Incentives for Early Retirement in Canada s Defined-Benefit Public and Private Pension Plans: An Analysis with a Dynamic Life-Cycle CGE Model

Transcription

1 Paper presened a he John Deusch Insiue Conference, Reiremen Policy Issues in Canada, Ocober 26-27, 2007 a Queen s Universiy. The final version is published in a book eniled Reiremen Policy Issues in Canada, edied by Michael G. Abbo, Charles M. Beach, Robin W. Boadway and James G. MacKinnon, 2009 (Kingson: John Deusch Insiue, Queen s Universiy). Published in cooperaion wih McGill-Queen s Universiy Press and available a: hp://mqup.mcgill.ca. Preliminary, please do no quoe wihou permission Incenives for Early Reiremen in Canada s Defined-Benefi Public and Privae Pension Plans: An Analysis wih a Dynamic Life-Cycle CGE Model Maxime Fougère, Simon Harvey, Yu Lan, André Léonard and Bruno Rainville Human Resources and Social Developmen Canada Absrac This paper reviews he incenive effecs of Canada s public pension sysem and defined-benefi employer pension plans on early reiremen behaviour. I uses a dynamic applied general equilibrium overlapping generaions model o quanify he impac of hese incenives on labour supply, producive capaciy and economic welfare and evaluaes some opions o reduce hese incenives. Simulaion analysis indicaes ha eliminaing he main work disincenive effecs of he Canadian public pension sysem on reiremen behaviour would have a moderae posiive impac on he labour supply of older workers in low- and medium-skilled occupaions, bu a marginal effec on high-skilled workers. On he oher hand, he main disorionary effecs of defined-benefi privae pension plans are significanly larger for all skills groups, bu paricularly for older workers in high-skilled occupaions. Résumé Ce aricle se penche sur les effes inciaifs à la reraie anicipée du régime canadien de pensions publiques e des régimes privés d employeurs. Un modèle d équilibre général calculable dynamique à généraions imbriquées es uilisé pour quanifier l impac de ces inciaifs sur l offre de ravail, la capacié de producion e le bien-êre. De plus, quelques scénarios de poliiques visan à réduire les inciaifs à la reraie anicipée son examinés. Les résulas de simulaion indiquen qu une éliminaion des effes inciaifs à la reraie anicipée du régime de pensions publiques aurai un impac posiif mais faible sur l offre de main-d œuvre des ravailleurs âgés dans les professions à faible e moyen niveaux de compéences, mais un impac rès minime sur les ravailleurs plus hauemen qualifiés. D un aure côé, les effes inciaifs à la reraie anicipée des régimes d employeurs à presaions définies son beaucoup plus grands e on beaucoup plus d influence sur le comporemen des ravailleurs dans les professions à compéences élevées The auhors wish o give a special hanks o Alain Denhez (PRI) and Geoff Rowe (Saisics Canada) for allowing us o use LifePahs o help calibrae he CGE model.

2 1. Inroducion Canadians are reiring when hey are younger han he sauory reiremen age of 65, he age a which hey become eligible for unreduced public benefis. According o Saisics Canada, he average age of reiremen has declined seadily in Canada over he 1976 o 1998 period from around 65 for men and 64 for women during he second half of he 1970s o 61.5 years and 60 years respecively by he lae 1990s. However, since 1998, he rend in reiremen seems o have haled. In fac, from he lowes level observed in 1998, he average reiremen age has ended o increase somewha, ranging beween 62 and 62.5 years in for men and around 61 years for women. Some sudies have shown ha he cos of early reiremen is subsanial in erms of unused producive capaciy and hours of work (e.g. Fougère e al. 2005, PRI 2005, Rowe and Nguyen 2003, Herbersson and Orszag 2001). Also, in he conex of populaion ageing, he negaive labour supply shock due o early reiremen will inensify given ha here will be more and more people in he age group. According o Human Resources and Social Developmen Canada - Policy Research Direcorae s demographic projecions, he proporion of he populaion will increase by abou 50% beween 2000 and Canada s public pension sysem generaes work disincenives for older workers. Alhough i is generally acknowledged ha hese disincenives are small compared o many oher OECD counries (Gruber and Wise, 2004), several commenaors have suggesed ha he C/QPP sysem should be reformed (Guillemee 2004, Milligan 2005). There is also some evidence ha defined-benefi employer pension plans in Canada provide incenives o reire before he age of 65. According o Pescarus and Rivard (2005), of he 13 privae pension plans hey examined, all of hem offer he sronges incenives o reire before age 60. The objecive of his aricle is hree fold. Firs, i reviews he incenive effecs of Canada s public pension sysem and defined-benefi privae pension plans on early reiremen behaviour. Second, i uses a dynamic applied general equilibrium overlapping generaions (OLG) model of he ype developed by Auerbach and Kolikoff (1989) o quanify heir 2

