The replacement rate of unemployment-related benefits are negatively signed and statistically significant. Ten percentage points increase in unemployment-related benefits could decrease participation rates by about 1.5-2 percentage points. Consequently, the increase in unemployment-related benefits between 1971 and 1995, for example, showed result in decreased older age male participation rates (by -8 percentage points). Special early retirement replacement rates had large standard errors and were not statistically significant. Earlier mentioned evidence that disability schemes are used as an early retirement path seems contrary to these results. However, Blöndal and Scarpetta explain that this contradictory result is most likely due to the difficulty in identifying the countries where disability schemes are used as early retirement paths.
Labor market conditions played a significant role in the participation rates of older male workers as well. One percentage point increase in the unemployment rate may decrease about 0,6-0,9 percentage points of the participation rate of older male workers in the longer run. For instance, unemployment rate increased in Finland between 1971-1995 by 12.4 percentage, which might have led to estimated 7.4-11.2 percentage decline in the older male participation rates [4] (Blöndal and Scarpetta 1999, p.38). The Finnish unemployment rate grew rapidly due to the economic depression in the beginning of 1990's. Unemployment was 3.5 percentage points in 1990 but accelerated to 17.8 percentage points in 1993 (OECD, 2010). From Figure 9 it can be deduced that different age groups reacted differently, unemployment rates being highest among 55-59 years old workers.
Figure 9: Unemployment rates between different age groups 1990-2009
Source: OECD 2010
Demographic changes have a significant impact on old labor supply. In particular, changes in the size and composition of the labor force due to the entry into the working age of the Baby Boom generation seem to create pressure to early withdrawal among older male workers. Results of empirical analyses suggest that the increase in the share of prime age population by one percentage point decreases participation rate of older workers by 0.9 percentage points. Effects of demographic changes on participation rates also depend upon labor market institutions. In countries with high centralization of wage bargaining there are bigger changes in the labor supply and participation rates.
Using the empirical results, Blöndal and Scarpetta offer a breakdown of the cross-country differences (Table 5) in the participation rates of older workers over the entire sample period 1971-1995. The average of the 15 OECD countries of the sample is used as a reference for the second column to estimate differences to the value observed in each country. Columns 4-9 display how these differences can be explained by differences in the explanatory variables.
Table 5: Accounting for the cross-country differences in participation rates of male workers aged 55-64:
Source: Blödnal and Scarpetta, 1999 p.75
It should be stressed that this empirical analysis has difficulties to asses the interaction of each component of old-age pension system and other non-employment benefits on the labor supply of older workers. To asses the overall impact of different pension and non-employment benefit structures on labor supply, all pension systems are merged together in one summary indicator: "social security wealth" [5] . The parameter of social security wealth suggests that a 10 percentage points reduction in the implicit tax on continued work of 10 years would lead to an increase of the older male worker participation rate by about 1.8 percentage points. Consequently, a significant drop in social security wealth accrual between 1971-1995 could have led to a fall of about 8-9 percentage points in Finland, Portugal and the Netherlands.
6. How to postpone effective retirement age?
Increases in the old-age dependency ratio in Pay-As-You-Go pension system and other early retirement paths create financial pressure on keeping costs of the society in sustainable levels. To restore financial stability rising the effective retirement is a powerful measure in two ways. It will increase the number of workers and, consequently, it will also decrease the number of eligible pensioners. In this chapter, some ways how to postpone effective retirement age will be explained.
To postpone retirement age it is necessary to eliminate, or at least adjust, factors that cause early retirement. As discussed in previous chapters, in Europe and, generally, developed countries there are many incentives and other factors which lead to early retirement. On the one hand, old-age retirement systems give incentives to retire to those who have reached the age of benefits becoming available. On the other hand, also social security systems, unemployment benefits and disability retirement systems, which function in many European countries as early retirement paths, should be rearranged so that people would work longer. It has to be kept in mind that increasing early- and standard retirement ages can be an effective action, but only if at the same time other pathways to early retirement are blocked. Otherwise the effective retirement age might not increase.
Policies to increase participation rates of older workers can be grouped under three categories:
increasing the earliest and the standard retirement age
increasing the link between contribution years and benefits (towards more actuarial neutrality)
tightening non-pension transfer programs which permit an early withdrawal from the labor market.
