Retirement: Early Retirement Incentives

Pension plans are an integral component of human resource policies in many firms. Approximately half of the labor force is covered by a retirement plan on their job (Employee Benefit Research Institute). There are two basic types of pension plans: defined benefit plans and defined contribution plans (McGill et al.). In a defined benefit plan, the retirement benefit is based on a formula that typically specifies benefits based on retirement at a certain age as a function of final average earnings, years of service, and a generosity parameter. Reduced benefits are usually available at a younger age. The employer has the responsibility for paying the promised benefits. Therefore, the plan sponsor makes annual contributions to the pension fund, invests the plans’ assets, and is required to purchase benefit insurance from the Pension Benefit Guaranty Corporation.

In defined contribution plans, the employer, the employee, or both contribute to individual accounts for each participant. The employee manages the account and makes all investment choices. The benefit is determined by the size of the account at retirement. Defined contribution plans include 401(k) plans, money purchase plans, and profit-sharing plans. Traditionally, defined benefit plans have been the dominant type of pension plan in the United States; however, since the mid-1970s there has been a major shift away from these plans and toward the increased utilization of defined contribution plans (Pension Benefit Guaranty Corporation).

Pension plans usually specify a ‘‘normal retirement age.’’ In defined benefit plans, this is the age at which a worker can begin to receive pension benefits under the plan’s benefit formula. If benefits are paid before this age, they typically are reduced by a factor that is a function of age and service. The normal retirement age is not the age at which a normal or average person retires, nor is it the age at which most people retire. Instead, the normal retirement age is the age at which a person qualifies for full or unreduced retirement benefits. In this discussion, ‘‘retirement’’ refers to workers leaving a particular company and does not mean that they completely leave the labor force, nor does it imply that the individual necessarily has substantially reduced his or her hours of work. For example, a person can retire from one job, start receiving a pension, and begin working full- or part-time for another employer (Quinn). Transition to a postcareer or bridge job is encouraged by ERIs because they provide an incentive for a person to leave a career job but not necessarily to leave the labor force.

Defined benefit plans. Defined benefit plans specify a retirement benefit that a worker will receive if he or she starts to draw a pension at the normal retirement age. While the most frequently used normal retirement age is sixty-five, many plan sponsors have a normal retirement age of sixty-two or sixty, and in some plans, workers can receive unreduced benefits after a specified length of service regardless of age—for example, thirty years of employment with the firm. Virtually all defined benefit plans also include early retirement ages, often as young as fifty or fifty-five. Individuals who start to receive retirement benefits before the normal retirement age have their annual benefits permanently reduced relative to the benefit they would receive at the normal retirement age.

The U.S. Bureau of Labor Statistics (1998, 1999) provides detailed information concerning important provisions of pension plans, including normal retirement ages, early retirement ages, and reduction factors for those who start to receive benefits prior to the normal retirement age. In most plans, the magnitude of the reduction in annual benefits for taking early retirement is less than the reduction required to set the actuarial present value of benefits beginning at the earlier age equal to the value of actuarial present benefits if they were started at the normal retirement age. This means that the present value (or discounted value) of benefits beginning at early retirement would exceed the present value of benefits beginning at normal retirement. This characteristic provides a subsidy to individuals who decide to take early retirement, and thus encourages retirement from the firm prior to the normal retirement age.

Another way of illustrating the early retirement incentive is to consider the annual gain in the value of actuarial present pension benefits (often called pension wealth) from working an additional year. In most defined benefit plans, the wealth value of pension benefits increases rapidly as a worker approaches the age of early retirement. The change in the wealth (or present) value of benefits is called the pension accrual. The pension accrual increases in absolute size and relative to annual earnings up until the age of early retirement. It rises with additional years of service and increases in annual earnings, and because the worker is getting closer to the time that he or she can begin to receive the pension benefit. The size of the pension accrual also depends on the firm’s choice of pension characteristics.

After the worker reaches the age of eligibility for early retirement, the pension accrual stops increasing and actually begins to decline. This is because the worker can now retire and start receiving pension benefits, and because the penalties for early retirement are less than the actuarially fair reduction. Thus, an employee who keeps working will forgo a year of benefits. The decline in pension accruals represents a reduction in total compensation, that is, it is equivalent to taking a pay cut. The reduction in compensation, combined with access to retirement benefits, provides a clear incentive to employees to leave the firm prior to the normal retirement age (Kotlikoff and Wise, 1985). This is the basic early retirement incentive that is embedded in virtually all final-pay-defined benefit plans.

The economics of employer pensions shows that firms can influence retirement decisions through choice of a pension plan, setting the normal and early retirement ages, and selecting the magnitude of reductions in the early retirement benefit. The change in pension accruals as the worker approaches and passes the ages for early and normal retirement can be very large. For example, Kotlikoff and Wise (1989a) found a pension accrual in one plan of 150 percent of salary for a person working from age fifty-four to age fifty-five, the latter being the age of early retirement. After passing the age of early retirement, the accrual dropped sharply, and by age sixty the pension accrual was only 10 percent of salary. Thus, the total compensation from working (salary plus pension accrual) dropped from 2.5 times annual salary at age fifty-four to 1.1 times annual salary at age sixty. In other words, the value of working an additional year after age sixty was only half that of working an additional year after age fifty-four.

Empirical research shows that individuals respond to these incentives by retiring in greater numbers when they qualify for early retirement benefits (Quinn et al.; Kotlikoff and Wise, 1989b). These types of early retirement incentives are inherent in most traditional defined benefit plans. They provide strong encouragement for workers to leave the company at these ages, and workers respond to the retirement incentives. Companies seeking to provide ongoing incentives for workers to retire at specified ages prior to sixty-five can effectively achieve their objective by adopting a defined benefit plan with subsidized early retirement provisions.

Defined contribution plans. Pension accruals based on employer contributions to defined contribution plans are less variable with age and service. Most plans specify an employer contribution that is a fixed percentage of salary. However, in many 401(k) plans, employee contributions are voluntary and thus depend on the worker’s decision to make annual contributions. Pension accounts in defined contribution plans grow because of these annual contributions and in response to returns on invested assets. There are no magic dates in which pension accruals spike up or drop sharply. In general, these plans provide actuarial equivalent benefits regardless of the age at which the benefits start or a lump sum is taken. Thus, defined contribution plans tend to be more age neutral in their retirement incentives and do not have ERIs. The dramatic growth in defined contribution plans means that fewer pension participants are covered by the ERIs that are part of most defined benefit plans.

Hybrid pension plans. During the 1990s an increasing number of large employers converted traditional defined benefit plans to cash balance plans and pension equity plans. These plans are technically defined benefit plans because the firm remains responsible for pension contributions and the management of the pension fund; however, they have many of the characteristics of defined contribution plans. The retirement benefit is specified as an account balance that grows with annual credits based on salary and returns to the pension account balance. Workers can leave the firm at any age and take the account balance with them. These hybrid plans do not contain the ERIs that are inherent in the traditional defined benefit plans (Clark and Schieber). In addition, managers at many of the firms that have converted their pensions from a traditional defined benefit plan to a hybrid plan give as one of the primary reasons for the change the desire to eliminate early retirement incentives (Clark and Munzenmaier; Brown et al., 2000). The trend toward increased use of these hybrid plans also means that fewer pension participants will be eligible for ERIs in the future.