To what extent may pension plans decrease labor force participationamong older workers? In a study undertaken for the National Bureau ofEconomic Research, economists at several universities probe the possibleeffect of defined-benefit pension plans on labor force behavior. Theirobjective, according to David A. Wise, author of the study, is “todemonstrate the order of magnitude of the potential incentive effectiveof these plans without attempting to present empirical estimates of theimpacts, but suggesting the response of workers to pension plancharacteristics could be substantial.
” The economists consider the case of a 30-year-old worker in a”typical plan.” the plan calculates normal retirementbenefits as 1 percent of average earnings over the last 5 years ofservice multiplied by years of service. Benefits are reduced by 3percent for each year that early retirement at age 55 precedes normalretirement at age 65. “Cliff vesting” occurs after 10 years,meaning the employee accrues no credits until meeting the servicerequirement. “The annual increment to pension wealth” iscalculated as a percentage of the wage rate. “Underlying thecalculations is a representative lifetime age-earnings profile thatassumes substantial growth in real wage rates between agess 30 and 50and very little growth from 50 to 65.” Under three accrual patterns based on wage inflation of 6 percentand nominal interest rates of 3.
6, and 9 percent, pension wealthincreases by from 4 to 14 percent of wages earnings when vesting begins.The rate of accrual increases “slowly at first and then rathersharply until the age of early retirement.” At the age of earlyretirement, the accrual rate drops sharply. This is because annualbenefits are not reduced enough to offset the increase in the number ofyears the worker would receive benefits if he or she chooses earlyretirement.
For a plan without an early retirement option, or one “thatuses an actuarially fair, early retirement reduction formula,”benefits continue to increase to age 65. The study emphasizes the importance of interest rates. It pointsout that “if interest rates are high relative to the rate ofinflation, the accrual after age 55 can indeed be negative. In thiscase pension wealth could actually decline with additional years ofwork.” Wise’s report is based on the introductory chapter of an NBER volume, “Pensions, Labor and Individual Choice,” to bepublished by the University of Chicago Press.