A number of countries have already changed retirement ages and eliminated incentives for early retirements. More countries are on the way with pension reforms. The United States, Italy, and Hungary, for instance, increased their standard retirement ages. Furthermore, many countries have increased the retirement age of women rendering it equal to that of men. Measures have been taken to increase the link between contribution years and benefits, so if people retire later and therefore contribute more, their pensions will be increased accordingly. In order to delay retirement, a number of countries (Germany, Belgium, Italy, Finland, Netherlands, Hungary, United Kingdom, and Canada) have started to tighten access to early retirement pension, disability benefits, and unemployment-related schemes. Countries still running Defined Benefit systems have also reduced the implicit tax rates by increasing pension accrual rates. This will increasingly effect replacement rates if people work longer (OECD 2002, p. 144-146).
6.1 Increasing the early and the standard retirement age
Removing or reducing incentives to early retirement can be achieved through more than one way. Blöndal and Scarpetta argue that incentives are usually less distorting prior to the age where old age pension benefits become available. Raising the pensionable age is considered the most direct way to encourage workers to continue work (Blöndal and Scarpetta 1999, p.8).
In countries with generous social security systems, it is not surprising that changing the system by increasing retirement ages and cutting other costs might not be supported by the population. It is not easy to explain that the current system is just not sustainable. A survey conducted in Finland in 2001 showed that raising the retirement age is favored by only 23 percentage of the public, whilst 69 percentage express disagreement. The Finnish survey results were very close to the EU-15 average (Lassila and Valkonen 2006, p. 3).
However, Cremer and Pestieau stated that the so-called iron law of Pay-As-You-Go social security system is inescapable (2003, p. 1). The authors argue that the challenges of aging can only be met by raising the age of retirement, cutting benefits, rising taxes and/or increasing the implicit social security debt.
In 2002, Gruber and Wise published a country-by-country analysis of retirement behavior based on macro-data. They analyzed delays of the benefit eligibility ages and the effect of these delays on retirement timing. They did so through simulating reforms where all eligibility ages of the retirement programs (including disability, unemployment and other retirement pathways) are delayed by three years in 12 countries. The simulation method does not use same year age groups for all the countries but are defined for each country separately. Age groups are defined by the first age at witch at least 25 percentage of men are out of the labor force. This so-called "25 percentage age" plus four years age is used as comparable five years age group for each country. Simulation compares male workers' retirement behavior among the countries in this five year age group.
Figure 10 demonstrates percentage changes of workers out of labor force in the age group "25 percentage age + 4 years" when eligibility age is delayed by three years. "25 percentage age" is shown at the top of the bars. Increasing the eligibility age reduced the number of workers out of labor force in all 12 countries. The average reduction was 47 percentage, with a range from 14 percentage to 77 percentage points (Gruber and Wise 2002, p. 26-27).
This simulation was run two times, firstly only linear measures of ages were used as control variables. In the second run, Gruber and Wise also included age indicators in the estimation. The estimated age indicator effects are used to predict the effect of the program changes. This means that in certain ages the probability to retire is higher than in others, depending on the retirement program.
Results in Figure 10 allow age-specific variables to capture the effect of benefit eligibility on retirement, thus the result is also higher than in the linear approach. Based on the strong impact of eligibility ages in retirement programs on the effective retirement age, the simulation which takes into account age-specific variables holds the more tenable prediction.
Figure 10: Percentage of changes of male workers out of the labor force in age group 25 percentage + 4 years when retirement age is delayed by 3 years.
Source: Gruber and Wise 2002, p. 28
Gruber and Wise did another simulation, in which instead of delaying retirement age by 3 years, early-retirement age was standardized for the age of 60 and standard retirement age for the age of 65 in all countries. Distinctly from the previous simulation, where retirement was delayed by three years, the reform of the retirement system depends here on the existing retirement system and entitlement ages of particular country. It can be assumed that in countries with 25 percentage age set before the early retirement age 60, the number of workers out of labor force will decline. Accordingly, where the 25 percentage age is set after 60, the new reform would lower the early retirement age and increase the number of workers out of labor force. Thus, this will attract more people to withdraw from working force.
Figure 11 displays percentage points of changes in the group of workers out of the labor force after the mentioned standardized early- and standard ages are applied. In Italy, Netherlands, Belgium, France, Canada, and Germany, the 25 percentage age was before age 60. In these countries, the new reform decreases the number of workers out of the labor force by an average of 44%. Accordingly, in Denmark, Japan, Sweden, UK, Spain, and the US, where the 25 percentage age was set after the age of 60, the number of workers out of the labor force increased by an average of 4% (In three of these countries, however, changes were negative). In countries where the number of workers out the working force declined, even the retirement age dropped, due to the replacement rates which were higher before the reform.
Figure 11: Percentage change in the group of male workers out of the working force age group (25 percentage + 4 years) according to the new reform: early retirement standardized to age 60, and standard retirement to age 65.
