Centre for Market and Public Organisation

What do DC pensions mean for retirement?

Evidence from the UK

Sarah Smith

CMPO, University of Bristol and IFS

Background

• UK experiencing shift from DB to DC schemes– Half of all men contracted out of state secondary scheme have a DC scheme

– More than half of those currently approaching retirement (50-64)

• What does this shift in pension provision mean for the timing of retirement?

• Numerous studies have established the importance of pension incentives for retirement

– Pension wealth – positive effect

– Accrual – negative effect

• Stock and Wise, 1990; Gruber and Wise, 2004, for international evidence

• UK – Blundell, Meghir and Smith, 2002, show that growth of DB occupational schemes can explain part of shift to early retirement in 1980s and 1990s

This paper

• How do retirement incentives evolve in DC schemes (compared to DB schemes) and what effect might this have on retirement?

– Absence of strong age-related incentives implies profile of retirements likely to be far smoother

• How do individuals respond in practice to incentives in DB and DC schemes?– Model DB and DC pension wealth and accrual for sample of older workers in English

Longitudinal Study of Ageing (ELSA) and estimate effect on probability of retirement

– DB wealth has positive and significant effect, but DC pension wealth does not

– DB and DC accruals have negative effect, sig only for DC schemes

– Results imply that DC schemes result in later retirements

Previous papers

• Friedberg and Webb (2005) • Estimate separate wealth effects for SS, DB and DC

– SS and DB have positive and significant effects– DC wealth has positive effect, but insignificant

• Estimate accrual effects for SS and DB, but not DC schemes• Simulations show that shift to DC schemes results in later retirements

– DB wealth, but zero accruals– DC pension wealth

• Coile and Gruber (2006)• Estimate separate wealth and accrual effects for SS, DB and DC

– SS and DB wealth have positive and significant effects– DC wealth has positive effect, but insignificant– DC accrual has negative effect, significant at 10% level

The UK

• DC pensions took off in 1988 when the government allowed people to contract out of state secondary pension scheme into DC schemes (previously only DB schemes)

• For people who have contracted out, the low value of the basic state pension means that their private scheme is likely to be the main driver of retirement

• Unique institutional features – compulsory annuitization by age 75

Modelling retirement

• Earliest reduced form models estimated probability of retirement as a function of wealth and single period accruals (or accruals over a discrete period). Failed to take account of non-linearities caused by early retirement windows in DB schemes

• Option Value model – modelled individual retirement decision as a comparison of PV of retiring now with PV of retiring at all possible future retirement ages

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early retirement age, 60

Single period accruals

Option value model

• Value of retirement in period r:

• Value of postponing retirement until r

• Assuming values for , k, and that expected random components are equal to zero, the probability of retirement as a function of G(r*) can be estimated using a probit model

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rsst

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tst EtkBErkBEYErG

Peak value model

• OV dominated by future earnings– These are uncertain

– They may also capture individual heterogeneity

• Coile and Gruber, 2002, proposed simpler Peak Value

• Assuming = k = 1, OV can be re-written as a pure revenue function

• OV should better reflect underlying incentives, but PV may give better approximation

• PV better suited to identifying effects of separate elements of pension system

S

tsst

tsS

rsst

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tst tBErBEYErG *

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Peak value

Accrual – DB and DC schemes compared

Delaying retirement in DB scheme

• Increase value of lump sum and pension by increasing final salary and years’ service (up to max)

• Entitlement to early retirement

• Loss of pension income (after normal/ early retirement age)

• Delay in receiving pension

• Probability of dying without ever drawing a pension

Delaying retirement in DC scheme

• Increase value of pension fund by receiving additional contributions from the state/ employer and getting another year’s return on accumulated fund

• Loss of one year’s pension (after age 50); change in the annuity rate with age

• Delay in receiving pension

• Probability of dying without ever drawing a pension

Accrual – DB and DC schemes compared

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50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74

Defined contribution

DB accrual rate = 1/60th

Age-earnings profile estimated using FES data 1968-2002Nominal discount rate = 5%; inflation rate = 2.5%Survival rate = CMIB, PNML02

DC contribution rate set at 13.5% to yield same pension wealth at age 65; nominal investment returns = 6%

Predicted retirements – for illustration

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DB early retirement DC

Take simulated wealth and peak values, apply previous estimates of pension incentive effects (Blundell, Meghir and Smith, 2002) and predict retirements under two types of pension

What happens in practice?