3 impac on labour supply, producive capaciy and economic welfare. Third, i evaluaes some opions o reduce early reiremen incenives. The OLG model used in his paper capures he economic impac of projeced fuure demographic changes and he incenive effecs of policy hrough he life-cycle. Moreover, in he spiri of Becker (1965), he model uses a ime allocaion srucure where labour supply, human capial and leisure/reiremen decisions are endogenous. We also innovae by modeling he reiremen incenives from Canada s public and privae pension plans. The incenives are expressed as implici ax raes for workers and are derived from a pension calculaor ha akes ino accoun he ineracions beween he various elemens of Canada s Public Pension Sysem and defined-benefi employer pension plans. The LifePahs model from Saisics Canada was also used o generae deailed informaion on RPP and RRSP conribuions and benefis o help calibrae he OLG model. Simulaion analysis indicaes ha eliminaing he main work disincenive effecs of he Canadian public pension sysem on reiremen decisions would have a moderae posiive impac on he labour supply of older workers in low- and medium-skilled occupaions, bu a marginal effec on high-skilled workers. The impac on high-skilled workers comes mainly from he eliminaion of he OAS claw back. Eliminaing early reiremen incenives in public pensions would also be welfare enhancing. Alhough lifeime leisure would decrease, i is generally more han compensaed by increases in lifeime consumpion. Several reform opions are also examined o make he program near incenive-neural. Among hose, raising he acuarial adjusmen in C/QPP has he mos favourable impac. However, delaying he sauory reiremen age is no a viable opion, since he macroeconomic impac is virually zero. The analysis also shows ha he main disorionary effecs of defined-benefi privae pension plans are significanly larger han hose in public pensions and generae more work disincenive effecs on older workers in high-skilled occupaions. The cos of early reiremen in erms of unused producive capaciy associaed wih DB employer pensions is abou seven imes larger han ha in he public pension sysem. Finally, i mus be noed ha since he mid-1980s, he proporion of members of privae plans ha are covered by DB plans has 3

4 decreased from 95% in 1984 o 84% in This reducion in he proporion of plans members in DB plans has likely conribued o an overall reducion in work disincenives. A coninued declining rend in he proporion of DB plans over he nex decades, if i maerializes, could also help o furher reduce he impac of early reiremen incenives. The remainder of his paper is divided as follows. Secion 2 presens an overview of early reiremen incenives from he Canadian public pension sysem and privae pension plans. Secion 3 provides esimaes of early reiremen incenives from boh public and privae pension plans in he form of implici ax raes using a pension calculaor. Secion 4 describes he CGE model used for he analysis and discusses he key parameer values. Secion 5 presens simulaion resuls of he impac of early reiremen incenives from boh public and privae pension plans on he economy and labour marke, simulaes some policy opions o eliminae work disincenive effecs in public pension plans and examines a likely scenario of furher reducion in he proporion of defined-benefi privae pension plans. Secion 6 presens some sensiiviy analysis. Finally, Secion 7 provides some concluding remarks. 2. Incenives o Early Reiremen This secion provides an overview of early reiremen incenives in boh Canadian public and privae pension plans. Following Sock and Wise (1990), reiremen incenives inheren in defined-benefi pension plans can be decomposed ino wealh and accrual (subsiuion) effecs. Firs, pensions increase an individual s wealh. Assuming leisure is a normal good, an increase in pension wealh - he presen value of fuure reiremen benefis - will lead an individual o consume more of every hing, including leisure. Second, an accrual or subsiuion effec exiss when pension wealh varies according o he reiremen age. The accrual effec can be defined as he difference in pension wealh beween aking reiremen now and one year laer. When i is posiive, meaning ha working one addiional year increases pension wealh, here is an incenive o coninue working; when negaive, here is an incenive o reire. If reiremen benefis are based solely on conribuions and do no depend on he age of reiremen, he accrual effec is zero and he reiremen decision is enirely based on he 4

5 rade-off beween addiional leisure and consumpion. Accordingly, defined-conribuion pension plans have no accrual effec, only a wealh effec. In he remaining par of his secion, we will discuss in more deails he source of early reiremen incenives in boh Canadian public and privae pension sysems. 2.1 Canada s Public Income Securiy Sysem Older individuals face financial disincenives o coninue working originaing from he public pension sysem, which is primarily composed of wo program groups: Old Age Securiy (OAS) programs and Canada/Quebec Pension Plans (C/QPP) 1. The combined OAS programs represen a similar share of reiremen income as C/QPP. For example, ne C/QPP paymens represened $33.5 billions in 2006, compared wih $31.0 billion for all OAS programs 2. The basic OAS pension is offered o all individuals 65 years of age and older who mee residency requiremens. The maximum benefi was $ per monh in July 2007 (benefis are adjused quarerly reflecing changes o he Consumer Price Index). Coninuing o work pas age 65 does no affec OAS benefis, unless he individual s annual income (oher han from OAS pension programs) is higher han $63,511 (in 2007), in which case 15% of he excess income is clawed back. This mainly affecs highly-skilled individuals. On op of he Old Age Securiy basic pension, he Guaraneed Income Supplemen (GIS) provides addiional money o low-income individuals 65 years of age and older. In July 2007, he maximum monhly benefi was $ for each member of a couple and $ for singles. The GIS is reduced by 50 cens for singles and 25 cens each for couples for every dollar of family income exceping OAS. This means ha GIS benefis are zero when monhly family income (exceping OAS) is higher han $1, for singles and $1, for couples. Coninuing o work pas age 65 will reduce GIS for all workers. However, highly- 1 Québec workers do no paricipae in he CPP, bu raher in he Québec pension plan, which is very similar o he CPP. 2 Daa for secion 2.1 come from Human Resources and Social Developmen Canada, The CPP & OAS Sas Book

