Behavioral Dimensions of Retirement Economics


Deciding when and how to retire are among the most important decisions most people make. Can they be depended on to plan with foresight and make sound decisions? According to standard economic analysis the answer is a qualified "yes." But studies by psychologists, sociologists, and economists themselves raise doubts about this comforting appraisal.

This volume by analysts trained in economics and other disciplines suggests that retirement planning and decisions fall far short of...

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Deciding when and how to retire are among the most important decisions most people make. Can they be depended on to plan with foresight and make sound decisions? According to standard economic analysis the answer is a qualified "yes." But studies by psychologists, sociologists, and economists themselves raise doubts about this comforting appraisal.

This volume by analysts trained in economics and other disciplines suggests that retirement planning and decisions fall far short of the rational ideal. Gary Burtless explains what economic research has to say about retirement behavior. Annamaria Lusardi reports that many people in their fifties and older say they have not even thought about retirement. Mathey Rabin and Ted O'Donoghue show that procrastination can cause huge economic losses. Robert Axtell and Joshua Epstein show that herd behavior explains observed patterns of retirement behavior better than does the assumption of rational decisionmaking. George Loewenstein, Drazen Prelec, and Roberto Weber report that many people incorrectly anticipate what retirement will be like and rationalize whatever decision they have made. David Fetherstonhaugh and Lee Ross report experimental evidence that the effect of Social Security provisions may depend on how these policies are "framed" as well as on the specific content of those policies. These and other authors also explore the broader implications of these behavioral patterns.

Copublished with Russell Sage Foundation

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Editorial Reviews

From the Publisher

"'Behavioral Dimensions of Retirement Economics'... takes a large step forward by providing a ready reference for a heterodox approach- behavioral economics- in addressing an important personal and public policy issue, retirement." —John J. Hisnanick, U.S. Naval Academy, Annapolis, Review of Social Economy, 6/1/2000

"A fascinating book for policymakers and scholars alike that applies insights from the new field of behavioral economics to the crucial decision of retirement. These psychologists, sociologists, and economists contend that people don't have the clear preferences often assumed, they lack full information, and they can't calculate the implications of all the options. As a result, they are influenced by their peers, and by how incentives are structured. In terms of Social Security reform, the implications are clear: don't expect people to respond instantaenously to changes in rules, and one lump-sum payment may be more effective than higher future benefits in encouraging people to defer retirement. A must read!" —Alicia H. Munnell, Boston College

"Fresh ideas on an old topic are always welcome, especially when that topic is once again high on the national agenda. By taking a refreshing new look at the retirement decision from the behavioral perspective, this book offers a treasure trove of them. Browse it for fun and profit." —Alan Blinder, Princeton University

"With all the talk about saving Social Security, hardly anyone grasps how individuals and families think about retirement beforehand, decide how and when to prepare for it, and experience it when it happens. That is what this fascinating book is about. It is live research still exploratory, offering new questions as well as new answers." —Robert M. Solow, Massachusetts Institute of Technology

Applies insights of behavioral economics, an emerging field that blends psychology, sociology, and economics, to retirement research and retirement policy. Topics include expectations and savings for retirement, procrastination in planning for retirement, an agent-based computational model for the timing of retirement, and family bargaining and retirement behavior. Material originated at an April 1997 seminar and an April 1998 conference. The editor is a senior fellow in economic studies at the Brookings Institution. Annotation c. Book News, Inc., Portland, OR (
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Product Details

  • ISBN-13: 9780815700647
  • Publisher: Brookings Institution Press
  • Publication date: 9/28/1999
  • Pages: 280

Meet the Author

Henry J. Aaron is a senior fellow in Economic Studies at the Brookings Institution, where he holds the Bruce and Virginia MacLaury Chair. Among his many books are Can We Say No? The Challenge of Rationing Health Care, with William B. Schwartz and Melissa Cox (Brookings, 2006), and Reforming Medicare: Options,Tradeoffs, and Opportunities, written with Jeanne Lambrew (Brookings, 2008).

