Centre for Market and Public Organisation

1. 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

2. 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

3. 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

4. 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

5. 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

6. 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 Single period accruals

7. 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

8. 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 Peak value

9. 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 Accrual – DB and DC schemes compared 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

10. Accrual – DB and DC schemes compared DB accrual rate = 1/60th Age-earnings profile estimated using FES data 1968-2002 Nominal 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%

11. Predicted retirements – for illustration 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

12. 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

13. 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

14. 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 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) Focus on main pension = private pension wealth > state pension wealth

15. Distribution of pension wealth, by earnings quintile Mean value (£’00,000) Proportion with pension main main any any DB DC No private pension State pension DB DC

16. 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

17. Regression analysis • Estimate the following model using a probit regression: R = binary variable if individual has left work by wave 2 SPW = state pension wealth at W1 for everyone DBW, DCW = DB, DC wealth at W1 for main DB, DC pension SPA, DBA, DCA = accrual (of total pension wealth) for those with main state, DB, DC pension NRA, ERA = binary variable if individual reaches normal, early retirement age by W2 Age = linear age term Y = earnings X 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

18. 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 Results Main wealth

19. 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

20. 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

21. Retirement and pension receipt Source: British Household Panel Survey

22. What does this mean for retirement? Predicted retirement hazards DC pensions associated with later retirement….

23. What does this mean for retirement? Predicted retirement hazards … this has little to do with lower levels of wealth, but largely driven by differential response to pension incentives

24. 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