Retirement: Early Retirement Incentives
RETIREMENT: EARLY RETIREMENT INCENTIVES
Early retirement incentives (ERIs) are programs or characteristics of benefit plans that encourage older workers to retire before the normal retirement age. This statement raises a series of questions: What is the normal retirement age? What is retirement? Are these incentives permanent components of human resource policies or temporary windows of opportunity? Why do firms seek to encourage early retirement? This entry examines each of these questions and also considers the ERIs in public programs and government regulation of private policies that encourage early retirement.
Employer-provided pension plans
Pension plans are an integral component of human resource policies in many firms. Approximately half of the labor force is covered by a retirement plan on their job (Employee Benefit Research Institute). There are two basic types of pension plans: defined benefit plans and defined contribution plans (McGill et al.). In a defined benefit plan, the retirement benefit is based on a formula that typically specifies benefits based on retirement at a certain age as a function of final average earnings, years of service, and a generosity parameter. Reduced benefits are usually available at a younger age. The employer has the responsibility for paying the promised benefits. Therefore, the plan sponsor makes annual contributions to the pension fund, invests the plans’ assets, and is required to purchase benefit insurance from the Pension Benefit Guaranty Corporation.
In defined contribution plans, the employer, the employee, or both contribute to individual accounts for each participant. The employee manages the account and makes all investment choices. The benefit is determined by the size of the account at retirement. Defined contribution plans include 401(k) plans, money purchase plans, and profit-sharing plans. Traditionally, defined benefit plans have been the dominant type of pension plan in the United States; however, since the mid-1970s there has been a major shift away from these plans and toward the increased utilization of defined contribution plans (Pension Benefit Guaranty Corporation).
Pension plans usually specify a ‘‘normal retirement age.’’ In defined benefit plans, this is the age at which a worker can begin to receive pension benefits under the plan’s benefit formula. If benefits are paid before this age, they typically are reduced by a factor that is a function of age and service. The normal retirement age is not the age at which a normal or average person retires, nor is it the age at which most people retire. Instead, the normal retirement age is the age at which a person qualifies for full or unreduced retirement benefits. In this discussion, ‘‘retirement’’ refers to workers leaving a particular company and does not mean that they completely leave the labor force, nor does it imply that the individual necessarily has substantially reduced his or her hours of work. For example, a person can retire from one job, start receiving a pension, and begin working full- or part-time for another employer (Quinn). Transition to a postcareer or bridge job is encouraged by ERIs because they provide an incentive for a person to leave a career job but not necessarily to leave the labor force.
Defined benefit plans. Defined benefit plans specify a retirement benefit that a worker will receive if he or she starts to draw a pension at the normal retirement age. While the most frequently used normal retirement age is sixty-five, many plan sponsors have a normal retirement age of sixty-two or sixty, and in some plans, workers can receive unreduced benefits after a specified length of service regardless of age—for example, thirty years of employment with the firm. Virtually all defined benefit plans also include early retirement ages, often as young as fifty or fifty-five. Individuals who start to receive retirement benefits before the normal retirement age have their annual benefits permanently reduced relative to the benefit they would receive at the normal retirement age.
The U.S. Bureau of Labor Statistics (1998, 1999) provides detailed information concerning important provisions of pension plans, including normal retirement ages, early retirement ages, and reduction factors for those who start to receive benefits prior to the normal retirement age. In most plans, the magnitude of the reduction in annual benefits for taking early retirement is less than the reduction required to set the actuarial present value of benefits beginning at the earlier age equal to the value of actuarial present benefits if they were started at the normal retirement age. This means that the present value (or discounted value) of benefits beginning at early retirement would exceed the present value of benefits beginning at normal retirement. This characteristic provides a subsidy to individuals who decide to take early retirement, and thus encourages retirement from the firm prior to the normal retirement age.
Another way of illustrating the early retirement incentive is to consider the annual gain in the value of actuarial present pension benefits (often called pension wealth) from working an additional year. In most defined benefit plans, the wealth value of pension benefits increases rapidly as a worker approaches the age of early retirement. The change in the wealth (or present) value of benefits is called the pension accrual. The pension accrual increases in absolute size and relative to annual earnings up until the age of early retirement. It rises with additional years of service and increases in annual earnings, and because the worker is getting closer to the time that he or she can begin to receive the pension benefit. The size of the pension accrual also depends on the firm’s choice of pension characteristics.