6 skilled workers are more likely o have income from oher sources (savings, privae pensions, RRSPs, ec.). Thus, wheher hey work or no, hey will no likely receive he GIS. Therefore, he GIS will be a greaer disincenive o work for low-skilled individuals (saring a age 65). The OAS sysem also has anoher feaure, he Allowance (formerly known as he Spousal Allowance), which is paid o low-income years-old spouses of GIS recipiens, widows and widowers. In July 2007, he maximum monhly benefi was $ for a spouse or parner and $ for a survivor. The maximum monhly Allowance is reduced by 75 cens for every dollar of oher income. The Allowance is a disincenive o work, mainly for low-skilled workers aged 60 o 64 years old. However, he upake of his program is very low (94,000 recipiens in 2006 compared wih 4.3 million for OAS and 1.5 million for GIS), since is requiremens apply o few individuals. The C/QPP is an earnings-based pension plan. I is compulsory from age 18 and covers almos all workers in Canada. I is funded by a payroll ax. In 2007, conribuions for boh he employee and he employer were 4.95% of annual earnings beween $3,500 (he year s basic exempion) and $43,700 (he year s maximum pensionable earnings), for a maximum annual conribuion of $1, Benefis are calculaed as 25% of a person s pensionable earnings over he period he individual is aged 18 o 65, wih he lowes-earning 15% of monhs in ha period being dropped from he calculaion. Therefore, someone wih earnings above he maximum pensionable earnings for a leas 85% of he 47 years beween 18 and 65 will earn he maximum benefi of $ per monh in The normal upake for he C/QPP is age 65, alhough reiremen pensions can begin beween ages 60 and 70. Early reiremen is penalized by 0.5% a monh, so ha if C/QPP is aken a age 60, benefis are decreased by 30%. Similarly, reiring afer age 65 increases he benefis by 0.5 % a monh, for a maximum of 30% if C/QPP is aken a age 70. Individuals have o sop working if hey wan o claim early C/QPP. Before age 60, C/QPP consiues an incenive o work, since working one addiional year will increase fuure benefis for mos workers, because of he possibiliy of dropping he 15% wors monhs in erms of earnings from he calculaion of benefis. Beween age 60 and 65, working one addiional year means losing one possible year of C/QPP benefis. On he 6

7 oher hand, i also means ha benefis will be increased by 6% over he res of he individual s lifeime (because of he accrual adjusmen), maybe more considering working one more year would help increase he number of years wih high income (he 15% drop rule). However, his 6% rae is insufficien o compensae for he los year of benefis, so overall, beween 60 and 65, C/QPP offers a disincenive o coninued work. Overall, he public sysem offers posiive work incenives unil age 60, because before his age, working longer increases fuure C/QPP benefis. A age 60, disincenives begin, caused by he possibiliy of collecing C/QPP benefis, in which case he person has o sop working. A his age, working one more year doesn increase fuure benefis enough o compensae for he loss of one year of benefi. The ineracion beween C/QPP and GIS is a major disincenive o coninue working beween age 60 and 65: working one addiional year increases he value of fuure C/QPP paymens, mainly because of he acuarial adjusmen, bu a he same ime diminishes fuure GIS benefis by 50 cens for every dollar of increased C/QPP benefis. The Allowance is also a disincenive o work beween age 60 and 64, bu he effec is very small as few people benefi from i. A age 65, OAS and GIS programs sar. The basic OAS pension is reduced for high-income individuals who coninue working. GIS, which is inended for low-income individuals, is also reduced by 50 cens for every dollar of income earned. 2.2 Regisered Privae Pension Plans (RPPs) RPPs are reiremen income plans provided by employers or unions. These plans are provided volunarily, and ake wo basic forms: defined benefi (DB) and defined conribuion (DC). DB plans are funded by conribuions of employers and employees, and are based on he cos of providing fuure benefis, which are defined in he plan ex. The benefis are normally based on he number of years of service wih he employer, and are ofen a percenage of he earnings of he individual during his whole career, or he bes or las years of he worker s career. Benefis normally sar a a cerain age or afer a cerain number of years of service wih he employer (or a combinaion of he wo). There can be penalies for 7

8 hose who choose o reire before hey reach he required number of years of service or age. Therefore, DB benefis vary according o reiremen age. A DC plan is a reiremen plan wherein a cerain amoun of money is se aside by employers every year. Employees can also conribue as much as hey wan. The benefis are no specified and are based on he reurn on invesmen and how much each employee conribued. Since benefis are no deermined by rules linked o reiremen age, as in DB plans, DC plans do no have accruals. They affec reiremen decisions only hrough he wealh effec. The percenage of beneficiaries of privae pension plans (DB or DC) sars o be significan in he year old group (9%), becomes sronger (around 26%) in he group, and is highes among high-skilled individuals 3. Char 2.1 Proporion of privae pension plan members covered by a DB plan, Canada, % 95% 90% 85% 80% Source: Saisics Canada, Pension Plans in Canada Survey In 2006, 84% of members of privae pension plans were covered by DB plans. As shown in Char 1, he proporion of members of a privae plan covered by a DB plan (raher 3 The daa source for he coverage by skills level and age group is he 1999 Survey of Financial Securiy. 8

9 han a DC plan) has seadily declined since he mid-80s. This shif owards DC plans was also experienced in he U.S., bu o a much larger exen. Munnell and Perun (2006), using he U.S. Survey of Consumer Finances, illusrae ha he proporion of members of privae plans covered only by DB plans decreased significanly, from 62% in 1983 o jus 20% in Esimaes of incenives o early reiremen from public and privae pension plans This secion provides esimaes of early reiremen incenives from boh public and privae pension plans, in he form of implici ax raes, using a pension calculaor o esimae pension accruals. Please noe ha he accrual effecs are calculaed by skill level since he CGE model used in his paper has hree represenaive workers by skill low-, medium- and high-skilled workers. This ype of pension calculaor was inroduced by Sock and Wise (1990) and was recenly used by Baker, Gruber and Milligan (2003) and Milligan and Schirle (2006). Pension accruals are expressed as implici ax raes by dividing he accrual for one paricular reiremen age by average earnings a ha age. In his exercise, we firs calculae Income Securiy Wealh (ISW) from public sources. The pension calculaor incorporaes all of he rules used o calculae C/QPP, GIS and OAS enilemens in The Allowance is no included in he pension calculaor, because i is only paid in very specific siuaions; he upake of he Allowance is also quie small, so incorporaing his program would have a negligible effec on work disincenives in aggregae. Daa from he 2001 Census are used o consruc age-specific lifeime earnings profiles for he differen workers by skill levels in he model. Earnings daa are for full-ime employees. We assume smooher earnings profile and calculae prediced earnings raher han acual earnings by esimaing a simple regression of earnings on a consan, age and age squared as independen variables. These earnings profiles are used o calculae C/QPP, GIS and OAS enilemens for reiremen a each age saring a 53. C/QPP paymens are received saring a age of reiremen or age 65, whichever is earlier. GIS is received a reiremen age or age 65, whichever is laer. OAS always begins a 65, because all seniors sar receiving a leas some OAS benefis a his age, unless heir income is very high (more han $100,000 in 9