• English Longitudinal Study on Ageing (ELSA)

• Panel study of 11,400 individuals aged 50+

• Interviewed every two years from 2002; waves 1 and 2 currently available• Detailed information on:

– Pensions – current two and past three schemes– Other wealth (net financial wealth, owner occupied housing, other physical assets)– Income, demographics, economic activity, health

• Here, focus on sub-sample of 1,478 men who are – Aged 50 – 64 and employed in wave 1– Survive to wave 2– Exclude high pension/ non-pension wealth and those who don’t know pension type

• Model retirement between W1 and W2 as a function of (modelled) DB, DC, state pension wealth and accrual

• Ignore possible selection effects into pension type

Modelling pension wealth

• DB pension• Wealth based on self-reported years in the scheme (or, if missing, years with employer)

and self-reported scheme accrual rate. • Assume uprating in line with 2.5% inflation and 50% survivor benefits• Future wealth based on accrual rate (up to max years) and constant, nominal earnings.• Early retirement with 4% reduction in pension value for each year

• DC pension• Self-reported fund value at wave 1, converted into wealth using the second best available

age-specific annuity rate (FSA).• Future wealth assumes contributions remain at their current rate and the fund attracts a

nominal 5% annual return.

• Both use age-specific life expectancies for the cohort from the Government Actuary’s Department and a 5% nominal discount rate

Modelling pension wealth

• Two features of UK pension system

• It’s complicated

• Lots of people have DC schemes with very small amounts in them (£’00,000)

Current DB 26.9% Current DC, past DC 3.4%

Current DB, past DB 4.7% Current DB and DC 3.0%

Current DB, past DC 0.8% Past DB 6.3%

Current DC 34.5% Past DC 1.9%

Current DC, past DB 9.1% No private pension 9.4%

Mean 25% 50% 75% N

Value of DB pension

2.19 0.74 1.88 3.06 670

Value of DC pension

0.49 0.07 0.18 0.46 746

Focus on main pension = private pension wealth > state pension wealth

Distribution of pension wealth, by earnings quintile

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1 2 3 4 5

mean of dbpen mean of dcpen

mean of nopen

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1 2 3 4 5

mean of dbmain mean of dcmain

mean of spmain0

12

34

1 2 3 4 5

mean of spval mean of dbval0

mean of dcval0

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mean of spval mean of dbval1

mean of dcval1

Proportion with pension Mean value (£’00,000)

any main any main

DBDCNo private pension

State pensionDBDC

DB DC - employer

DC - individual

State pension

% sample 33.8% 3.6% 7.4% 55.3%

Total pension wealth 3.26 2.05 2.22 1.38

State pension wealth (£’00,000)

0.47 0.59 0.45 0.63

DB pension wealth (£’00,000)

2.59 0.07 0.54 0.03

DC pension wealth (£’00,000)

0.03 1.29 1.16 0.10

Financial wealth (£’00,000) 0.45 0.61 0.65 0.39

Total non-pension wealth (£’00,000)

1.46 3.18 3.11 1.73

Age 55.0 55.2 55.1 56.6

Gross annual earnings £27,965 £34,357 £41,006 £17,113

Job tenure 16.0 19.6 16.1 10.9

% doing manual work 0.25 0.26 0.35 0.46

% self-employed 0.04 0.02 0.56 0.31

% who retire 0.17 0.09 0.09 0.15

Sample characteristics

Regression analysis• Estimate the following model using a probit regression:

R = binary variable if individual has left work by wave 2SPW = state pension wealth at W1 for everyoneDBW, DCW = DB, DC wealth at W1 for main DB, DC pensionSPA, DBA, DCA = accrual (of total pension wealth) for those with main state, DB, DC pensionNRA, ERA = binary variable if individual reaches normal, early retirement age by W2Age = linear age termY = earningsX includes log of non-pension wealth, whether the individual is working full-time at W1, whether the

individual is self-employed at W1, whether they are in manual work at W1, their job tenure at W1 (and its square), whether their spouse is in work at W1, whether they have college education and indicators for a range of health problems at W1