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Read an Excerpt

Behavioral Dimensions of Retirement Economics

Edited by Henry J. Aaron

Brookings Institution Press

Copyright © 1999 The Brookings Institution.
All rights reserved.
ISBN: 0815700644

Chapter One

An Economic View
of Retirement


Retirement is an event with profound personal, social, and economic consequences. Economists, not surprisingly, focus on its financial ramifications. When workers withdraw from the labor force in old age, their earnings cease and must be replaced by some other source of income. Nowadays the main alternative sources of income are employer-provided pensions and social security. But these only became important within the past half century. Before that, workers who wished to retire were ordinarily forced to rely on transfers from relatives, their own savings, public aid, or charity.

    Economists' interest in retirement has focused on three interrelated phenomena: saving in anticipation of retirement, the timing of retirement, and the impact on the economy of transfers needed to support a large retired population. This chapter focuses on the timing of retirement and its relationship with lifetime consumption.

Trends in Retirement

When workers retire, they withdraw from their normal occupations and reduce their work effort or stop work altogether. At the turn of the twentieth century, retirement was relatively rare but not unknown; two out of three men past age 65 were employed, but one-third were not. By mid-century retirement was far more common: less than half the men 65 and older held jobs in 1950. By 1990 just 16 percent of men older than 65 were employed or actively seeking a job. The proportion of women past age 65 who were employed also fell during the century, but the reduction was far smaller than among men because the percentage of older women in paid work has always been low.

    The decline in labor force participation among older men has not been confined to the United States. It is characteristic of all rich industrialized countries. In some European countries, employment rates among the elderly are now significantly below those in the United States. Along with a shrinking workweek and rising labor force participation among women, earlier retirement among men has been a distinctive feature of economic development in the rich countries.

    That older men are increasingly retired is clearly evident in figure 1-1. Each line traces the labor force participation rate of older American men, by age, during a different year of the twentieth century (a person is considered a labor force participant if he or she holds a job or is actively searching for work). The top line shows age-specific participation rates of older men in 1910. There was a clear pattern of labor market withdrawal with advancing age. Even at age 74, however, the participation rate in 1910 was only slightly below 50 percent. Participation rates in 1940, 1970, and 1995-96 also show a characteristic pattern of labor market withdrawal as men grow older, but the fall-off begins at an earlier age and proceeds at a faster pace.

    The decline in male participation has been neither smooth nor uniform over the century. Figure 1-2 shows the amount of decline in participation at each year of age, measured as a percentage of the 1910 participation rate at the same age. By far the largest proportionate declines have occurred among men past the age of 66. In 1996, for example, the participation rate among 74-year-olds was nearly 80 percent below the equivalent rate in 1910. The fall-off in participation has been proportionately smaller at younger ages.

    The shading scheme in the figure shows how fast participation rates fell in different periods. In general, large declines occurred early in the century for the oldest age groups; large declines have occurred more recently among younger groups. The largest percentage declines among men older than 70 occurred between 1910 and 1940. The fastest declines among those aged 65 to 69 took place between 1940 and 1970. The biggest declines among men younger than age 65 did not occur until after 1970. As we shall see, this pattern of labor market withdrawal is consistent with the view that the introduction and liberalization of social security was an important factor in pushing down the rates. Social security old-age pensions were first paid in 1940, and they were first made available to men aged 62 to 64 in 1961.

    The basic pattern in figures 1-1 and 1-2 is that, although retirement has been present throughout the twentieth century, it is now more prevalent and occurs at a much younger age. Figure 1-3 shows the trend in the "average" retirement age, if that age is defined as the youngest age at which fewer than half the men in the age group remain in the labor force. Under this definition, the average male retirement age fell from 74 to 62 between 1910 and 1996, a drop of about 1.4 years a decade.

    The decline in the average retirement age has occurred in an environment of rising life expectancy among older Americans, especially since 1940 (table 1-1). Falling mortality rates among the elderly have added 3 years to the expected life span of a 65-year-old man and 5.5 years to the life expectancy of a 65-year-old woman since 1940. Because expected male life spans increased about 0.6 year a decade during a period in which the retirement age dropped 1.4 years a decade, the amount of the male life span devoted to retirement climbed about 2 years a decade. Retirement now represents a substantial part of a typical worker's life. For many if not most workers, retirement will last longer than the period from birth until full-time entry into the job market.