After the worker reaches the age of eligibility for early retirement, the pension accrual stops increasing and actually begins to decline. This is because the worker can now retire and start receiving pension benefits, and because the penalties for early retirement are less than the actuarially fair reduction. Thus, an employee who keeps working will forgo a year of benefits. The decline in pension accruals represents a reduction in total compensation, that is, it is equivalent to taking a pay cut. The reduction in compensation, combined with access to retirement benefits, provides a clear incentive to employees to leave the firm prior to the normal retirement age (Kotlikoff and Wise, 1985). This is the basic early retirement incentive that is embedded in virtually all final-pay-defined benefit plans.
The economics of employer pensions shows that firms can influence retirement decisions through choice of a pension plan, setting the normal and early retirement ages, and selecting the magnitude of reductions in the early retirement benefit. The change in pension accruals as the worker approaches and passes the ages for early and normal retirement can be very large. For example, Kotlikoff and Wise (1989a) found a pension accrual in one plan of 150 percent of salary for a person working from age fifty-four to age fifty-five, the latter being the age of early retirement. After passing the age of early retirement, the accrual dropped sharply, and by age sixty the pension accrual was only 10 percent of salary. Thus, the total compensation from working (salary plus pension accrual) dropped from 2.5 times annual salary at age fifty-four to 1.1 times annual salary at age sixty. In other words, the value of working an additional year after age sixty was only half that of working an additional year after age fifty-four.
Empirical research shows that individuals respond to these incentives by retiring in greater numbers when they qualify for early retirement benefits (Quinn et al.; Kotlikoff and Wise, 1989b). These types of early retirement incentives are inherent in most traditional defined benefit plans. They provide strong encouragement for workers to leave the company at these ages, and workers respond to the retirement incentives. Companies seeking to provide ongoing incentives for workers to retire at specified ages prior to sixty-five can effectively achieve their objective by adopting a defined benefit plan with subsidized early retirement provisions.
Defined contribution plans. Pension accruals based on employer contributions to defined contribution plans are less variable with age and service. Most plans specify an employer contribution that is a fixed percentage of salary. However, in many 401(k) plans, employee contributions are voluntary and thus depend on the worker’s decision to make annual contributions. Pension accounts in defined contribution plans grow because of these annual contributions and in response to returns on invested assets. There are no magic dates in which pension accruals spike up or drop sharply. In general, these plans provide actuarial equivalent benefits regardless of the age at which the benefits start or a lump sum is taken. Thus, defined contribution plans tend to be more age neutral in their retirement incentives and do not have ERIs. The dramatic growth in defined contribution plans means that fewer pension participants are covered by the ERIs that are part of most defined benefit plans.
Hybrid pension plans. During the 1990s an increasing number of large employers converted traditional defined benefit plans to cash balance plans and pension equity plans. These plans are technically defined benefit plans because the firm remains responsible for pension contributions and the management of the pension fund; however, they have many of the characteristics of defined contribution plans. The retirement benefit is specified as an account balance that grows with annual credits based on salary and returns to the pension account balance. Workers can leave the firm at any age and take the account balance with them. These hybrid plans do not contain the ERIs that are inherent in the traditional defined benefit plans (Clark and Schieber). In addition, managers at many of the firms that have converted their pensions from a traditional defined benefit plan to a hybrid plan give as one of the primary reasons for the change the desire to eliminate early retirement incentives (Clark and Munzenmaier; Brown et al., 2000). The trend toward increased use of these hybrid plans also means that fewer pension participants will be eligible for ERIs in the future.
Special window plans
Early retirement programs that are available to workers for a specified period of time are often called window plans. Such plans offer special terms for retirement, but the worker must accept the offer and retire by a certain date; the retirement window opens and then closes. These plans have taken many forms but are often linked with an existing defined benefit plan. For example, the plan might state that if the worker retires within the window, pension benefits will be calculated by adding three or five years to the worker’s actual age, or by adding three or five years to the worker’s years of service, or both. Obviously, retirement benefits will be higher under the terms of the window plan, thus providing the worker with an incentive to retire now rather than waiting. Window plans were widely used by large corporations in the 1980s and early 1990s in efforts to downsize their workforces. Switkes provides a detailed assessment of the effectiveness of window plans offered by the University of California.