10 2007 which is greaer han he income of our represenaive high-skilled worker). Lifeime pension receips are hen discouned for ime-preferences and survival probabiliies o give a measure of ISW a each poenial reiremen age. The individual rae of ime preference is se a 0.03, which is common in he lieraure, and survival probabiliies come from Saisics Canada s Life Tables. 4 ISW is compared beween subsequen reiremen ages o deermine raw accruals, which are hen divided by age-specific earnings o express hem as an implici ax on earnings. Table 3.1 shows he average implici ax raes by age group and skill level. A negaive sign means here is a disincenive o coninue working a his age. Implici ax raes are generally posiive before age 60, as coninuing o work increases fuure C/QPP benefis. Table 3.1 Average implici ax rae, by age of reiremen and skill level, public pensions only Age Low-skilled Medium-skilled High-skilled The implici ax rae is he difference in income securiy wealh if reiremen occurs a age x and a age x-1, divided by earnings a age x-1. A negaive sign means here is a disincenive o coninue working. Saring a age 60, disincenives arise because of he possibiliy of aking early C/QPP. This is mainly he case for low or medium-skilled individuals, because heir earnings are lower, and because he los year of C/QPP benefi represens a higher share of heir earnings. Also, conrary o he high-skilled individuals, hey are more likely o receive GIS in he fuure. Therefore, coninuing o work, while increasing heir C/QPP enilemen, will also decrease heir GIS enilemen. The disincenive usually grows from 60 o 65, because he 4 Saisics Canada, Life Tables, Canada, Provinces and Terriories,

11 penaly for aking C/QPP before age 65 decreases: he los year of C/QPP becomes of a higher value. In he meanime, fuure GIS enilemens decrease o a greaer exen, because every dollar of increase in C/QPP enilemen reduces fuure GIS benefis by 50 cens. Afer age 65, he disincenives are he following: for he low-skilled, he only disincenive is he loss of one year of GIS benefi. For he medium-skilled who ake heir reiremen afer age 65, he C/QPP benefi is high enough ha hey don ge any GIS benefi, so here are no more disincenives. The high-skilled don receive any GIS benefi as well, bu heir OAS benefis are reduced if hey coninue o work because heir earnings are higher han he hreshold of $63,511. We hen inroduced privae plans in he pension calculaor. Since here is no one unique privae pension plan bu housands of hem, we had o illusrae he disincenive effec of such plans for a represenaive agen, using he average benefi received from privae plans by age group and skill level, from he Survey of Financial Securiy of We hen muliply hese numbers by he proporion of beneficiaries of DB plans in each age group and skill level. Table 3.2 shows he resuls of his calculaion. We sar by measuring he work disincenives a age 55, which is he normal upake in many pension plans; daa also shows ha he upake sars increasing wihin he age group. The disincenive reaches a maximum a age 61-64, and we keep i consan aferwards, even hough daa shows ha benefis decrease afer his age. We believe his observed decline in he daa reflecs he financial siuaion of older cohors raher han an acual decrease in benefis afer 64. Table 3.2 Average benefis from DB plans for represenaive agens, by age group and skill level Age group Low-skilled Medium-skilled High-skilled $894 $2,039 $4, $1,474 $2,696 $6, and more $3,208 $4,702 $9,454 Survey of Financial Securiy, Saisics Canada, 1999 Table 3.3 shows he new implici ax raes, when boh public and privae plans are included, as well as he difference beween hese new implici ax raes and he raes from Table 1, where only public plans were included. This difference can be roughly seen as he 11

12 effec of privae plans on implici ax raes (a negaive signs means he disincenive increases). Including privae pension plans in he pension calculaor increases o a grea exen he work disincenives, especially afer age 61, and more so for he high and medium skilled han for low-skilled workers. This is because a higher proporion of high-skilled workers are covered by such plans and heir benefis are higher. Table 3.3 Average implici ax rae, by age of reiremen and skill level, privae and public plans and difference wih Table 1 (public plan only) Public and privae plans Privae plans only Age Low- Medium- High- Low- Mediumgroup Skilled Skilled Skilled Skilled Skilled High-Skilled The implici ax rae is he difference in pension wealh if reiremen occurs a age x and a age x-1, divided by earnings a age x-1. A negaive sign means here is a disincenive o coninue working. 4. The Model The analysis is based on a dynamic compuable general equilibrium model wih an OLG srucure. The model is calibraed o represen he Canadian economy. In his secion, we presen a deailed descripion of he model. 4.1 Household Behaviour The populaion is represened by 16 represenaive Canadian-born agens and 16 represenaive immigrans agens, srucured in an Allais-Samuelson OLG srucure. Consequenly, a each period of ime, 16 Canadian-born plus 16 foreign-born generaions live 12

