On the other hand, the
compensating decrease of the labour income tax constitutes a welfare gain: the effective wage rate
increases. So on balance the agent is better off. By decreasing the amount of forced saving, and
increasing the amount of current labour income the liquidity constraint is relieved. The higher effective
wage induces both an income effect and a substitution effect. With the substitution effect dominating,
life-time labour supply will increase. Depending on institutional constrains (fixed labour time) this
increase could take the form of longer work during active working life, later retirement, or both.
In magnifying the accept-scenario, the stop-scenario has similar but stronger effects13. When agents do
not compensate for the lack of forced pension savings by increasing their free savings the wealth gap at
the early retirement age is considerable. Table 3 presents some calculations of this gap for a fictitious
worker with a standard income and a full supplementary occupational old age pension provision.
According to current fiscal regulations this old age pension provision can partly be used to finance early
retirement as well. The table is derived under the assumption that the worker equalizes his net post
retirement pension income as much as fiscal law allows for. The column repair corresponds to the
current situation including the fiscal subsidy. The column accept illustrates the effect of abolishing the
fiscal subsidy: a lifetime decrease of net pension income in the order of 1 000 euros a year. This is not
likely to have a significant effect on the retirement age. The column stop illustrates the effect of stopping
the early retirement saving scheme altogether. The loss of pension benefit is concentrated in the four
early retirement years. It is in the order of 8 000 euros a year for a single, and 10 500 euros a year for a
single earner couple. For many workers this is likely to imply that they will have to postpone retirement.
Table.3 Net total pension benefit of a standard income worker retiring at the age of 61
Scenario
Repair
accept
stop
Age 61
15 472
14 517
7 246
Age 62-64
15 472
14 517
7 246
Age > 65
15 472
15 517
14 131
Age 61
19 165
18 210
8 504
Age 62-64
19 165
18 210
8 504
Age > 65
19 165
18 210
18 723
Single
Couple (single earner)
Source: CPB 2004.
13
Referring to the size of the tax subsidy mentioned earlier of about one-third of the net own contribution, the size of the initial pension
wealth shock is four times as large.
11
5. Evaluation
According to standard economic theory a worker on the eve of retirement has to evaluate the options
available to him in an intertemporal utility framework. One option is to continue to work, another one is
to retire irreversibly. Other exit routes may be available, both reversible and irreversible. Each of these
options carries an expected income path, representing future consumption possibilities, and an expected
leisure time path. These are combined in a utility function, and, conditional on the initial wealth, a
preferred option follows.
A common shortcut to this formal approach to the retirement decision is to consider the so-called
replacement rate. This is the ratio of net pension benefits over the net wage prior to retirement. With
higher replacement rates workers can more easily afford to quit since the benefits received as a
replacement income come closer to the former wage. The concept of a replacement rate misses the point,
though. Suppose a worker gets a benefit of 70% of his final wage, so that his replacement rate is 0.7.
When his pension scheme is pure PAYGO without actuarial corrections the effective price of retirement
is 30% of the wage. When his pension scheme is actuarially fair the effective price of retirement is 100%
of the wage. So, although the replacement rates are equal, the effective price of leisure differs widely,
and so will the incentive to retire. Although in a system without actuarial corrections the replacement rate
might be a relevant measure, it is not very informative in case of actuarially fair systems.
A more appropriate shortcut, that we have used in this paper, considers the true price of leisure 14. This
price equals labour income foregone corrected for implicit subsidies or taxes entailed in the ruling
pension system and/or in alternative exit routes that are accessible for the worker. If no such alternative
exit routes exist, and the pension system is actuarially fair, the true price of leisure equals the (net) full
wage. However, if the pension system is unfair, or other exit routes are easily accessible, the implicit tax
on continued working may be large, and the price of leisure drops. Given his preferences, which could be
strongly culturally influenced, and his initial wealth, the worker decides whether retiring is his preferred
option or not. Analytically, this conforms to a standard labour supply decision, where the usual income
and substitution effects are relevant.
From our reading of the international empirical literature of the past two decades we tend to conclude
that income effects play a far less dominant role in the early retirement decision than price effects. In the
U.S. literature, wealth effects are often insignificant, and always of low magnitude. 15 Recent evidence
for Germany also points in this direction.16 A possible explanation is that employees have alternative
14
This measure is also a shortcut since, like the replacement rate, it only compares one-period ahead alternatives. A “true” measure
should also consider de option value of retiring at future dates, see Stock and Wise (1990)
15
The most prominent studies finding no significant income effects are Krueger and Pischke (1992), Samwick (1998), Coile and Gruber
(2000). On the other hand, Chan and Stevens (2003) find a significant income effect for employees with low income.
16
See Berkel and Börsch-Supan (2003).