     Most of the early U.S. research on retirement trends was conducted by analysts in the Social Security Administration using survey information from retired workers receiving social security benefits or workers who had recently retired. This research, which dates to the mid-1940s, has been summarized by Joseph Quinn, Richard Burkhauser, and Daniel Myers. In the earliest surveys an overwhelming majority of male respondents reported retiring because they were laid off by their latest employer or were in such poor health that further work was unappealing or impossible. In fact, these explanations for retirement dominated the survey responses from the 1940s through the early 1970s. Only a very small percentage of men reported leaving work because they wanted to retire. Quinn quotes an early analyst as suggesting that "most old people work as long as they can and retire only because they are forced to do so.... [O]nly a small proportion of old people leave the labor market for good unless they have to."

     In more recent surveys of new social security beneficiaries the proportion of workers who say they have retired to enjoy additional leisure or other purely voluntary reasons is plainly on the increase. Figure 1-4 presents Quinn's summary of survey responses by men aged 65 and older to the question "Why did you retire?" He has divided responses into four broad categories: "Lost last job," "Health reasons," "Wished to retire," and "Other." This classification is not precise, because survey questionnaires were not always consistent in the way they framed the question or the possible responses a retiree might offer.

Table 1-1. Life Expectancy, by Gender and Decade, 1900-2070 a 
  Life expectancy
at birth

  Life expectancy
at age 65

Year Male Female   Male Female

1900 46.4 49.0   11.4 11.7
1910 50.1 53.6   11.4 12.1
1920 54.5 56.3   11.8 12.3
1930 58.0 61.3   11.8 12.9
1940 61.4 65.7   11.9 13.4
1950 65.6 71.1   12.8 15.1
1960 66.7 73.2   12.9 15.9
1970 67.1 74.9   13.1 17.1
1980 69.9 77.5   14.0 18.4
1990 b 71.1 78.8   14.9 18.9
Projected c
2000 72.6 79.7   15.4 19.4
2010 74.0 80.5   15.8 19.7
2020 74.7 81.2   16.3 20.2
2030 75.3 81.8   16.7 20.6
2040 75.9 82.4   17.1 21.1
2050 76.5 82.9   17.5 21.5
2060 77.0 83.5   17.9 22.0
2070 77.5 84.0   18.3 22.4

    Source: Office of the Actuary, Social Security Administration.
    a. Life expectancy for any year is the average number of years of life remaining for a person if that person were to experience the death rates by age observed in, or assumed for, the selected years.
    b. Estimated.
    c. Based on the intermediate mortality assumptions of the 1993 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds.

     The growing importance of voluntary retirement is clearly apparent in figure 1-4. In the 1940s and early 1950s fewer than 5 percent of new retirees reported leaving work because of a wish to retire or enjoy more leisure. About 90 percent left because of poor health or a layoff. By the early 1980s the desire to leave work explained nearly half of all retirements among men aged 65 or older, while poor health accounted for only a little over a fifth and involuntary layoff about 15 percent.

     Many readers might accept these responses at face value, but economists treat them more skeptically. For example, from 1940 through the early 1970s well over a third of respondents explained their entry into retirement as the result of involuntary job loss. Although this explanation might seem reasonable to noneconomists, hard-headed practitioners of the dismal science realize that millions of workers lose their jobs each year without becoming retired. The overwhelming majority of workers who offer "job loss" as the explanation for their retirement probably lost several jobs during their careers, but on no previous occasion did a layoff cause them to withdraw permanently from the work force. When forced into unemployment at a younger age, they looked for another job and eventually found one. It is natural to ask why job loss pushed them into retirement on this one occasion but not on the others. Even the health explanation arouses skepticism among some economists. Social security beneficiaries may justify their retirement with the excuse that poor health leaves them no alternative, but many economists wonder whether their decision would have been any different if social security were not available.

     Economist and noneconomist can both agree, however, that the persistent trend toward earlier retirement has an important voluntary component. The survey responses plainly show it, and the responses are consistent with what we know about increasing wealth, wider eligibility for public and private pensions, and the increasing generosity of pensions.

