Project in detail

Correct Actuarial Calculation of Pension Reductions

Members of this project:

The level of correct pension reductions for early retirement has often been a matter of contention among scientists, depending on whether actuarial calculations are based on the perspective of the individual or that of the pension insurance scheme. The two methods thereby applied have been termed the incentive-neutral and the budget-neutral approach. From the standpoint of the insured person, reductions are incentive-neutral if early retirement and regular retirement render the same net annuity value. From the standpoint of the pension insurance scheme, retirement age is irrelevant as long as contribution rate development remains unchanged (budget-neutral approach). The project aimed to conceive and apply new approaches for the computation of correct benefit reductions, and to compare these approaches, setting the reductions thus obtained in opposition to the currently applicable 3.6% rate of reduction. In addition, the various determinants of correct reductions were elaborated. The correct level of reductions for early retirement was initially calculated with the help of three ``net present value (NPV)-based´´ approaches – (i) incentive-neutral, (ii) budget-neutral and, as a novelty, (iii) yield-neutral. It was found that all of them ultimately differed not in their mode of calculation but only in respect of the discount rate used. Another finding was that the incentive neutrality of the first approach ensued if the implicit taxation of contributions equaled the implicit tax on early retirement pensions. Hence, incentive neutrality was accomplished through the creation of two disparate distortive taxes, rendering this approach problematical. Correct reductions were moreover calculated also for cases in which the relevant alternative to early retirement was not the ongoing pursuit of a gainful occupation but unemployment and inactivity. The NPV approaches were subsequently contrasted with the utility-oriented approach, where results are highly dependent on the imputed utility function and parameter values. All in all, the currently valid statutory reductions are too low when applying the NPV approaches. Correct reductions are subject to numerous determinants. Thus, life expectancy is of considerable significance as it determines the duration of pension payments, hence the timeframe throughout which reductions can be distributed. Dependence on life expectancy also explains the disparities between correct reductions for men and women, as well as among birth cohorts. Of equal importance is the discount rate as it determines how heavily future pension payments are weighted. Accordingly, correct reductions decline in proportion to • longer life expectancies, • younger birth cohorts, • lower imputed discount rates, • larger gaps between actual and regular retirement age, • higher wage increase rates and/or pension adjustment rates, and • prolonging effects of survivors' pensions on the duration of pension payments. Consequently, if uniform reductions are applied to all birth cohorts, to men and women, and to every early retirement age, this will always be a mistake. The amount of reductions also depends on the relevant alternatives available for the period between potential early retirement and the statutory, i.e. normal, retirement age. The standard approach used for the calculation of reductions presumes sustained employment subject to social insurance contributions as the relevant alternative. Yet that need not be the case. If the relevant alternative before reaching normal retirement age is unemployment or inactivity, incentive-neutral reductions will be much lower. If an early retiree achieves additional earnings in the phase prior to normal retirement, the correct reductions must be higher. Analogous to reductions, pension credits can likewise be calculated; they are awarded if the insured extend their gainful occupation beyond the statutory age limit, thus delaying retirement. The condition for the computation of incentive-neutral credits, mirroring that for reductions, is that the taxation of contribution payments must just equal the subsidy paid to the late retiree. Here again, the statutory credits currently set at 6% are as a rule too low. To remove the incentive for regular retirement as per the statutory age limit, the rates would have to be about 7% to 8%. In sum, the findings suggest that statutory pension reductions and, where applicable, pension credits should be increased. This holds true all the more if the planned introduction of the ``combi pension´´ is to be flanked by drastically raised limits on early retirees' additional earnings. Beyond augmenting reductions, another meaningful step would be to distinguish according to retirement age and birth cohorts. The study has been published in Jahrbuch für Wirtschaftswissenschaften.

News & Events

SHARE User Conference 2019 in Budapest, Hungary

Registration open

Read more

SHARE Book Release in Brussels - June 25, 2019

First results of SHARE Wave 6 and 7 - Health and socio-economic status over the life course

Read more


Latest Newsletter

MEA is coordinating