Source: Gruber and Wise 2002, p. 32
These simulations of Gruber and Wise point out that an increase of eligibility age can be an effective policy to influence retirement decisions of older workers. Despite the fact that retirement systems are different in all observed countries, the reaction of labor force on delayed entitlement age tuned out to be similar and showed positive results on participation.
6.2 Increasing the link between contribution years and benefits
Implicit tax rates on continued work embedded in old-age pension vary among countries. They are, however, significantly high in most Continental European Countries, reaching up to more than 90 per cent (Luxembourg). Implicit taxes on continued work tend to influence the retirement decision towards early labor market withdrawal as continuing work is less profitable for the individual than retirement (Duval 2004, p.10,34).
Blöndal and Scarpetta confirm that a more effective change to public pension systems consists in strengthening the link between life-time contributions and retirement benefits. This actuarially neutral way does not distort the worker's retirement decision. Hereby each additional year of work would be compensated by greater pension benefits upon retirement. This link of contribution and benefits has been discovered and reinforced in many OECD countries, including Finland. This approach leaved individuals their own choice: those wanting to retire earlier will do so at the cost of a lower pension, while those retiring later are rewarded correspondingly (Blöndal and Scarpetta 1999, p.24).
By reducing the implicit tax of continued work this approach encourages workers to stay longer in working life without affecting pension wealth.
Cremer and Pestieau claim that the reduction of the implicit tax has so-called double dividend effect. First, it will encourage able and healthy workers to work longer as they will face smaller implicit taxes. Second, the poor and unhealthy are not going to be effected by implicit taxes as they retire early anyway. Yet through the increase of retirement ages, higher social contributions would also improve pension wealth of the poor and unhealthy (Cremer and Pestieau 2003 p.11). In other words, decreasing the implicit tax would have increasing effect on retirement ages. As a result, this will free resources needed to meet the challenge of aging and improve the lifetime welfare of those with low wages and bad health.
Related to the previous explanations, Blöndal and Scarpetta did a simulation in which the OECD social security systems are reformed to be actuarially neutral. Changes in the participation rates after that reform are shown in Table 6. Changing social security systems to actuarially neutral significantly increased most of the countries' participation rates of workers aged 55-65. The cross-country variability of the participation rates turned also more equal, with most countries reaching a participation rate of at least 60%. Generally, this simulation suggests that a shift to a neutral system could have sizable effects on participation rates in the age group 55-65.
Table 6: Moving to an actuarially neutral pension system 1995
(in percentage of population)
Source: Blöndal and Scarpetta 1999, p.77
Italy, France, Finland, the Netherlands, and Portugal would experience marked increases in their participation rates, especially if unemployment-related benefit systems would be included in the reform package (Blöndal and Scarpetta 1999, p. 41-42).
Nevertheless, there are also doubts. In actuarially fair systems it might become more difficult to use the pension system for redistribution within generations. Only the simple assumption that contributions to the social secure would be the same as benefits gained out of pension leads to further assumptions that individuals with long unemployment and disabilities will have to be covered by some additional scheme to cover their minimum welfare when they retire. Pay-As-You-Go system as non-actuarially fair system where originally more favorable to redistribution of welfare within generation. Although Lindbeck and Persson reminds that institutional features, such as tying pensions to the particular number of working years (for instance only last 30 years are counted as working years), tend to favor those with a steep lifetime income profile. On the other hand less educated starting their working career earlier and work as long as highly educated will have to accept smaller benefit counted only from last 30 working years. Their accumulated pension is still relatively smaller because not all years are included in retirement benefits. Furthermore, women tend to be also favored by non-actuarial systems. Women tend to work less than men but due to institutional features they receive the same retirement benefits as men. In other words: non-actuarial systems redistribute income from poorly educated men to highly educated women. (Lindbeck and Persson 2002, p.19-20)
6.3 Gradual retirement
An alternative to decreasing implicit tax on continued work consists in gradual retirement. This combination of part-time work and partial pension is an important tool to increase the willingness to stay longer at work and make the pension system more sustainable. Winding down the (timely) work commitment is also from the worker's view considered to be a more desired option than a single abrupt departure from the full-time job. Common believe is that reduced hours help individuals to keep their work capacity and work motivation, which in turn allows for longer working careers (Ilmakunnas and Ilmakunnas 2007 p.1).
Moreover, Duval claims that work combined with the pension benefit of a reduced old-age pension or with the receipt of full-pension results in more positive pension wealth and lower implicit tax. He argues that in the extreme case where the pension benefits are not income tested and no contributions to the old-age pension have to be paid, the implicit tax on continued work is simply zero. This is because the stream of pension payments remains unchanged, weather the individual works or not (Duval 2004 p.27).
