Rethinking Retirement - May 2009

 

Population ageing imposes major challenges on European governments. The rising ratio of older inactive persons to the young active population induces substantial pressure on public finances and causes tensions in the solidarity between generations. Moreover, the decline in labor supply may cause scarcity in of non-tradable services in the economy, leading to wage increases and higher prices.

 

One key remedy to these challenges is an increase in the labor-market participation of elderly workers. European governments have agreed in the Lisbon agenda that the participation rate of people between 55 and 64 should increase from an average of 38% in 2000 to over 50% in 2010. To achieve this, governments in Europe have started to reform their pension schemes, social insurances and tax systems during the last decade. The Netherlands is no exception: it reformed disability and unemployment insurance, early retirement schemes and introduced new tax incentives, all with the aim to improve labor market outcomes for the elderly.

 

Dutch policy is now entering a new phase. After a first wave of reforms, the question arises whether and what type of new reforms would be desirable in the future. How - or should - the Dutch government encourage participation incentives for elderly? What reforms would raise the productivity of older workers? And how should the welfare state interfere with saving and learning? Is it time - as the study is titled - for Rethinking Retirement?

 

Today’s institutions in the Netherlands can be characterized as being friendly towards labor market participation. This is markedly different from the past. Indeed, retirement schemes have been made actuarially fair, which removed an important distortion in the labor market for elderly. In fact, postponing retirement at old age is currently subsidized due to the way Dutch pensions are financed, an age-related tax credit for older workers, and deferred payment schemes. Substitution towards other retirement routes, such as disability schemes, is limited as the Netherlands has also reformed this scheme. Pressure on unemployment insurance as a substitute pathway into retirement may become more relevant in the future. Although financial incentives for participation are large, several institutions distort the labor market for elderly. Elderly workers are well protected by employment protection legislation. Moreover, relatively generous unemployment insurance with long duration causes high reservation wages. Workers also accumulate considerable wealth during their life via mandatory and subsidized savings for pensions.

 

 

Dutch labor market participation of elderly was relatively low in the 1980s, but has caught up during past decades. Today, it is comparable to the average in Europe. The unemployment rate among the elderly is relatively low, especially due to small inflows into unemployment. Moreover, early retirement schemes and disability insurance have long been used as early exit routes in the Netherlands and functioned as substitutes for unemployment insurance. Unemployed elderly face a very low probability to find a job, resulting in relatively long unemployment duration. The mobility of older workers is small, both when measured by job movements and when we look at the tenure distribution. It reflects a relatively rigid labor market for elderly workers in the Netherlands.

 

 

Pensions, early retirement schemes and tax incentives determine financial incentives that play a role in early retirement behavior. The effects can be measured by the impact of wealth on retirement (the wealth effect) and the impact of the return to postponing early retirement (the price effect). Empirical evidence shows that both incentives play a significant role. The price effect however exceeds the wealth effect. From the empirical literature we can obtain consensus estimates for the size of both effects. In particular, a reduction of retirement wealth with one year-salary induces workers to retire one to two months later. An increase in the return to postponing early retirement with one year-salary induces a postponement of five to six months. The Dutch early retirement system went through substantial reforms in recent years. Most importantly, the Dutch system moved from an actuarially unfair system in which the financial reward of postponing early retirement was very low towards an actuarially fair system. The reform has already increased the participation rate of individuals aged 55 to 64, and it is expected to increase the rate further in the coming years.

 

Are policies that reduce pension wealth or increase the reward to postponing retirement welfare improving? Not necessarily. Retirement decisions are made on the basis of individual choices. These choices are distorted if there is a gap between the social and private value of retirement. High implicit tax rates on continuing work form such a distortion. However, the implicit tax in the Netherlands has been transformed into an implicit subsidy. This is a consequence of reforms in the early retirement scheme. By further stimulating participation through a higher price of leisure at old age, the government may well move beyond the optimum. Subsidies for postponed retirement involve an income transfer to healthy and able elderly workers. As it is financed from the general budget, it may be unattractive from a distributional perspective as it tends to increase inequality. Yet, in-work subsidies for elderly may be desirable on efficiency grounds. In particular, economic theory suggests that tax rates for elderly should be reduced if the supply of labor is more elastic at old age.

 

Policies that reduce pension wealth are expected to increase participation. Hence, institutions supporting wealth formation such as saving subsidies and mandatory savings induce a distortion in participation. The financial crisis is likely to extend working lives due to a reduction in pension wealth.

The full report is online at: http://www.cpb.nl/nl/pub/cpbreeksen/bijzonder/80/bijz80.pdf.