Workers respond to these special retirement incentives by moving up their retirement date and leaving the firm sooner than they had planned. Firms typically introduce window plans when they are attempting to reduce the size of the labor force. By downsizing, firms reduce the cost of active workers; however, pension costs are increased. This may not be considered a problem if the pension is overfunded, so that new contributions are not required to support the cost of the window program. These plans are less cost effective if the company is trying to address imbalances in the age or skill mix of its workforce at the same time higher payments to retirees are coupled with additional wage payments to persons hired to replace the departing workers.
Companies that adopt early retirement window plans are usually large firms seeking to reduce the size of their labor force and, thus, their labor costs. These offers have to be generous enough to alter the retirement decisions of workers. One problem often associated with these plans is that high-quality workers (the ones the company would like to keep) are often the first to leave because they can take the ERI from their current firm and find employment with another company. Workers with fewer employment opportunities (lower-quality workers) may be less likely to accept the ERI. Because of this incentive, some organizations have attempted to target their window plans to certain divisions or workers with below-average pay.
Employer-provided retiree health insurance
A major factor influencing the retirement decision of many workers is the ability to purchase health insurance and the cost of this coverage. Medicare provides almost universal coverage to persons age sixty-five and over; however, individuals considering early retirement must be concerned with how to pay for their health care from retirement until age sixty-five. Workers who are covered by employer-provided health insurance while employed must include the cost of buying individual health insurance coverage if they retire. Comprehensive health coverage for a retiree and spouse is very expensive. The prospect of paying for health insurance until age sixty-five reduces the probability that older workers will take early retirement.
Beginning in the 1960s, many large companies adopted retiree health plans that allowed workers to remain in their former employer’s health plan until age sixty-five, or, in many instances, for life. Employer-provided retiree health insurance should be considered an important ERI program. Limited evidence indicates that persons covered by retiree health plans are more likely to retire than other older workers (Currie and Madrian). These plans are often used in conjunction with pension plans to facilitate retirement (Clark et al.). The incidence of coverage by retiree health plans declined substantially during the 1990s in response to increases in medical costs, changes in accounting rules, and reductions in Medicare payments (U.S. Bureau of Labor Statistics, 1998).
Impact of ERIs
Early retirement incentives can be either permanent or temporary, part of an ongoing pension plan or a special offer to workers. In general, ERIs are adopted by firms seeking to reduce their labor forces by increasing retirements rather than resorting to layoffs. ERIs provide workers with monetary incentives to leave the firm. Evidence indicates that older employees respond to these incentives and retire earlier than they would without the ERI. The impact of ERIs on labor costs depends on the generosity of the incentive plan, whether all retiring workers are replaced or the workforce is actually reduced, and whether the organization is able to use monies in overfunded pensions to finance the ERI. Typically, wage and salary costs will decline; however, pension costs including the ERI will increase. The impact on the quality of remaining workers is less certain, and depends on which workers accept the ERI. Given the economic incentives, firms risk losing their best older workers. As a result, companies may attempt to target their ERIs.
Robert L. Clark
See also Pensions, Financing and Regulations; Pensions, Plan Types and Policy Approaches; Retirement, Decision Making; Retirement Planning; Retirement Planning Programs.
Brown, K.; Goodfellow, G.; Hill, T.; Joss, R.; Luss, R.; Miller, L.; and Schieber, S. The Unfolding of a Predictable Surprise: A Comprehensive Analysis of the Shift from Traditional Pensions to Hybrid Plans. Bethesda, Md.: Watson Wyatt Worldwide, 2000.
Clark, R.; Ghent, L.; and Headen, A. ‘‘Retiree Health Insurance and Pension Coverage.’’ Journal of Gerontology 49 (1994): S53–S62.
Clark, R., and Munzenmaier, F. ‘‘Impact of Replacing a Defined Benefit Plan with a Defined Contribution or Cash Balance Plan.’’ North American Actuarial Journal 5, no. 1 (January 2001): 32–56.