12
resources to finance early retirement. In 2000 the median non-pension wealth17 of the Dutch aged 55-64
was 84 000 euro, four times a net yearly standard income. It may also play a role that post-Second World
War retirement ethos includes ‘the right’ to retire at a certain age after a long life of hard work (Burtless,
1986). Another explanation is that the income elasticity has decreased over time, since there are now
better opportunities to enjoy leisure time (better health, leisure industry, lower transport costs) than in
earlier days (Costa, 1995).18
Abolishing the favourable tax treatment of early retirement saving may be rather ineffective not only
because of a relatively low income elasticity of the retirement decision. As we have demonstrated the
effect could partly be countered by a compensating increase either in mandatory pension premiums
negotiated in collective labour agreements, or in private free saving. Recent empirical evidence for the
Netherlands confirms that households do substitute free savings for mandatory savings when the latter
are being reduced. However the rate of substitution is less than predicted by the standard life-cycle model
(Kapteyn et al, 2004) and varies by income group (Euwals, 2000). The international empirical literature
finds similar results, see e.g.. Gale (1998), Attanasio and Brugiavini (2003) and Attanasio and
Rohwedder (2003). Although most studies do find substitution, the variation in the rate of substitution
obtained is considerable and on average the rate of substitution is rather low.
Finally, reducing the amount of forced saving could have the adverse effect that a suitable provision is
lacking in case a worker inevitably has to retire, e.g., due to bad health or reduced productivity. If no
other options exist he will be forced to access the social security system through one of its available
channels. The early retirement pension provision then acts as a private insurance against the risk of losing
one’s human capital too early. It allows him to quit the labour force without entering social assistance.
Such private precautionary savings may help to reduce moral hazard associated with publicly financed
social security schemes.
A more powerful line of attack seems to be to aim at a fair price for retirement leisure. Continuing to
work should not lead to a loss of pension wealth. This requires recalculation of pension entitlements
according to actuarial standards in case of work continuation. Although this might fit more naturally in a
pre-funded system, it can also be achieved in a pure PAYGO context, as the Swedish Notional Defined
Contribution scheme demonstrates, see e.g. Sunde’n (2000) or Williamson and Williams (2003). Pension
entitlements are being administered as if an underlying savings account existed. However, such accounts
are virtual: pension premiums paid by current workers are fully used to cover benefits of current retirees.
17
Including real estate, excluding valuables, durables, money, annuities. Source: Statistics Netherlands.
18
Note that earlier studies on early retirement, e.g. Leonard (1979), Parsons (1980), Hurd and Boskin (1984), have often found a
relatively high income effect. The income elasticity estimated by Parsons was as high as 0.63. This supports the theory postulated by
Costa (1995). On the other hand, it should be mentioned that these relatively high income effects did not suffice to explain to entire drop
in labour force participation of the elderly (Diamond and Hausman, 1984; Blau, 1994). It should also be mentioned that these studies did
not control for dynamic price effects, but instead included the early retirement replacement rate as an explanatory variable.
13
For the individual worker the savings account is real, since it constitutes a real claim on a future pension
annuity19.
Restoring actuarial fairness makes quitting through the early retirement pension channel less attractive,
and thereby other exit routes more attractive. The moral hazard problem associated with exit routes
through the social security system are likely to increase. Under actuarial fairness, pension wealth does
not evaporate as long as no pension benefits are being collected. So if one succeeds in exiting through
another channel, and collect the benefits provided through that channel, pension wealth can be reserved
for later use20. So the corollary to making early retirement systems more fair is to restrict access to, and
reduce the generosity of other provisions of the social security system. Otherwise one runs the risk of a
considerable spill-over from inactivity through early retirement into inactivity through these alternative
channels.
One final aspect related to the price effect is the following. Usually pension benefits can only be
collected when one stops working. Continuing to work entails that the pension wealth cannot be
accessed. For liquidity constrained workers this means a loss of wealth. This, again, functions as an
implicit tax that has to be subtracted from the wage obtained. It lowers the price of retiring. Indeed by
retiring one immediately gets access to the pension wealth, which is a plus. So in the baseline situation
the work/no-work decision gets distorted in favour of no-work. Since the amount of pension wealth is
sizable, and the price sensitivity is significant, this could be a substantial effect when liquidity constraints
prevail. The distortion disappears when older workers get access to their pension wealth, without
requiring them to quit fully. This could lead to part-time retirement schemes, or allowing retirees to work
without deducting the proceeds from working from their benefit. To relieve the considerable shortages of
caring personnel (hospital nurses) the Dutch pension fund of the medical sector allows its retirees to
work since January 2001, without any deduction of their benefits. Almost 10% of the early retirees keeps
on working part time now, for an average 40% of a full time equivalent 21.
19
Barr (2000) argues that the way of financing pension provisions, by PAYGO or pre-funded schemes, is of secondary importance
anyhow.
20
The “optimal” way to quit is to enter into a generous social security program, and start informal work, either legally as non-market
household production, or illegally at the black labour market. Thus one collects social security benefits, the wage associated with the
informal labour (which goes untaxed), and the pension benefit is reserved for later use. This type of “fraud” is certainly not hypothetical,
as we know.
21
See Nyfer (2003)
14
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