13 side by side. A any period, a new generaion is born and he eldes dies. Each naive-born agen eners he labour marke a he age of 17 and dies a he age of 81. This implies ha each period of he model corresponds o four years. Younger individuals are assumed o be dependen on heir parens (he represenaive agens), implying ha hey play no acive role in he model. The populaion growh rae and immigraion are exogenous. The model also disinguishes beween four caegories of agens in each immigraion class: hree differen skill levels of workers (high, medium and low) and a fourh caegory of aduls who are unaached o he labour marke (inacive). Canadian and foreign-born agens opimize a CES ype iner-emporal uiliy funcion of consumpion and ime allocaion subjec o lifeime income and ime consrain. The household (or agen) s opimisaion problem consiss of choosing he consumpion and savings paern over he lifecycle, as well as he allocaion of ime beween work, educaion and leisure. Time spen in educaion is considered o be human capial invesmen. Human capial gains also raise effecive labour supply and he qualiy of leisure. For each of he 8 differen ypes of agens, he iner-emporal uiliy funcion akes he following form: (1) U C qual na, g, g 80 1 σ θ 1 θ 1 θ qual, na = Cqual, na, g, + g 1 + φqual, na, g qual, na, g, + g 1 1 σ g= ρ ( ), l 0 < θ < 1., and l qual, na, g, are respecively consumpion and leisure aciviy of an agen of qualificaion qual, naionaliy (Canadian-born or foreign-born) na, age group g a ime ; ρ he pure rae of ime preference; σ he inverse of he iner-emporal elasiciy of subsiuion ε (ε = 1/σ); θ he inverse of he inra-emporal elasiciy of subsiuion beween consumpion and leisure aciviy η (η = 1/θ); and ø qual, na, g he leisure aciviy preference parameer. Noice ha as he 4 h caegory of agens is inacive, heir iner-emporal problem is simplified by assuming ha hey consume wha hey receive in ransfers from he governmen. Consequenly, heir wealh (Ag, ) remains equal o zero a all imes and heir ime allocaion is exogenous. The human capial echnology is described by a well-behaved funcion, linear in he sock of human capial h, bu sricly concave wih respec o educaional and raining ime. 13

14 Human capial producion is individualized, and oal producion of new human capial in he economy is simply he sum of all generaions producion. The specificaion chosen is similar o ha in Lucas (1988, 1990). The echnology for he producion of human capial akes he following form: hqual, na, g, γ (2) h qual, na, g + 1, + 1 = + βhqual, na, g, zqual, na, g, + Expqual, na, g, 1+ δ, β > 0, 0 < γ < 1, δ > 0, where z is he fracion of ime allocaed o he producion of human capial, δ he human capial depreciaion rae, γ he elasiciy of human capial producion, β a producion parameer and Exp an experience variable ha evolves exogenously wih age. Each agen is endowed wih one uni of ime for each period of life. As ime can be allocaed o leisure aciviy and he producion of human capial, wha is lef for labour marke paricipaion (Lpar) is: (3) Lpar qual, na, g, = 1 zqual, na, g, l qual, na, g, The represenaive agen of each ype opimises equaion 1 subjec o 2, 3 and o he budge consrain. The represenaive agen budge consrain in each period of life is: (4) A A = w h Lpar (1 τ cr dbcr ) + w qual, na, g+ 1, + 1 qual, na, g, qual, qual, na, g, qual, na, g, ra (1 τ ) + Tr (1 τ ) + OAS (1 τ ) + k w w qual, na, g, qual, g, qual, g 13, GIS + C / QPP (1 τ ) + RPP, 10, (1 τ ) (1 + τ ) C,,,, w w c qual, g 13, qual, na, g 12, qual, na g qual na g where A qual,na,g represens he asses accumulaed by skill level, immigraion saus a age g and ime, cr he conribuion rae o public pensions, dbcr he conribuion rae o definedbenefi privae pensions, τ w he ax rae on labour income, τ k he ax rae on capial income and τ c he ax rae on consumpion expendiures. Governmen ransfers are represened by Tr qual,g,, OAS qual,g,, GIS qual,g, and C/QPP qual,na,g,. Tr represens governmen ransfers excluding public pensions, OAS is Old Age Securiy, GIS includes Guaraneed Income Supplemen and Spouse's Allowance (SPA). C/QPP is Canada and Quebec Pension Plans (C/QPP) benefis and RPP qual,na,g, is benefis from a defined-benefi regisered pension plan (privae pension 14

15 plan). Boh C/QPP and RPP benefis are a fracion of lifeime bes labour earnings and are deermined respecively by he pension replacemen rae CQPP_rr and RPP_rr qual,g (see able 4.1). In equaions (5) and (6), he lef-hand side is oal pension benefis o be paid and he righ-hand side is workers conribuions. (5) POPqual, na, g 12, C / QPPqual, na, g 12, = cr POPqual, na, g, wqual, hqual, na, g, Lparqual, na, g, qual, na, g qual, na, g POP RPP = dbcr POP w h Lpar (6) qual, na, g 10, qual, na, g 10, qual, na, g, qual, qual, na, g, qual, na, g, qual, na, g qual, na, g Also, as discussed in Secion 2, he public pension sysem and defined-benefi pension plans have wo ypes of effecs on he individual s reiremen decision: a wealh effec and an accrual (subsiuion) effec. However, hey are modeled o capure only he wealh aspec of he incenives o individuals, as i is compuaionally difficul o include he pension rules ha give rise o he accrual effec in he overall model. To circumven his problem, we develop an exernal pension calculaor o calculae pension accruals, and express hese as implici ax raes which direcly affecs he price of leisure expressed in forgone wages for older workers. Differeniaing he household (or agen) uiliy funcion wih respec o is lifeime budge consrain yields a reserve wage, Wres for each generaion: (7) Wres,,,,,,,,,, (1 w qual na g = wqual hqual na g Lparqual na g τ cr dbcr aqual, g, ) + μqual, na, g, where μ qual,na,g, is a Kuhn-Tucker muliplier and differs from zero if and only if he agen chooses o reire in year and represens he exra money he individual would require o leave reiremen and supply labour. The presence of cr and dbcr in he equaion means ha workers consider C/QPP and RPP conribuion raes as a marginal ax raes on labour. This implies ha an increase in payroll axes o finance income securiy reduces he price of leisure or he reserve wage. Also, noe ha a qual,,g is he implici ax rae represening he accrual effecs of defined-benefi public and privae pension plans. For example, for an individual aged 60, if working one more year reduces he discouned sum of fuure pension benefis, a becomes posiive and disors labour-leisure decision in he same manner as a rise in τ w, cr and dbcr. 15