Retirement and Consumption

The downward drift in the labor force participation of older men has had a significant effect on the growth in aggregate labor supply, both in the United States and in other industrialized countries. The long-term trend in the retirement age did not attract much notice from economists until the 1970s. Curiously, the first aspect of retirement to command their attention was the effect—or hypothesized effect—of retirement on individual and national saving. The classic statement of this relationship is contained in articles written or coauthored by the economist Franco Modigliani. His theory has had a wide influence on economists' thinking about the timing of retirement as well as the determination of saving. For that reason it is useful to describe the theory in some detail.


Modigliani's basic idea was that farsighted workers will rationally plan their consumption over a full lifetime. In devising their lifetime consumption plans, they will take account of the likely path of their labor earnings as they age and will prudently accumulate savings in anticipation of their retirement. The goal of a good consumption plan is to maximize the worker's lifetime well-being, subject to the constraint that lifetime consumption cannot exceed the worker's lifetime wealth. Lifetime wealth consists of the worker's initial assets and the present discounted value of anticipated labor earnings and other kinds of income such as public assistance and inheritances that are not derived from initial assets or labor earnings. Rational and farsighted workers will plan to avoid situations in which all their lifetime wealth has been consumed long before they expect to die. In the absence of transfers from relatives, public aid, or private charity, the consequences of this kind of planning error might be unappealing.

     It is possible to sketch out the implications of this theory for the path of consumption and wealth accumulation using a few simple assumptions. The top panel in figure 1-5 shows the path of a worker's expected earnings over a lifetime. When he first enters the labor force at age 20 his earnings are just $10,000 a year, but they will climb rapidly as he gains work experience. His earnings reach a peak around age 50 and then gradually decline. He withdraws from the work force on his sixty-fifty birthday, at which point his earnings cease. By assumption, he is completely certain about the path of his future earnings, his age at death (85), and the interest rate throughout his life (5 percent). The worker is able to borrow freely at this interest rate, and if he accumulates savings he will receive the same interest rate on his investments. It is also assumed that the worker has stable preferences throughout his life.

     A worker who successfully solves the consumption planning problem under these assumptions will plot out a desired path of consumption for each future year of life and will then stick with the plan. The best plan will depend on the relationship between the worker's subjective rate of time preference and the interest rate he can obtain on his savings. The rate of time preference is a measure of the worker's impatience in consumption. People who insist on consuming nine-tenths of a box of chocolate truffles today, leaving only one-tenth of it for consumption tomorrow, are said to have a high rate of time preference; they are very impatient in their consumption.

     If the worker's rate of time preference is equal to the market interest rate, the consumption path will be level throughout the worker's life, as I have drawn it in the figure. If instead the rate of time preference is higher than the interest rate, he will attempt to shift his consumption toward the early part of his life, and his consumption will fall as he grows older. People with a very low rate of time preference, those who are very patient in their consumption, will shift consumption to later stages of their life and will plan to increase consumption as they age. Workers may wish to leave bequests to survivors, in which case they will consume all their lifetime wealth except the amount needed to leave to their heirs. I assume in figure 1-5 that the worker plans to make no bequests and will thus consume all his lifetime wealth by the time he dies.

     The resulting consumption path is shown as the horizontal line in the top panel. Because the worker's consumption is initially higher than his earnings, he must borrow money when he is young to finance consumption. In the benign world assumed here, he can borrow as much money as he wants as long as he can repay the loan out of his lifetime wealth. The lower panel in figure 1-5 shows the lifetime path of the worker's asset holdings. He accumulates increasing amounts of debt to finance his consumption until he reaches age 33, when rising earnings allow him to begin paying off liabilities. By age 45 he is free of debt and begins to accumulate assets. The peak of his asset accumulation occurs on his sixty-fifth birthday, the day he retires. His assets are then used up over the last twenty years of his life, when he has no labor income to help pay for consumption.

     The characteristic pattern of increasing and then declining asset holdings over the life cycle is one of the central empirical predictions of Modigliani's consumption theory. The asset buildup would not be needed if workers did not expect to retire. In the absence of retirement, saving would be needed mainly to finance bequests and smooth out consumption in comparison with earnings. Readers may notice that some of the assumptions I have mentioned are highly stylized and are unlikely to be true in life. For example, workers cannot borrow money at the same interest rate they obtain on their investments: usually they must pay a much higher rate than the one they can safely earn. More important, few workers can borrow large sums of money to finance current consumption. These are comparatively minor matters for many workers, however, and addressing them does not fundamentally alter many of the implications of the theory.

