Imagine yourself on a comfy seat like the ones they give to ministers. But do not get too cozy as you are about to make a difficult decision. Population is aging in your country, and there simply is not enough resources to finance the pension benefits of the retirees. What should you do?
The conventional wisdom suggests that you should increase the retirement age. The argument goes as follows. People live six years longer in retirement now than half a century ago. Therefore, using some of those additional years for work is not completely unfair. By increasing the retirement age, you could increase the number of contributors while decreasing that of beneficiaries at the same time. This should provide an effective remedy for the imbalances in pension system accounts.
Although often used by policy advisers, this approach is not always justified as we show in our recent work. It focuses narrowly on pension system imbalances and does not pay enough attention to other factors that may affect people's well-being.
Take savings for instance. Young people often save voluntarily to finance their consumption in old age. If they expect to live longer, then they save more. Starting from relatively low levels, such an increase in voluntary savings should boost capital per worker, wages, and consumption, and thus make everyone better off. Technically speaking, there is a dynamic efficiency gain.
The problem is that savings also respond to other factors including the duration of work in old age and the size of pension benefits. The increase in savings may not be great if people live longer but they also work more in the old age. Wages earned in those extra work years would pay some of the additional bills, sharp increases in savings would be avoided, and dynamic efficiency gains would be limited.
With this perspective in mind, let us rephrase our question: under what circumstances should we increase the retirement age? Our results suggests that we should not do so when pension system is unfunded (pension benefits are financed by current contributions) and based on defined contributions (that is, benefits adjust when the numbers of contributors or beneficiaries change). To see this, note that in such a case the drivers of demographic aging, e.g. living longer or having fewer babies, reduces pension benefits. Knowing this, young people save more to offset the loss in retirement income. Increasing the retirement age, thus, reduces the need to save and weakens dynamic efficiency gains.
Such an effect is particularly significant if aging is driven by increasing longevity. The reason is simple. Savings could potentially increase a lot more in this case. With longer lives, people both need to consume longer and offset the loss in retirement income. As a result, by increasing the retirement age, we forego a larger efficiency gain.
This does not, however, mean that increasing the retirement age is always a bad idea. When the unfunded social security system comes with defined benefits (that is, contributions adjust when the numbers of contributors or beneficiaries change), increasing the retirement age is indeed a good policy option. Aging does not change the pension benefits in this case, but it increases the payroll taxes for social security. These higher taxes could reduce voluntary savings. Under these circumstances, increasing the retirement age allows people to work longer and contain the need to increase taxes. This effect is, again, especially true in longevity driven cases of aging for similar reasons.
Overall, this discussion also has implications for a popular political debate. Do government regulations distort the economy or improve it? In this case, they can do both. Unfunded social security systems reduce voluntary savings by replacing them with inter-generational transfers. In contrast, mandatory retirement rules increase savings as people prefer to smooth their consumption. Therefore, the former distortion makes the latter desirable as a “second-best” solution. Because the sizes of these distortions vary in alternative pension systems, increasing the retirement age may increase or decrease the economic efficiency in an aging society.