Plus, dummies for main pension type

• Estimate pooled model, plus separate regressions for each of three main pension types

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2 '7 8 9 10 11ln ln

i

i i i i i i i

i i i i i i

R SPW DBW DCW SPA DBA DCA

NRA ERA AGE Y Y X u

Any wealth

Main wealth

Main wealth

Sep accrual

DB wealth(£’00,000)

.0362**(.0095)

.0374**(.0095)

.0361**(.0094)

.0366**(.0094)

.0380**(.0103)

DC wealth(£’00,000)

-.01773(.0356)

-.0213(.0467)

-.0216(.0484)

-.0224(.0497)

-.0363(.0440)

SP wealth(£’00,000)

.0531(.0469)

.0516(.0467)

.0463(.0476)

.0572(.0478)

.0511(.0478)

DB peak(£’000)

-.1011(.1271)

-.1042(.1269)

DC peak(£’000)

-.2351(.2071)

-.2344(.2071)

SP peak(£’000)

.0503(.1035)

.0544(.1036)

DB acc2005(£’000)

-.0018(.0023)

-.0075(.0050)

-.0087*(.0051)

DC acc2005(£’000)

-.0148**(.0070)

-.0227*(.0127)

-.2330(.1611)

SP acc2005(£’000)

.0003(.0016)

.0008(.0040)

-.0020(.0040)

DB acc2004(£’000)

.0071(.0052)

.0091(.0055)

DC acc2004(£’000)

.0116(.0135)

.2251(.1611)

SP acc2004(£’000)

-.0006(.0041)

.0020(.0047)

N 1395 1395 1395 1395 1395

Log likelihood -472.38 -471.92 -469.98 -467.72 -469.68

ResultsMain wealth

Results

• Wealth

• DB pension wealth enters positively and significantly in all specifications

• State pension wealth enters positively and significantly in single regression

• DC pension wealth enters negatively and insignificantly in all specifications

• Including DB and DC wealth only for main pension results in slightly better fit than including for all, but little effect on the results

• Accrual

• DB pension accrual has expected (negative) sign, but is insignificant in most specifications. Not capturing full range of early retirement incentives?

• State pension accrual is insignificant, but little variation across individuals

• DC pension accrual has expected (negative) sign and is significant in most specifications. Variation across individuals reflects contribution rates. Endogenous?

• Single period accruals result in slightly better fit than peak value

Why no DC wealth effect?

• Researchers are better at modelling (formulaic) DB pension wealth?– But DC pension wealth comes from individuals’ reported values

• Individuals have better understanding of what DB pension wealth means for retirement income?

• DC pension wealth has very different risk properties to DB pension wealth?– Jan 2003 onwards, period of rising stock market, but after-effects of earlier crash

• DC pension wealth may be endogenous for some?– But bias should go the other way

• DC pensions are more flexible and imply a less close relationship between retirement and pensions?

– Part of accrual in DC scheme is independent of working– Individual can draw a DC pension and work

Retirement and pension receipt

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personal pension employer pension

Den

sity

Difference between age started to draw a pension and age stopped workGraphs by pen

Source: British Household Panel Survey

What does this mean for retirement? Predicted retirement hazards

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DB predictions DC predictions

DC pensions associated with later retirement….

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DB predictions DC predictions

DC wealth, DB paras0

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DB predictions DC predictions

DB wealth, DC paras

… this has little to do with lower levels of wealth, but largely driven by differential response to pension incentives

What does this mean for retirement? Predicted retirement hazards

Conclusions

• Shift from DB to DC schemes has implications for the timing of retirement

• DB schemes:• Provided a tool for employers to manage labour market exits (through early retirement

windows). Strong age-related incentives and clustering of retirements

• DC schemes: • Age profile of retirements is (likely to be) smoother. • Estimates suggest weaker link between wealth and retirement, consistent with greater

flexibility. But accruals (contributions?) still appear to be important.• Results suggest that DC schemes result in later retirements.

• Important unresolved issues include– Selection into pension type– Endogeneity of pension wealth and contributions