     A more serious problem arises when a realistic picture of the worker's uncertainty about the future is introduced. In formulating an ideal consumption plan, it obviously helps if the worker is completely confident about his future earnings, his age at retirement and at death, and the future interest rate. But no one can predict these with much confidence. In formulating the consumption plan, one must take account of the possibility that the future may turn out to be more or less congenial than anticipated.

     In one respect, the life-cycle consumption theory and the closely related permanent-income model represented a major advance in economists' understanding of how consumers handle unexpected events. The two models make a clear and plausible distinction between (unanticipated) changes in flows of income that can be expected to last and changes that are only temporary. According to both theories, an unexpected income improvement that is permanent, such as an earnings gain that accompanies a promotion, will have a much larger impact on a worker's consumption than an improvement that is only temporary, such as a one-time bonus for outstanding job performance. By the logic of the life-cycle model, a person who wins a lottery that pays $10,000 a year for thirty years will plan to make a much bigger change in short-term consumption habits than the person who wins a one-time prize of $10,000. By the same reasoning, the lottery winner who obtains a prize paying a modest annual amount (say $700 a year) that has a present discounted value of $10,000 will alter consumption by the same amount as the winner of a one-time prize equal to $10,000.

     Consumers still face the problem of deciding whether an income change will be long-lasting or only temporary. And if it is long-lasting, when will it cease? These considerations are crucial in determining how much workers should adjust their flow of consumption once they have obtained new information about future income flows. In theory, alert consumers will formulate a new lifetime consumption plan every time they receive new information about the future. If an employer's quarterly earnings statement shows an unexpected drop in profits, employees in the company should scale back their consumption in anticipation of layoffs or slower future wage growth. If interest rates rise, workers may postpone consumption until later in life to take greater advantage of improved earnings on their investments. If a worker suffers an unexpected heart attack, he may boost his saving in anticipation of an earlier retirement and lower lifetime earnings.

     New information about the future state of the world is seldom clear cut. Does a heart attack mean that retirement will last longer because the victim may be forced to leave the work force earlier? Or will it shorten retirement because the worker can expect an earlier death? The two outcomes, if fully anticipated, would have opposite effects on the rate of consumption over the remainder of life, but a farsighted worker will take account of both possibilities in formulating a consumption plan. Will an interest rate hike be temporary or permanent? Even financial market specialists do not have enough information to answer this question confidently.


To say that solving the consumption planning problem under uncertainty is difficult does not mean it is impossible. Workers who devote enough intelligence and attention to the problem will usually make more prudent and satisfying decisions about consumption than those who approach the issue casually or ignore it altogether. The life-cycle-permanent-income theory has produced important insights into consumption planning. Among economists it remains by far the most influential model of consumption. Whether it provides an accurate explanation for observed consumption behavior remains an open question.

     Some evidence supports the theory. Most empirical research suggests that the model is correct in emphasizing that households discount short-run fluctuations in their income when determining current consumption and that retirement is one important motive for saving. There is competing evidence, however, that consumption is more volatile and closely related to current income changes than would be the case if there were complete smoothing of consumption over full lifetime resources. As the theory predicts, economists observe a tendency among many workers to steadily but gradually build up their wealth, increasing their rates of saving in peak earning years and as they approach retirement. The life-cycle theory's implication that consumers have a target wealth-income ratio that increases with age up to retirement also seems to be valid for many households.

     Nonetheless, some economists are doubtful of the theory because simple versions of it are not very successful in accounting for important aspects of personal saving. For example, many American workers enter retirement without any assets. A large percentage of others who do have assets apparently continue to add to them after retirement. Neither fact is easy to reconcile with simple versions of the life-cycle model. Theorists are thus forced to adopt modifications in the basic theory to account for obvious empirical contradictions. Different theorists have proposed different modifications to rescue the basic model. Whatever their criticisms of the model, however, few have strayed far from it in trying to explain retirement behavior.