16 The inra-emporal firs-order condiions of he household problem can be wrien as: C φqual, na, g (1 + τ ) (8) LAqual, na, g, = Cqual, na, g, Wresqual, na, g, η As shown in equaion 8, an increase in he reserve wage Wres causes a decline in leisure relaive o consumpion. In fac, one uni change in he leisure-consumpion raio following a change in he reserve wage is equal o he inra-emporal elasiciy of subsiuion η. Also, looking a equaions 7 and 8, an increase in τ w, cr, dbcr, or a reduces he reserve wage, which in urn raises leisure aciviy relaive o consumpion. 4.2 The Producion Secor A represenaive firm produces a unique good. Is producion echnology is represened by a Cobb-Douglas producion funcion. The naional firm hires labour and rens physical capial up o heir marginal producs. Effecive labour is a composie facor of he hree skills levels ha akes ino accoun boh qualiy and quaniy dimensions. I is represened by a consan elasiciy of subsiuion (CES) funcion. Wih Y represening oupu a ime, K he capial sock, L he effecive labour force, and A he scaling variable, we have: (9) Y = AK L α 1 α where α is he share of capial in value added. Firms are assumed perfecly compeiive and facor demands follow from profi maximizaion: (10) re K = αa L α 1 (11) K α w = ( 1 )A L α where re is he renal rae of capial and w he wage rae per uni of effecive labour. 16

17 The labour force is a CES funcion of labour by skill level. Consequenly, he demand for labour of a given skill level equals: w (12) Lqual ς, = qual L w qual, σ L where L qual, is he effecive labour force by skill level, w qual, he wage rae per uni of skilled effecive labour, ς qual a consan parameer and L σ he elasiciy of subsiuion of he CES funcion for labour demand. Given equaion (4), he wage rae per uni of effecive labour w becomes a CES funcion of he wage rae per uni of skilled effecive labour w, : qual (13) L 1 σ w = ς qualw qual L 1 σ qual, 4.3 Invesmen and Asse Reurns The accumulaion of he capial sock ( K ) is deermined by he following equaion: (14) K = Inv + (1 ) K + 1 δ, where Inv represens invesmen made a ime and δ is he depreciaion rae of capial. The rae of reurn on capial R is a funcion of is renal rae re minus he depreciaion rae: (15) 1 R = (1 + re δ ) + Since bonds and capial shares are perfec subsiues, expeced reurn on capial also equal he expeced reurns on bonds: (16) 1+ R + 1 = 1+ ri where ri is he rae of reurn on bonds issued a ime. 4.4 The Governmen Secor The naional governmen issues bonds o finance he public deb and o saisfy is budge consrain. I axes labour income and axable ransfers, capial income and 17

18 consumpion expendiures. I spends on public expendiure, healh care, educaion and ineres paymens on he regional governmen public deb. I also provides ransfers o agens hrough he social ransfers. The governmen budge consrain is defined as: (17) Bond Bond + ( Pop ( τ ( w h Lpar + Tr w + 1 qual, na, g, qual, qual, na, g, qual, na, g, qual, na, g, qual, na, g + OAS + C / QPP + RPP )) + τ C + τ ri a ) = ( Gov c k qual, g 13, qual, na, g 12, qual, na, g 10, na, g, na, qual, g, + GovH + GovE ) + Pop ( Tr + OAS + GIS ) + ri Bond qual, na, g, g, qual, g 13, qual, g 13, qual, na, g On he lef hand side of he above equaion, Bond is he sock of deb accumulaed by he governmen a ime and Bond +1 Bond is he governmen defici. The hree remaining erms on he lef-hand side are governmen revenues from axes levied on labour income (plus axable ransfers), consumpion and capial income. On he righ-hand side of he equaion, Gov is public expendiure, GovH healh care spending, and GovE educaion spending. The remaining erms include oal ransfer paymens (Tr, OAS and GIS), which evolve wih demographic changes and ineres paymens on he public deb. 4.5 Marke and Aggregaion Condiions The model assumes perfecly compeiive markes and agens wih perfec foresigh. The equilibrium condiion for markes of goods saes ha oal oupu mus be equal o oal demand: (18) Y = ( Popqual, na, g, Cqual, na, g, ) + InvI + Gov + GovH + GovE. qual, na, g There is a demand for labour by level of qualificaion. The sock of effecive skilled labour supplied is he number of workers in each skill caegory muliplied by heir corresponding human capial socks and labour force paricipaion raes: (19) L = ( Pop h Lpar ) qual, na, g qual, na, g, qual, na, g qual, na, g 18

