Breaking the Implicit Contract: Using Pension Freezes to Study Lifetime Labor Supply 
When the baby boom generation members who are still working reach retirement age and leave the labor force, economic growth could slow, the number of Social Security and Medicare benefit claims will rise, and fewer workers will pay into these programs. Eliminating the Social Security component of the payroll tax for workers over the age of 60 has been proposed as a way to incentivize older workers to delay retirement and thus mitigate these adverse effects. To better understand how retirement behavior might respond to such an unexpected policy-induced change in compensation structure, this paper examines the elimination of traditional pensions and subsequent adoption of 401(k) plans by U.S. employers. More specifically, it studies how workers aged 50 to 70 have responded to these so-called pension freezes. The author uses a novel data set that combines detailed administrative information on pension plan characteristics with matched employer-employee data to estimate a model that highlights the importance of forward-looking behavior in determining retirement decisions. This model is suited to evaluating the potential effect of a policy that would incentivize delayed retirement through a permanent shift in future compensation trajectories.
Key Findings
- When faced with freeze-induced compensation changes, some workers choose to retire early while others choose to delay retirement, thereby illustrating that differences in wealth and differences in preferences for leisure are important in explaining retirement decisions.
- Simulations from the estimated model show that eliminating the Social Security payroll tax on workers when they reach age 60 induces a 10-month increase in the average retirement age and increases retirement saving by about $5,700 on average.
- Workers would pay $12,400 more in federal income taxes after age 60, on average, but these gains would accrue against a loss in payroll tax revenue per worker of $25,300.
- The equivalent variation from the Social Security tax reform would average about $54,000 per worker.
Implications
This paper’s counterfactual analysis involving a Social Security payroll tax sunset at age 60 shows that the relatively elastic labor supply of older workers could be harnessed to extend their careers with such a policy. Older workers could obtain substantial welfare gains from the reform and have more income in retirement, although net revenues collected from workers after age 60 could decline by about 10 percent.
Consistent with previous studies, this paper indicates that unobserved determinants of the relationship between employers and employees, such as implicit contracts with a rich set of contingencies, can be influential in driving the association between current labor supply and expected future compensation.
Abstract
This paper studies the elimination of traditional pensions and subsequent adoption of 401(k) plans by U.S. employers. Using thousands of firm-level natural experiments, it shows that unexpected losses in future compensation engendered by pension plan transitions induce premature retirement for some workers and delayed retirement for others. Observed heterogeneity in retirement behavior is indicative of differences in wealth and in preferences for leisure. Using credibly identified treatment effects as estimation targets, it fits a structural model of retirement and uses the model to evaluate the effect of a counterfactual reform that eliminates Social Security payroll taxes for older workers.