Promoting Work at Older Ages: The Role of Hybrid Pension Plans in an Aging Population

Promoting Work at Older Ages: The Role of Hybrid Pension Plans in an Aging Population Richard W. Johnson and Eugene Steuerle PRC WP 2003-26 Pension Research Council Working Paper Pension Research Council The Wharton School, University of Pennsylvania 3641 Locust Walk, 304 CPC Philadelphia, PA 19104-6218 Tel: 215.898.7620 ● Fax: 215.898.0310 Email: prc@wharton.upenn.edu http://prc.wharton.upenn.edu/prc/prc.html Pension Research Council Working Papers are intended to make research findings available to other researchers in preliminary form, to encourage discussion and suggestions for revision before final publication. Support for this research was provided by Watson Wyatt Worldwide. Opinions and errors are solely those of the authors and not of the institutions with whom the authors are affiliated. © 2003 Richard W. Johnson and Eugene Steuerle. All Rights Reserved. The authors are grateful to Watson Wyatt Worldwide for financial support, and to Adam Carasso and Meghan Bishop of the Urban Institute for updating the estimates presented in Figure 11. Promoting Work at Older Ages: The Role of Hybrid Pension Plans in an Aging Population Richard W. Johnson and Eugene Steuerle Abstract Employers are beginning to search for ways to elicit more labor supply from older adults as the population ages, the ability to work in later life increases, and younger workers become relatively scarce. Many employers are turning to hybrid pension plans, such as cash balance plans and pension equity plans. Whereas traditional defined benefit plans often subsidize workers who retire early and penalize those who remain at work beyond the plan’s retirement age, most hybrid plans reward work at older ages. This paper documents the impact of population aging on the labor market and changes over time in work capacity at older ages. It then shows how movement toward hybrid pension plans, among other types of private and public retirement plan reforms and redesigns, can be used to increase work incentives for older adults. Promoting Work at Older Ages: The Role of Hybrid Pension Plans in an Aging Population Richard W. Johnson and Eugene Steuerle Introduction The world of retirement plans has changed dramatically since the early 1970s. Defined contribution (DC) plans have now supplanted the defined benefit (DB) format as the most common type of retirement plan, in terms of number of participants and value of assets, while hybrid pension plans, including cash balance and pension equity plans, have transformed the DB universe. Although these changes partly represent reactions to tax laws and new conventions among employers perhaps looking to save money, broader economic forces are also clearly at play. Demographic shifts, reflected in the aging of the population, stand out. During the 1970s and 1980s, when the nation’s labor force was growing rapidly, many employers used their pension plans to encourage workers to retire early. Traditional DB plans typically provide lifetime annuities paid in monthly installments that depend on years of service and salary earned near the end of the career. The size of the monthly benefit increases with years of service, but plan participants lose a year of payments for each additional year of work beyond the age at which they can first collect benefits. Because the increase in benefits paid in each installment is often insufficient to offset the reduction in the number of installments, many workers in DB plans lose pension wealth by delaying retirement. DB plans also often include early retirement provisions, which further discourage work at older ages by subsidizing benefits for those who retire early, often as young as age 55. Although many workers remain productive at older ages but retire with many years of life expectancy remaining, employers still used to argue that the retirement incentives in traditional DB plans enabled them to make room for the large numbers of young workers entering the labor 2force each year without resorting to layoffs or wage cuts for older workers, which can destroy employee morale. In addition, seniority pay systems often ended up compensating some older workers more than they were worth in productive output, making the retirement incentives in DB plans even more appealing to employers. Employers were able to let productive workers go because the influx of women and young baby boomers into the workforce created an ample supply of labor. Today, however, as the relative size of the younger population falls, employers confront potential worker shortages and are reluctant to lose their skilled workers to retirement. Meanwhile, pension costs for traditional DB plans have risen over the past few decades, after adjusting for stock market gyrations, because retirees are now living and collecting benefits lo