Economic Models of Retirement

Economic theories of retirement naturally focus on financial aspects of workers' decisions. This section describes some of the financial considerations affecting workers' choice of retirement age. It then considers the theories economists have advanced to explain retirement choice and the evidence they have used to test them. Although economic studies on choice of retirement age did not begin in earnest until the mid-1970s, their number has grown explosively since then. Rather than provide another survey of them, I will focus on a handful to highlight the growing complexity of economists' models of worker decisionmaking.

Financial Aspects of Retirement

Modigliani's life-cycle consumption model emphasizes the single most important financial aspect of retirement—the sharp reduction or complete cessation of labor earnings. Most worker households rely heavily on labor earnings to pay for consumption. When earnings cease at retirement, workers must find another way to pay for it. Modigliani stressed personal saving as an alternative source of support in old age. Even though other income sources are now more important (and still others may have been more important in the past), it is useful to think about the choice of retirement age in a world in which retired workers rely solely on their own savings to finance consumption.

     Consider a worker who can earn exactly $10,000 in each year she is employed. If she begins working at age 20 and has been reliably informed she will expire on her seventieth birthday, she can work for up to 50 years, potentially earning as much as $500,000 over her life. To keep the calculations simple, let us also assume the interest rate and the worker's rate of time preference are the same and are exactly 0 percent. Under that assumption, she will plan to consume her lifetime wealth at a constant rate over her life span. Her lifetime wealth in this case is simply her lifetime earnings, which in turn are equal to $10,000 times the number of years she chooses to work. If she works 40 years, for example, her lifetime wealth will be $400,000, and she will consume this amount at a rate of $8,000 a year ($400,000 / 50 years).

     In this highly stylized case, the worker's retirement choice can be described as a simple trade-off between a higher flow of consumption per year and a longer period of time spent in retirement (figure 1-6). If the worker retires at age 20, she will earn no money, accumulate no assets, and consume $0 a year throughout her life (which is likely to be brief). If she works until age 70, she can consume all of her annual wages ($10,000) each year. It seems reasonable to expect that the worker would prefer to consume more each year (holding fixed the amount she works) and would prefer to retire sooner rather than later (holding fixed the amount she consumes). The illustration in figure 1-6 should be familiar to anyone who has studied freshman economics. The worker's problem is to select the best possible combination of consumption and years of retirement in light of her preferences and the trade-off shown in the diagram. In the figure, the most desirable combination occurs if the worker retires at age 50 after working 30 years and consumes her lifetime earnings at a rate of $6,000 a year. Other workers facing the same trade-off might choose to retire at a younger or older age, depending on their preferences for consumption and retirement.

     Although the analysis may seem trivial, it can shed light on the retirement trends discussed earlier. Retirement ages have declined in the twentieth century, and the simple economic model suggests three reasons this might have occurred. Workers may now enter their careers with a higher flow of income from inherited assets. This provides a straightforward explanation for earlier retirement because under plausible assumptions about worker preferences greater initial wealth will induce most workers to spend more of their life in retirement. Workers also earn much higher wages in the 1990s than they did in 1910 or 1940. The higher rate of pay provides greater lifetime wealth at any fixed retirement age, which may induce workers to spend more years in retirement. Of course, a higher wage also increases the financial penalty on workers who retire early. If a worker's earnings doubled from $10,000 to $20,000 a year, she would give up $20,000 in lifetime wealth rather than only $10,000 if she chose to retire one year earlier. The larger penalty for early retirement might offset some or all of the effect of higher lifetime wealth. Finally, worker preferences may have changed. Independent of the change in initial wealth or yearly pay, workers today may simply prefer to spend more of their life in retirement.

Social Security and Pensions

Other changes in the environment have also affected the trade-off between consumption and the age at retirement. Employer-sponsored pensions are now much more prevalent than was the case fifty or a hundred years ago. Workers covered by a pension are provided with a potential source of income in addition to their own savings for financing retirement. Social security, which was introduced in 1935 and greatly liberalized between 1950 and 1975, also offers a reliable source of income in old age.

