An Evaluation of the Life-cycle Effects of Minimum Pensions on Retirement Behavior

Abstract

In this paper we explore the distortions that minimum pensions generate on individual decisions, paying special attention to their impact on retirement behavior. This is done with the help of a stylized life-cycle model, which provides a very convenient analytical characterization of the optimality conditions, and a very easy qualitative exploration of the impact of pension rules on optimal behavior. In this context we show that a standard life cycle model, that does not consider minimum pensions, is unable to fit the data. This anomaly is resolved once the mechanism of the minimum pension is taken into account. We follow two steps in order to quantitatively assess the contribution of minimum pensions to early retirement patterns. We first recovered the preference parameters using the model as the data generating process in a structural econometric estimation. We then simulated the change in the aggregate retirement distribution induced by the minimum pension scheme. We found that 3 out of 4 workers leave the labor force before 65 under the minimum pension scheme, while this ratio is 3 in 5 without it. This result suggests that minimum pensions should be carefully considered in any attempt to reform the Spanish pension system. The same conclusion could be extended to other countries with similar systems.

The incentive effects of minimum pensions

“…The model also shows that the minimum pension influences people's saving behavior and welfare [1]. For example, the minimum pension benefits low-income workers, but at the cost of higher contribution rates for the overall population.…”

“…In general, contributory minimum pensions whose benefits are available only after the normal retirement age have little incentive effect on low-income workers [3]. But contributory minimum pension benefits that are available at early retirement age can have strong incentive effects on the transitions to retirement of both employed and unemployed workers [1], [4]. The strength of the effect depends on both the eligibility conditions and the generosity of the guaranteed minimum pension relative to the average wage.…”

“…For simplicity, the utility function is additively separable in consumption and leisure. A visual interpretation of the solution of the individual choice problem for a representative low-income earner, in the institutional environment described in [1], is shown in Figure 1 and Figure 2. The figures show optimal life-cycle behavior and the key determinants of optimal retirement with and without a minimum pension.…”

“…In a life-cycle model estimated using Social Security data, the minimum pension increases the opportunity cost of forgone pension income and removes the incentive to work arising from early retirement penalties [1]. These two effects make it optimal for most low-income workers to retire at the earliest age allowed.…”

An empirical analysis of retirement behaviour in Spain: partial versus full retirement

“…Particularly, the retirement decision of the individual is affected not only by retirement benefits, but also by the future evolution of work and wealth. Another alternative approach is to consider a full life-cycle model, which an example for the spanish case is developed by Jiménez-Martín and Sánchez-Martín (2007). For simplicity, this paper follows a hazard rate approach to capture the effects of personal characteristics, contributory life characteristics and social security incentives on the path to enter retirement.…”