In order to gain economical sense out of the part-time pension, it should extend the length of a working career. To encourage workers to stay longer at work, special part-time pensions should be designed to substitute for full-time early retirement. Working while being entitled to old-age pension could be encouraged by removing earning-related tests and by giving new pension credits for the earnings received after retirement.
In Finland, work after reaching the retirement age has also been encouraged by introducing gradual retirement. Part-time pensions have become a popular way of achieving a smooth transition from work to retirement (approximately one fifth of workers aged 60-64 are enrolled in part-time pension). In part-time pensions, the benefit gained is 50 per cent of the difference between full-time and part-time earnings. It is granted to an employed person that changes from a full-time work to part-time work, full-time working hours being reduced to 16-28 hours a week. However, the Finnish pension reform in 2005 increased the eligibility age by two years from 56 to 58. Furthermore, the old-age pension accrual on the part-time pension time (non-working time) was reduced from 1.5 % to 0.75 % (Ilmakunnas and Ilmakunnas 2007 p.1,3).
Seija and Pekka Ilmakunnas have analyzed the effects of partial retirement in Finland. Partly due to the partial retirement scheme, employment rates of older workers have risen, especially in the age group 60-64. Since half of the corresponding loss in wage income is compensated as pension income, the partial pension is a popular way of transition from work to retirement. Furthermore, part-time pension accrues benefits to old-age pension, both from the part-time work itself and from the difference between full-time and part-time wage (Ilmakunnas and Ilmakunnas 2007).
Nevertheless, the results of this analysis does not alter the fact that part-time pension has a postponing effect on the timing of retirement. Being already on part-time pension does not have a significant effect in any of the alternative estimations done on the continuing work after the age of 63. Seija and Pekka Ilmakunnas conclude that partial retirement might be a tool that helps in increasing the labor force participation of older workers, yet if it does not increase effective retirement age, it is a relatively expansive tool for the society. First of all, financing partial pensions implies a direct cost to the pension system. Secondly, the reduction in working hours also affects the pension contribution negatively (Ilmakunnas and Ilmakunnas 2007 p.19-20).
6.4 Tightening early withdrawal conditions
As mentioned in previous chapters, reforms in standard pension age should be accompanied by tightening early withdrawal conditions. Blöndal and Scarpetta are also referring to this synergy in their study. The experience of reforming countries states that tightening one benefit system may result in a greater use of other systems. In the Netherlands, for example, reforms to tighten disability systems resulted in a strong increase of unemployment and social welfare benefits. In general, reforms in reducing early retirement conditions need to factor in all possible retirement programs in order to reduce the danger of workers migrating from one system to another (Blöndal and Scarpetta 1999, p.32).
Duval mentions that in the reverse situation where early retirement benefits are allowed or extended, both the wealth of older workers and the implicit tax on continued work tend to rise. Historical experiences show the effective age of retirement plummeting the benefit extensions (Duval 2004, p.11).
In countries where alternative pathways to early retirement are easy accessible, replacement rates and implicit tax rates on continuing work tend to be high. Special early retirement pension schemes are often used to bridge the time until people are entitled to receive the normal old age pension. In order to delay retirement, a number of countries have started to tighten access to early retirement pensions, unemployment- and disability related schemes, and strengthened job-search requirements for older unemployed workers (OECD 2002, p.145).
In the case of Finland radical changes in policies also related to early retirement systems since the 1990's. Unemployment related schemes have been introduced in 1971 followed by other early retirement schemes in the 1980's. These schemes were originally meant for a relatively small number of people which seemed to have weak chances for re-employment. Nevertheless, these pathways were significantly loosened up during the economic depression of early the 1990's. Since 1994, unemployment pension schemes have been tightened up to increase the work participation of older people. Through the reform, which came into force at the beginning of 2005, early retirement schemes were pruned, and both unemployment pension scheme and special early retirement scheme were abolished (Forma et al. 2006, p.7; Hytti 2002, p.287). The next chapter will take a closer look on that reform.
7. The Finnish retirement system reform from 2005
Finland developed a universal pension system later than most Western European countries did. The National Pension Act came into force in 1956, followed by the Earning Related Pension Act in 1962. The first employees whose pension was accrued fully in accordance to the earnings-related pension scheme began to retire in the early 2000's (Järnefelt 2010, p.25).
Nowadays, Finland has a two-tier statutory pension system which consists of the national state pension and earnings-related pension schemes. The system involves buffer funds and the PAYG system aiming at guaranteeing a minimum pension level for those with no (or a very small) earnings-related pension. The aim of the (partially pre-funded) earnings-related pension scheme is to maintain the attained income level to a reasonable degree (Forma et la. 2006, p. 9).
