The false promise of later retirement

Alain Jousten Professor of economics University of Liege Project Syndicate

EU Economics Commissioner Pedro Solbes warns that Europe's shrinking population will soon hit the Continent's economies hard. Reforms to defuse the crisis are needed. Alain Jousten examines one alluring but false reform that is often discussed.

Social welfare systems are shaking as never before. Not only in Europe, but in parts of North and South America, and Asia as well. A collapse in fertility rates, coupled with longer life expectancy, is driving a rapid and pronounced aging of populations. Worse still, the demographic threat is being heightened by the way most countries finance their public pension schemes.

Many retirement systems rely heavily on a pay-as-you-go (PAYG) philosophy. Rather than forcing each generation to pay for its own retirement, benefits paid to today's pensioners are financed by contributions from the young.

Inter-generational solidarity, however, is only as strong as the number of entrants into the labor force. When this number falls as a result of lower fertility rates, and when higher life expectancy swells the ranks of pensioners, the only way to sustain PAYG systems is to decrease the level of benefits relative to contributions.

The technical remedies for restoring financial balance are rather straightforward and entail either explicit or implicit measures. An explicit remedy is to raise revenues through higher contributions, increased labor force participation, stronger productivity growth, or larger transfers from general tax revenue. Alternatively, the number of working years required to qualify for a full retirement benefit can be increased.

What is the most effective method? Many experts advocate raising the official retirement age as an efficient tool, because it would-in theory, at least-increase the pool of contributors while shrinking the pool of benefit recipients. Unfortunately, this intuitively simple expectation does not fit with what actually happens in most industrialized countries.

What actually happens is that the average retirement age is sometimes noticeably lower than the earliest eligible age for the normal retirement system. The period between departure from paid employment and entry into PAYG programs is bridged on a country- specific basis by a plethora of public, private, or mixed early- retirement benefit arrangements, such as unemployment insurance, disability insurance, or some form of severance pay.

Besides the generosity of benefits, there is the issue of when one can first claim them. Individuals respond to the incentives created by the variety of early-retirement and retirement programs. The accessibility of early retirement varies widely across different countries and different sectors. While paths to retirement as early as age 50 exist in some countries, in others the lowest eligible age is much higher.

Recent studies show that financial incentives to promote earlier retirement are sometimes powerful, so much so that continuing to work becomes a prohibitively expensive. The implicit tax from working another year and forgoing pension benefits can sometimes be close to a person's net earnings during that year. This type of extreme financial incentive is particularly true in some countries like Belgium or the Netherlands with easily accessible early retirement schemes - schemes which, to boot, often fail to adjust benefit levels to offset their longer duration.

It is argued that early retirement systems cater to needs that are different from those addressed by traditional PAYG schemes. Many European governments used compulsory early retirement to push down the unemployment rate, effectively reducing the number of applicants for any given job by ridding the labor market of older, more expensive workers. Such policies also facilitated structural change, as older workers often lack the skills required in emerging economic sectors.

However, early retirement schemes also imply tremendous-and often neglected-costs for government budgets and the pension systems by increasing benefit payments while reducing contributions. But even leaving aside the fiscal implications, many labor economists now believe that early retirement has failed to open up jobs for young people and reduce unemployment rates.

Early retirement policies everywhere stand in clear need of reform. It is illogical to continue subsidizing a compulsory exit from the labor force while simultaneously trying to safeguard public retirement systems in the face of tremendous demographic challenges. It is all the more irrational in view of the rather modest effects early retirement plans have on unemployment in general, and on youth unemployment in particular.

But reform should not be confined to public retirement systems. Instead, change must be comprehensive and include an overhaul of the myriad pathways to early retirement. An increase in the official retirement age - currently close to 65 in most countries - is pointless to the extent that many people no longer exit the labor force directly into official retirement systems.

In Belgium, for example, only one-third of men exit the labor force directly to one of the public retirement systems. The rest pass through some type of early retirement scheme.

Tightening the rules governing accessibility to different early retirement systems is more likely to be effective than raising the "official" retirement age. But reform of early retirement rules should not completely cut off access to social insurance programs before, say, age 60. There is a considerable degree of heterogeneity in any population, so it is neither fair nor desirable that everyone should be forced to retire at the same age.