19 Bonds and physical capial ownership are considered perfec subsiues, hence oal supply of asses mus equal oal demand: (20) Pop qual, na, g, Aqual, na, g = K + Bond qual, na, g 4.6 Behavioural Parameers Table 4.1 repors key behavioural and governmen program parameer values. The value of he iner-emporal elasiciy of subsiuion is 0.9 and he value of he inra-emporal elasiciy of subsiuion beween consumpion and leisure is 0.8. These values are similar o hose used by Alig e al. (1997), Kolikoff e al. (1999) and Baylor (2005). The C/QPP replacemen rae is 0.2. RPP replacemen rae varies by age and skill and ranges beween 0.02 and The elasiciy of subsiuion for labour demand across qualificaion is se o 1.5. This is based on a survey of recen sudies who esimaed long-run elasiciy of subsiuion beween more educaed and less educaed workers. 6 The elasiciy of human capial echnology is equal o 1.7 (ψ + γ) and is aken from Fougère and Méree (1999, 2000) and Heckman e al. (1998). 7 Table 4.1 Behavioural and Governmen Program Parameers Symbol Iner-emporal elasiciy of subsiuion ε 0.9 Inra-emporal elasiciy of subsiuion η 0.8 CPP/QPP replacemen rae CQPP_rr 0.2 Value RPP replacemen rae RPP_rr Elasiciy of ime allocaed o he producion of human capial γ 0.7 Elasiciy of human capial already acquired o he producion of human capial ψ The RPP replacemen rae of represenaive individuals is posiively associaed wih age and skill level. I reflecs he fac ha he proporion of Canadians who receive benefis from a DB privae pension plans increases wih age and ha average and median benefis from such plans increase wih skill levels. 6 These sudies are Ciccone and Peri (2005), Krusell e al. (2000), Caselli and Coleman (2000) and Kaz and Murphy (1992). 7 Heckman e al. (1998) have esimaed he value of γ and ψ o sum o

20 Elasiciy of subsiuion for labour demand across qualificaion σ L 1.5 Producion share of physical capial α 0.3 Rae of ineres ri 0.04 Depreciaion rae of physical capial δ Labour income ax rae τ w Capial income ax rae τ k Consumpion ax rae τ c Measuring Lifeime Economic Welfare by Cohor and Level of Qualificaion We calculae he impac of populaion ageing and alernaive public pension opions on lifeime economic welfare by cohor and level of qualificaion. The measure is calculaed as follows. Firs, according o equaion (1), we calculae he level of uiliy U I qual, before he demographic shock by cohor and level of qualificaion, which depends on life-ime consumpion and leisure aciviy, where I indicaes he level of uiliy in he iniial seady sae, for cohor and level of qualificaion qual. Nex, we recalculae uiliy levels by cohor and level of qualificaion, F I I U, and repor he percenage difference, ( U, -U, )/ U,. F qual The same calculaion is made o evaluae he economic welfare effec of alernaive public pension plan scenarios. Also, we decompose he change in economic welfare in wo: lifeime consumpion and leisure. 5. Simulaion Analysis As indicaed in he inroducion, in his secion we analyze he impac of eliminaing early reiremen incenives in public and defined-benefi privae pension plans and examine alernaive policy opions o make he public pension sysem near incenive neural. Also, for DB privae pension plans, we examine he likely scenario ha he recen declining rend in he proporion of DB privae pension plans observed since he mid-1980s coninues unil qual qual qual 20

21 5.1 Impac of Eliminaing Early Reiremen Incenives in Public and Privae Pensions The simulaions of eliminaing early reiremen incenives in public and privae pension plans are underaken separaely. We firs discuss he impac on he labour supply of older workers, followed by an analysis of he impac on key economic indicaors. Lasly, we discuss he economic-welfare implicaions Public Pensions To apply he shock of eliminaing early reiremen incenives in he curren public pension sysem, we se he implici ax raes from Table 3.1 o zero in he CGE model. Table 5.1 presens he impac of he shock on he labour supply of older workers by age group and skill level. Table 5.1 Impac of Removing Early Reiremen Incenives in Public Pensions Change in Weekly Hours by Skill Level (Level Difference relaive o Benchmark Scenario) High-skilled workers Medium-skilled workers Low-skilled workers As can be seen, for age groups 53-60, he labour supply impac is slighly negaive as hours of work fall by one or wo weekly hours. Under he curren sysem, before age 60, 21

22 workers are encouraged o coninue working o obain more C/QPP benefis. Removing early reiremen incenives hus eliminaes his effec early on. A age 61-64, he impac on he labour supply of low and medium-skill workers is posiive as hey increase weekly hours by 6 o 8 hours. However, here is virually no effec on high-skilled workers. Afer age 64, high-skilled workers have somewha more incenive o work, since he OAS claw-back is eliminaed. According o he model-resul, he highly skilled would raise heir labour supply by abou 2 weekly hours. There is no impac on medium-skilled workers, since hey are no affeced by he OAS claw-back. Finally, low-skilled workers aged 65+ increase heir labour supply slighly afer age 64 because of he eliminaion of he work disincenive effec of he GIS Privae Pensions Table 5.2 presens he impac of removing early reiremen incenives from DB privae pension plans on he labour supply of older workers by age group and skill level. To apply he shock of eliminaing early reiremen incenives in privae pension plans, he implici ax raes in Table 3.3 for privae pensions only are se a zero in he CGE model. As can be seen, he labour supply impac of removing early reiremen incenives in privae pensions is several imes larger han in public pensions. Across all skill levels, he labour supply of older workers begins o rise a age 57 and coninues o increase unil hey evenually fully reire. High-skilled workers increase heir labour supply from 3.5 weekly hours a age o abou 10 hours a age In comparison, changes in weekly hours for medium and low-skilled workers range from 2.2 hours o 10 hours and from 0.8 hours o 9 hours, respecively beween age 57 and 72. Finally, when work disincenives are removed, workers are expeced o work longer. Accordingly, hey change work behaviour earlier in heir life. For example, a age 53-56, here is a small reducion in heir labour supply and a corresponding increase in leisure. 22