Clark, R., and Schieber, S. ‘‘Taking the Subsidy Out of Early Retirement: The Story Behind the Conversion to Hybrid Pensions.’’ In Innovations in Managing the Financial Risks of Retirement. Edited by Olivia Mitchell, Zvi Bodie, Brett Hammond, and Steve Zeldes. Philadelphia: University of Pennsylvania Press, 2001.
Currie, J., and Madrian, B. ‘‘Health, Health Insurance and the Labor Market.’’ In Handbook of Labor Economics. Edited by David Card and Orley Ashenfelter. Amsterdam: Elsevier Science, 1998.
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Kotlikoff, L., and Wise, D. ‘‘Labor Compensation and the Structure of Private Pension Plans: Evidence for Contractual vs. Spot Labor Markets.’’ In Pensions, Labor, and Individual Choice. Edited by D. Wise. Chicago: University of Chicago Press, 1985. Pages 55–85.
Kotlikoff, L., and Wise, D. ‘‘Employee Retirement and a Firm’s Pension Plan.’’ In The Economics of Aging. Edited by D. Wise. Chicago: University of Chicago Press, 1989. Pages 279–330.
Kotlikoff, L., and Wise, D. The Wage Carrot and the Pension Stick. Kalamazoo, Mich.: W. E. Upjohn Institute for Employment Research, 1989.
McGill, D.; Brown, K.; Haley, J.; and Schieber, S. Fundamentals of Private Pensions, 7th ed. Philadelphia: University of Pennsylvania Press, 1996.
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Quinn, J. Retirement Patterns and Bridge Jobs in the 1990s. Employee Benefit Research Institute Issue Brief no. 206. Washington, D.C.: EBRI, 1999.
Quinn, J.; Burkhauser, R.; and Myers, D. Passing the Torch: The Influence of Economic Incentives on Work and Retirement. Kalamazoo, Mich.: W. E. Upjohn Institute for Employment Research, 1990.
Switkes, E. ‘‘The University of California Voluntary Early Retirement Incentive Programs.’’ In To Retire or Not? Faculty Retirement Policy in Higher Education. Edited by Robert Clark and Brett Hammond. Philadelphia: University of Pennsylvania Press, 2000.
U.S. Bureau of Labor Statistics. Employee Benefits in Medium and Large Establishments, 1995. Washington, D.C.: U.S. Government Printing Office, 1998.
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Companies offer incentive plans to encourage employees to work harder. Incentive pay is a reward for employees or employee groups whose extra effort on the job results in higher production levels. For instance, incentive pay might be given to a sales department that exceeds its monthly sales goals. In addition to helping motivate employees, many companies believe that incentives improve recruiting and retaining high-quality workers, boost morale, and send a positive message about management's performance expectations.
Incentive schemes can be found at all levels of a company, from the shop floor to the boardroom. To be effective, an incentive plan must be clearly defined and the terms for payment understood and agreed upon by the employer and employees. There are several types of incentive schemes, which provide different ways to determine if an employee should receive incentive pay. The type of program will also affect how an employee's job performance will be measured. For example, factory workers might have their job performance rated according to their contribution to a team or the quality of the product they produce. On the other hand an executive's job performance might be based on company profit or cash flow. The outcome of these performance measures will determine whether an employee qualifies for incentive pay.
Incentives may be monetary or nonmonetary and may include cash or vest an employee in a profitsharing plan. In some ways incentive pay is similar to an employee bonus program because compensation in both plans is based on exceptional job performance and paid in addition to an employee's basic salary. Bonuses, however, are usually given to employees only once a year, while incentive payment is made immediately after an employee becomes eligible for it.
Incentive programs are an outgrowth of the piece-rate system. The piece-rate system bases payment on the number of units that workers produce. The system began in the sixteenth century with the disintegration of the craft guilds. At that time, merchants hired people to work from their homes; home-based workers were then paid based on piecework. This piecework system was replaced by the rise of the Industrial Revolution in the late 1700s, which took production out of the home and into the factory. The use of incentives for factory work did not come about until the end of the 1800s, when scientific management theorists said that financial rewards could improve worker performance.
See also: Industrial Revolution
in·cen·tive / inˈsentiv/ • n. a thing that motivates or encourages one to do something: there is no incentive for customers to conserve water | ∎ a payment or concession to stimulate greater output or investment: tax incentives for investing in depressed areas | [as adj.] incentive payments.