The Wage Carrot and the Pension Stick: Retirement Benefits and Labor Force Participation. - book reviews

Monthly Labor Review, Sept, 1990 by Michael Bucchi

rities in pension accrual The Wage Carrot and the Pension Stick: Retirement Benefits and Labor Force Participation. By Laurence J. Kotlikoff and David A. Wise. Kalamazoo, MI, W. E. Upjohn Institute for Employment Research, 1989. 147 pp. According to the Bureau of Labor Statistics' 1989 survey of employee benefits in medium and large firms, 63 percent of full-time workers are covered by an employer's defined benefit pension plan. Given this broad coverage, there is interest in determining the nature of the actual annual rates of accrual that are provided by defined benefit plans.

In their monograph, The Wage Carrot and the Pension Stick.- Retirement Benefits and Labor Force Participation, Laurence J. Kotlikoff and David A. Wise take an indepth look at pension accrual. They outline the precise relationships that exist between rates of accrual and such defined benefit plan provisions as vesting schedules and early and normal retirement ages. They also examine the effects, if any, of legislative attempts at eliminating the practice of pension backloading. Finally, they use their findings to test the validity of the spot and contract theories of the labor market.

Kotlikoff and Wise utilize two primary sources of data in this study. The first is the Bureau of Labor Statistics' 1979 Level of Benefits Survey, which provided the authors with specific pension plan provisions such as vesting (years of participation required before benefits become nonforfeitable) and retirement schedules. These BLS data were used to develop the formulas that provided the statistical basis for this study. The authors also examined the characteristics of the defined benefit plan of a Fortune 500 corporation. By tracking the retirement behavior of the firm's employees, it was possible for Kotlikoff and Wise to examine the retirement responses of workers to the specific accrual rates provided by their plan. Pension accrual is defined by the authors as ". . . the difference between the present expected value of vested future benefits at the beginning and the end of the year." Expanding on that definition, annual pension accrual can be described as the actual yearly increase in an individual's accumulated pension wealth beyond the interest earned on previously existing pension assets.

The authors show that actual pension accrual varies widely from year to year. This disparity is a result of several factors, including plan vesting rules and the employee's age, annual salary, and proximity to retirement. For instance, the largest pension accrual typically occurs in the year that the employee becomes fully vested in the pension plan. This is particularly evident when the employee does not become fully vested until late in his or her working life. Of course, each defined benefit plan is different. Therefore, the various vesting and early/normal retirement age provisions create different accrual percentages.

This study shows that significant declines in pension accrual occur after an employee reaches a plan's early and normal retirement ages. The authors maintain that these declines are the result of the failure of most plans to provide for an actuarial increase in benefits for workers who choose to postpone their retirement. The authors also state that, before the 1986 Age Discrimination Act that outlawed the practice, most plans failed to reward employees who continued to work beyond normal retirement age with additional service credit. Because annual pension accrual often decreases (and may even become negative) after the attainment of a plan's early and normal retirement ages, there is actually a large incentive for older workers to leave the labor force. It is this incentive that is the basis for the comparison of the wage carrot and the pension stick. When an employee reaches retirement age, he or she is forced to make a decision. The worker can choose to remain an active member of the labor force and continue receiving wage compensation. However, by choosing this option, Kotlikoff and Wise feel that the employee is sacrificing a portion of the pension wealth to which he or she is entitled. As a result, with each continued year of employment, the employee is actually experiencing a year of reduced (and sometimes even negative) pension accrual, because he or she is reducing the number of years that pension benefits will be received.

Kotlikoff and Wise also attempt to outline the effect that recent legislation has had on the receipt of pension benefits. Prior to passage of the Employee Retirement Income Security Act (ERISA) in 1974, pension plans often were designed in such a way that it was not possible to accrue significant amounts of pension wealth until a long service requirement (typically 25 years) had been met. This custom was referred to as "pension backloading." Pension backloading was believed to inhibit worker mobility because it penalized workers who left the employ of a firm before they had fulfilled the necessary vesting requirement. The authors reach the conclusion that ERISA (which required 100 percent vesting upon 10 years of plan participation) and the Tax Reform Act of 1986 (which lowered this requirement to 5 years) did little to prevent the practice of backloading. Instead of including a specific service provision, plan administrators have placed restrictions upon supplemental benefits, altered early retirement benefits, and restructured Social Security offset policies. The authors use the Fortune 500 finn as an example. Under the firm's defined benefit pension plan, an employee becomes 100-percent vested after 10 years of service. Annual pension accrual from this point on is positive, but not significant. However, at the plan's early retirement age, pension accrual is quite large. By limiting the value of annual pension accrual in the years between the point of 1 00 percent vesting and early retirement, the firm effectively forces the employee's hand. In order to reap the large pension benefit, the employee must stay at the firm. Therefore, these new provisions have the same effect as the old substantial service clauses.