Finnish national pension is benefit-tested, which means that if the earnings-related pension increases, the national pension decreases. The national pension would not be paid if earnings-related benefits of non-married individuals exceed 1207,38€/month, 1075,30€/month for married ones (Forma et la. 2006, p.9; Laesvuori and Elo 2009, p.15).
Since the early 1990's, several changes have been carried out within the pension system, mainly aiming at rising the average retirement age and controlling the growth of costs.
The most significant change, however, was carried out in the beginning of 2005. Main objectives of that reform were to adapt the retirement system to growing average life expectancy. The retirement benefit base was now taking into account the whole life income and combined, and therefore simplified, different retirement schemes. A core aim of the reform was to rise the average retirement age by 2-3 years in the long term, and to increase the link between contribution years and benefits. In the last chapters of this work, an overview of changes made in the Finnish retirement system shall be given. In addition, a short analysis of how these changes will effect retirement behavior of future workers will conclude the topic discussed (Forma et al. 2006, p. 9; Hietaniemi and Ritola 2007, p.9).
7.1 Main characters of the reform
Finish reforms in 2005 made many changes in the retirement system, especially in computation of retirement, income bases, retirement index adjustments, and retirement ages. In Table 7, key elements of changes are presented. Hietaniemi ja Ritola stated five most important issues of the reform as following:
The earnings principle has been strengthened. Pension is now calculated based on the income of each year and changing the work place does not effect pension benefits anymore (before the reforms, the pension was determined by the income of the last ten years of each employment relationship).
The earnings-related pension scheme has become flexible. It is now possible to retire on the old-age pension accrued up to the point of the age of 63 until the upper limit for the old-age pension of 68 years. The formerly fixed retirement age was 65.
The age limit of early retirement has been risen from 60 to 62 years. Now it is possible to access old-age pension only one year early. In that case, the reduction of ones pension per year is 7.2 per cent.
The individual early retirement pension and the unemployment pension have been abolished. (Hietaniemi ja Ritola 2007, p.9)
Life expectancy is now taken into account when calculating pension entitlements. The life expectancy coefficient will be applied for the first time in 2009.
Table 7: Changes in the Finnish retirement system after the reform of 2005
Source: Hakola and Määttänen 2007, p.50-51
7.2 Analyzing the effect of the Finnish retirement reform of 2005
on retirement behavior
To analyze the Finnish pension reform of 2005 based on empirical evidence will not be possible for a long time. Nevertheless, Hakola and Määttänen carried out study using theoretical approaches by describing labor supply and retirement withdrawal decisions on the individual level with the life cycle model [6] .
The authors have thus evaluated how Finnish reforms affected retirement, employment and benefit distribution in the private sector. Their model includes pension rules, unemployment benefits, and progressive income taxation. This model is also more general as it takes into account labor supply decisions even before retirement entitlement age by applying possibilities to withdraw through unemployment- and disability pension pathways. (Hakola and Määttänen 2007, p.9)
The results of the model of Hakola and Määttänen are presented in Figure 12. It can be observed that the expected retirement age before the reform is concentrated on the age 60. 23% of the individuals retire at this age. After the reform, this spike shifts by three years to the age of 63. [7] Hakola and Määttänen explain that this shift is mainly caused by the abolishment of unemployment pension. After the reform, individuals on the unemployment path can choose official withdrawal to retirement between the age 62 and 65. This means also that changes in retirement ages have significant effect on the retirement decision. The average expected retirement age increased by 8.5 months (0.7 years) from age 59.9 to age 60.6.
Figure 12: Distributions of retirement ages before and after the reform of 2005 (sample size: 2000 individuals)
Before the reform After the reform
Source: Hakola and Määttänen 2007, p. 31
It is also important to consider the fact that changes in the disability pension scheme are not taken into account. In Figure 12 the number of disability pensioners after the reform is equal to the one before reforms. As it was already stated, individual early retirement schemes and the unemployment pension scheme were abolished with the reform, so there is a risk that the number of individuals in the disability pension scheme might increase. This effect is not taken into account in the figures. Consequently, the demonstrated increase in retirement age might be overestimated.
(Hakola and Määttänen 2007, p.30-32)
Additionally to estimated expected retirement ages, Hakola and Määttänen have also predicted the timing of withdrawal from labor force before and after the reform. Especially in Finland, the withdrawal age from labor force is significantly different to withdrawal to retirement, as unemployment paths have been used as a bridge between withdrawal from working life and the age when retirement benefits become officially available. Figure 13 shows that withdrawals from labor force (distributed
