The Pension Inducement to Retire: An Option Value Analysis

The option value model developed in an earlier paper is used to simulate the effect on retirement of changes in a firm's pension plan compared to the effect of changes in Social Security provisions. The provisions of the firm's pension plan have a much greater effect than Social Security regulations on the retirement decisions of the firm's employees. The analysis supports the following conclusions: (1) Increasing the firm's early retirement age from 55 to 60, for example, would reduce by almost 40 percent, from .48 to .30, the fraction of employees that is retired by age 60. (2) The effect of changes in Social Security rules, on the other hand, would be small. Raising the Social Security retirement ages by one year, for example, has very little effect on employee retirement rates. The proportion retired by age 62 is reduced by only about 4 percent. (3) Changes in Social Security provisions that would otherwise encourage workers to continue working can easily be offset by countervailing changes in the provisions of the firm's pension plan. Firm responses, like delaying the Social Security offset to correspond to m later Social Security retirement age, may simply be m logical revision of current firm plan provisions.

Pensions, The Option Value of Work, and Retirement

The paper develops a model of retirement based on the option value of continuing to work. Continuing to work maintains the option of retiring on more advantageous terms later. The model is used to estimate the effects on retirement of firm pension plan provisions. Typical defined benefit pension plans in the United States provide very substantial incentives to remain with the firm until some age, often the early retirement age, and then a strong incentive to leave the firm thereafter. (This may be a major reason for the rapidly declining labor force participation rates of older workers in the United States.) The model fits firm retirement data very well; it captures very closely the sharp discontinuous jumps in retirement rates at specific ages. The model is used to simulate the effect on retirement of potential changes in pension plan provisions. Increasing the age of early retirement from 55 to 60, for example, would reduce firm departure rates between ages 50 and 59 by almost forty percent.

Three Models of Retirement: Computational Complexity Versus Predictive Validity

Empirical analysis often raises questions of approximation to underlying individual behavior. Closer approximation may require more complex statistical specifications, On the other hand, more complex specifications may presume computational facility that is beyond the grasp of most real people and therefore less consistent with the actual rules that govern their behavior, even though economic theory may push analysts to increasingly more complex specifications. Thus the issue is not only whether more complex models are worth the effort, but also whether they are better. We compare the in-sample and out-of-sample predictive performance of three models of retirement -- "option value," dynamic programming, and probit -- to determine which of the retirement rules most closely matches retirement behavior in a large firm. The primary measure of predictive validity is the correspondence between the model predictions and actual retirement under the firm's temporary early retirement window plan. The "option value" and dynamic programming models are considerably more successful than the less complex probit model in approximating the rules individuals use to make retirement decisions, but the more complex dynamic programming rule approximates behavior no better than the simpler option value rule.

Why are Retirement Rates So High at Age 65?

In most data sets of labor force participation of the elderly, an empirical regularity that emerges is that retirement rates are particularly high at age 65. While there are numerous economic reasons why individuals may choose to retire at 65, empirical models that have attempted to explain the age-65 spike have met with limited success. Interpreted another way, while many models would predict a jump in the hazard rate at age 65, the magnitude of the spike indicates excessive response given the economic considerations that retirees typically face. This paper considers the puzzle of why retirement rates are so high at age 65 and explores a variety of explanations.

The Effects of Race and Sex Discrimination Laws

The question of the effects of race and sex discrimination laws on relative economic outcomes for blacks and women has been of interest at least since the Civil Rights and Equal Pay Acts passed in the 1960s. We present new evidence on the effects of these laws based on variation induced first by state anti-discrimination statutes passed prior to the federal legislation and then by the extension of anti-discrimination prohibitions to the remaining states with the passage of federal legislation. This evidence improves upon earlier time-series studies of the effects of anti-discrimination legislation. It is complementary to more recent work that revisits this question using data and statistical experiments that provide 'treatment' and 'comparison' groups. We examine the effects of race and sex discrimination laws on employment and earnings, in each case focusing on outcomes for black females, black males, and white females relative to white males. Overall, we interpret the evidence as corroborating the general conclusion that race discrimination laws positively impacted the relative employment and earnings of blacks, although the evidence is less dramatic than that reported in other research, and there are some cases (in particular, earnings effects for black males) and periods for which we find little positive impact. We find some evidence that sex discrimination/equal pay laws boosted the relative earnings of black and white females. Finally, we find that sex discrimination/equal pay laws reduced the relative employment of both black women and white women.

Age Discrimination Laws and Labor Market Efficiency

In Lazear's (1979) model of efficient long-term incentive contracts, employers impose involuntary retirement based on age. This model implies that age discrimination laws, which bar involuntary terminations based on age, discourage the use of such contracts and reduce efficiency. Alternatively, by making it costly for firms to dismiss older workers paid in excess of their marginal product, such laws may serve as precommitment devices that make credible the long-term commitment to workers that firms must make under Lazear contracts. Given that employers remain able to use financial incentives to induce retirement, age discrimination laws may instead strengthen the bonds between workers and firms and encourage efficient Lazear contracts. We assess evidence on these alternative interpretations of age discrimination laws by estimating the effects of such laws on the steepness of age-earnings profiles. If long-term incentive contracts are strengthened or become more prevalent, average age-earnings profiles should steepen for workers who enter the labor" market after age discrimination laws are passed, and vice versa. The empirical analysis uses decennial Censuses of Population and state-level variation in age discrimination laws induced by state and federal legislation. The evidence indicates that age discrimination laws lead to steeper age-earnings profiles for cohorts entering the labor market, suggesting that these laws encourage the use of Lazear contracts, and increase efficiency.