     Social security and pensions affect the lifetime trade-off between consumption and retirement in a complicated way. Here I will focus on social security. Workers who become eligible to receive benefits under social security are entitled to receive a pension starting at age 62 or when they retire, whichever occurs later. Because the system has historically been very generous, all generations retiring up to the present have received larger pensions than their contributions could have paid for if the contributions had been invested in safe assets. In effect, this generosity increased the lifetime wealth of older workers who became vested in the system. If they consumed all of the benefits paid to them, they enjoyed higher lifetime consumption than their labor income alone could have financed. The fortunate generations that received this windfall may have retired earlier than they would have if social security had not been introduced or if it had offered less generous pensions.

     The effect of social security on retirement depends on the social security tax and the benefit formula linking monthly pensions to a worker's past covered earnings. Employers and workers pay into the system a combined tax equal to 12.4 percent of wages. The tax thus reduces workers' wages by about 12 percent in comparison with the wages they would receive if the program were abolished. But, of course, contributions allow a worker to earn credits toward a social security pension. The pension entitlement goes up as the worker's covered lifetime wages increase. Whether the increase in the pension entitlement is large enough to compensate a worker for his extra contributions is an empirical question. Low-wage workers receive favorable treatment under social security, so they usually receive a generous return on their contributions. High-wage workers typically receive lower returns.

     Workers who delay their retirement until after age 62 are at least temporarily passing up the opportunity to receive a social security check, which can begin immediately after the worker's sixty-second birthday. If a worker is entitled to a pension of $500 a month, for example, he is sacrificing $500 in retirement income every month he delays retirement past age 62. If his regular monthly pay is $10,000, this represents a small sacrifice. But if his usual pay is $1,000, the sacrifice amounts to half his wage. Between the ages of 62 and 64 the social security formula offers workers a fair compensation for giving up a year's benefits. Monthly benefits are adjusted upward about 8.5 percent for each year's delay in claiming a pension. For workers with average life expectancy and a moderate rate of time preference, this adjustment is just large enough so that the sacrifice of a year's benefits is compensated by eligibility for a higher pension in future years. After age 65, however, the benefit formula is much less generous toward delayed retirement. Postponement of retirement after that age is not fairly compensated by increases in the monthly pension.

     The reason that many people must retire in order to collect a social security check is that the program imposes an earnings test in calculating the annual pension. Workers who are between 62 and 64 and who earn more than $8,640 a year lose $1 in annual benefits for every $2 in earnings they receive in excess of $8,640. Workers between 65 and 69 lose $1 in benefits for every $3 in annual earnings in excess of $13,500. (Pensioners age 70 and older do not face an earnings test.) At one time the earnings limitations were much lower and the tax on excess earnings was much higher, discouraging pensioners from work and possibly encouraging them to postpone claiming a pension until they were confident their earnings would remain low.

     Social security has, then, boosted the lifetime wealth of older people who have received benefits under the program. Its complicated benefit formula provides an incentive for people to become entitled to benefits but may discourage extra work by high-wage workers, who do not receive good returns on their marginal contributions to the program. At age 62, when pensions can first be claimed, eligible people who continue to work give up a year's benefits every year they postpone their retirement. For workers who have a high rate of time preference or who do not expect to live long, this sacrifice is equivalent to a big cut in annual pay. Between the ages of 62 and 64, however, the pension formula fairly compensates most workers for this sacrifice. Starting at age 65 the compensation formula is much less generous, so workers must sacrifice some lifetime benefits every year they delay retirement past 65. Social security does not provide a simple annuity. Most workers must substantially cut their earnings to collect a full pension.


Excerpted from Behavioral Dimensions of Retirement Economics by Henry J. Aaron. Copyright © 1999 by The Brookings Institution. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.

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Table of Contents

Introduction 1
1 An Economic View of Retirement 7
2 Retirement, Retirement Research, and Retirement Policy 43
3 Information, Expectations, and Savings for Retirement 81
Comment 116
4 Procrastination in Preparing for Retirement 125
Comment 157
5 Coordination in Transient Social Network: An Agent-Based Computational Model of the Timing of Retirement 161
Comment 184
6 Framing Effects and Income Flow Preferences in Decisions about Social Security 187
Comment 210
7 What, Me Worry? A Psychological Perspective on Economic Aspects of Retirement 215
Comment 247
8 Family Bargaining and Retirement Behavior 253
Comment 273
Contributors 283
Index 285
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