Flexible retirement age increases income inequality

Many countries in Europe and North America have changed the retirement age in an effort to turn government pensions economically sustainable. The basic idea is sound, people can postpone retirement by a couple of years and in return get higher payments from social security or other forms of government pension. People who need or want to retire early can do so but have to either wait for government pension payments to kick in at a later date or accept lower pension income.

Given that we all live much longer today than when the pension systems we benefit from were designed, it is on average a good idea to pay a lower pension to people who retire early and presumably draw on their pension for longer before they die.

But the problem with this policy, as with so many policies designed by macroeconomists is that while it works on average it does not reflect the differences between individuals. A study in Sweden looked at who these people are who retire earlier or later than the statutory retirement age. In Sweden, at least, about 24% of the workforce retire between ages 61 and 63 and about 18% retire between ages 57 and 61. Compared to that, only about 15% retire after the age of 66.

Effective age of retirement in Sweden

Source: Landais et al. (2021)

So almost half the population retires early or prematurely even though that means they lose pension income. And yes, you guessed it, many of these early retirees don’t do it because they want to, but because they have to. One big driver is ageism in the labour market. People who lose their jobs once they are over 55 have a really hard time finding a new job. But more importantly, people who are in physically demanding jobs may need to retire early because their bodies won’t let them work any longer.

And that is where the problem comes in because people who work in physically demanding jobs also tend to earn less than people who are white collar workers in an office where the biggest physical demand on their bodies is to sit straight in a chair.

So, if you are in a physically hard job, you are probably not able to save a lot for retirement above and beyond your government pension. And then you have to accept a lower pension because your body is acting up and forces you to retire early. Meanwhile, we office workers have well-paid jobs and can work longer in old age (maybe even get a few consulting gigs in retirement to make some extra money) and our bodies allow us to work until we are 65 or older. In the end, the labourer who retires early has a much larger drop in income and consequently in consumption than the office worker. The income inequality that existed before retirement is increased after retirement. The chart below shows the reduction in consumption from two years before retirement until two years after retirement depending on the age of retirement.

Decline in consumption after retirement vs. before retirement

Source: Landais et al. (2021)

What’s the solution to this problem? My friend Michael Falk, who unfortunately passed away last year has provided a lasting legacy with his books on reforming and improving the retirement system. He suggested in his highly recommendable “Let’s All Learn How to Fish” that retirement age should depend on the type of job you do. People with a physically demanding job should have a lower retirement than people with an office job. In essence, this would shift retirement age more in the direction of a percentage of life expectancy without making it too complex. It would really be good if politicians everywhere would start to think about retirement reform in this way rather than thinking about how to cut pensions without actually having to call it a cut.