Reinforcing the Link between Contributions and Pensions: The Effect of the Population Aging
Lacomba, Juan A., Lagos, Francisco, International Advances in Economic Research
In this paper, we analyze a majority voting process on the earnings-related part of pension benefits in a Social Security system with flexible retirement. We show that the aging of the population may make it easier to implement one of the proposed reforms to achieve a delay in the average retirement age of workers, to reinforce the link between contributions and pensions. (JEL H55, J26)
Keywords Social Security, aging, flexible retirement, earnings-related pensions
Unless serious changes take place, the aging of the population implying a rise in the number of retirees relative to that of workers will threaten the viability of Pay-As-You-Go public pension systems in the long run. On the other hand, it has been demonstrated that pension systems in virtually all OECD countries in the mid-1990s made it financially unattractive to work after the age of 55 [Blondal and Scarpetta, 1999; Gruber and Wise, 1997]. The reason is that after the earliest age at which pensions can be accessed, the costs of postponing retirement (paying contributions for an additional year and foregoing one year of pensions, provided that pensions will be paid out only after leaving the labour force) are higher than the gains (increasing the pension benefits per year). That is, the pension system is implicitly taxing to prolong the working period and then becomes a clear incentive to retire early.
So, in order to solve future financing problems, most Social Security reforms aim to reduce the disincentives to continue working and to delay the retirement age. Two of these economic policy measures are to allow greater flexibility in the retirement decision and to reinforce the link between lifetime contributions and pension benefits (e.g., Germany, Italy, and Sweden). In point of fact, these two measures are part of the policy conclusions of the OECD project The Retirement Decision in OECD Countries, [Blondal and Scarpetta, 1999: p. 8]: "the most appropriate reform would be to allow people to retire at the age of their own choice and to adjust pension levels so that the pension system is neutral on average." The pension system will be neutral when the raise in pensions due to a further year of work makes up for an additional year of pension contributions and for delaying the receipt of pensions by one year removing the incentives to early retirement. But reinforcing the link between life-contributions and pension benefits might imply a reduction in the redistribution from high-wage workers to low-wage workers, and this fact may lead to an excessive degree of compulsion.
Based on Casamatta et al.  two overlapping generations model, we consider a Pay-As-You-Go Social Security system where people can retire at the age of their own choice. (1) Those retiring early receive a lower pension, while those retiring later have a higher pension. Unlike Casamatta et al. , we assume that pension benefits are paid out only after leaving the labour force and the contribution tax rate is given. (2) As such, we focus our attention on the main aspect of the problem of the implicit tax on postponing retirement, the link between lifetime contributions and pension benefits. We introduce a retirement formula consisting of an earnings-related part and of a uniform one. To analyze the extent to which the link between lifetime contributions and retirement benefits can be reinforced, we consider the earnings-related part to be endogenously determined. So, the population chooses the intra-generational redistribution level of the pension system through a majority voting process.
We show that with flexible retirement, population aging may lead to a reduction in the redistribution within generations, implying a lower implicit tax on postponing retirement. This result suggests that to combine neutrality with flexibility in a population-aging context may ease the introduction of such reforms. …