23 Table 5.2 Impac of Removing Early Reiremen Incenives in DB Privae Pensions Change in Weekly Hours by Skill Level Level Difference relaive o Benchmark Scenario High-skilled workers Medium-skilled workers Low-skilled workers Long-Term Economic Impac of Removing Early Reiremen Incenives We now presen he long-erm economic impac of removing early reiremen incenives in boh public and privae pension plans. Table 5.3 provides an overview of he resuls on key economic indicaors, including he impac on real GDP per capia, effecive labour supply per capia, he capial-labour raio, naional savings per capia and real wages by skill level. As can be seen, he impac of removing early reiremen incenives from public pension plans has a small posiive impac on real GDP per capia. By 2050, real GDP per capia is 0.7% higher relaive o he benchmark scenario. The real GDP gain comes from boh an increase in effecive labour supply and physical capial. However, here is a sligh decline in physical capial inensiy. Alhough, households do no have o save as much for reiremen since hey work longer, naional savings per capia increases. The effec on naional savings is induced. The 23

24 policy change simulaes oal income and raises he overall ax base somewha. If he governmen chooses o mainain expendiures and ax revenues consan, he governmen balance improves, hus raising public savings. If on he oher hand, he governmen chooses o lower axes (in his scenario, we assume axes on labour are reduced), his simulaes privae savings and consumpion. Finally, low-skilled workers are he mos affeced wih a greaer labour supply increase han medium and high-skilled workers. As a resul, heir real wage declines by 0.9% in he long run, while real wages for medium and high-skilled workers do no change much. Table 5.3 Impac of Eliminaing Early Reiremen Incenives on Key Economic Indicaors Percenage poin difference relaive o he benchmark scenario Real GDP per-capia Public pensions DB privae pensions Effecive labour supply per-capia Public pensions DB privae pensions Physical capial per-capia Public pensions DB privae pensions Capial-labour raio Public pensions DB privae pensions Naional Savings per-capia Public pensions DB privae pensions Real wages (high-skilled) Public pensions DB privae pensions Real wages (medium-skilled) Public pensions DB privae pensions Real wages (low-skilled) Public pensions DB privae pensions The economic impac of eliminaing early reiremen incenives in DB employer pension plans is much larger. As shown in Table 5.3, he increase in effecive labour supply 24

25 per capia is quie significan and he impac on real GDP per capia is abou seven imes larger. By 2050, real GDP per capia rises by 5.2%, compared wih 0.7% when we eliminae early reiremen incenives in public pensions. Naional savings per capia also increases subsanially, bu he capial-labour raio diminishes, compared o he benchmark. The significan rise in he labour supply of older workers across skill levels reduces real wage pressures. For example, high, medium and low-skill real wages fall by 4.1%, 2.9% and 2.1%, respecively in This in urn encourages firms o subsiue away from physical capial oward labour. Char 5.1 also illusraes he change in labour marke behaviour, over he life cycle for high-skilled and medium-skilled cohors who ener in he labour marke in For highskilled workers, he impac of removing early reiremen incenives in public pensions has virually no effec on heir labour supply unil age 53. Beween 53 and 60, hey reduce heir labour supply somewha, since he eliminaion of he accrual no longer encourages hem o work more inensively o receive C/QPP benefis. Beween 61 and 64, heir labour supply remains unchanged because he accrual effec is virually zero. Finally, afer 64, he eliminaion of he OAS clawback encourages hem o work more. Hours of work per week Char 5.1 Weekly Working Hours of Cohors Who Ener he Labour Marke in 2006 High-Skilled Workers Medium-Skilled Workers Benchmark No RPP work disincenives No pubpp work disincenives Age Hours of work per week Benchmark No RPP work disincenives No pubpp work disincenives Age Eliminaing early reiremen incenives in DB privae pension plans has a much larger impac on high-skilled workers over he life-cycle. Under his scenario, high-skilled workers significanly increase heir labour supply when hey are older. They also expec real wages o 25

26 grow more slowly and hey adjus heir labour supply accordingly, over heir working life. For example, he expeced reurn o educaion is smaller, so hey choose o spend less ime in school and o work more beween age 17 and 24, which has a small negaive impac on human capial invesmen. During middle age, hey also reduce heir labour supply and choose o spend more ime in leisure. Finally, afer age 57, hey significanly increase heir labour supply. For medium-skilled workers, removing work-disincenives in public pensions has no impac on heir labour supply unil age 57. Beween age 57 and 61, hey reduce weekly hours jus like high-skilled workers. The eliminaion of accruals beween age 61 and 64 encourages hem o work more during hose years, while a 65 and over, heir labour supply remains virually unchanged. When RPP work disincenives are eliminaed, medium-skilled workers reduce heir labour supply during middle age and spend more ime in leisure. However, around age 57, hey significanly increase heir labour supply, jus like high-skilled workers, unil hey fully reire. 5.3 Impac on Economic Welfare Char 5.2 presens he impac of removing early reiremen incenives in public and privae pension plans. As can be seen, he eliminaion of early reiremen incenives in boh public and privae pension plans raises economic welfare. No surprisingly, he posiive impac is much greaer when we eliminae early reiremen incenives in privae pensions han in public pensions. Eliminaing early reiremen incenives in public pensions has a marginally small negaive impac for exising cohors of low-skilled workers. Even hough lifeime consumpion increases, i is more han compensaed by a fall in lifeime leisure. For fuure cohors of low-skilled workers, he effec is slighly posiive and is dominaed by a rise in lifeime consumpion. In comparison, boh medium and high-skilled workers enjoy a greaer increase in economic welfare. Boh groups of workers do no increase heir lifeime labour supply as much and do no suffer from real wage decrease. In comparison wih public pensions, all hree ypes of workers across cohors benefi from an economic welfare increase, when we eliminae early reiremen incenives in privae 26