Work Impediments at Older Ages

Number 06-02 in The Retirement Project Discussion Paper Series

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Executive Summary

Private and public retirement systems discourage work at older ages. People now retire earlier than they did 50 years ago, even though they are now healthier and work in less physical jobs. Unless older adults work more, the aging of the population will reduce the share of adults that is employed, slow the rate of growth in national output, and strain government's ability to pay for retirement programs and other public services. Changes to private pensions, Social Security, Medicare, and tax and discrimination law can promote work at older ages.

Traditional defined benefit plans penalize workers who remain on the job after they become eligible to receive pension benefits. Plans pay monthly lifetime benefits beginning at retirement. Benefit formulas typically pay more for more years of service, so participants can generally increase future monthly benefits by working longer. But for every year that workers remain on the job past the plan's retirement age, they forego a year of retirement benefits. The increase in annual benefits from an additional year on the job does not offset the loss from the reduction in the number of pension payments, lowering lifetime benefits. In a typical plan, older workers can lose as much as $10,000 in lifetime benefits every year they remain on the job past the plan's normal retirement age.

Cash balance plans generally do not create incentives to retire early, but their legal status remains uncertain. Employers offering cash balance plans regularly set aside a given percentage of salary for each employee and credit interest on these contributions. Retirement benefits are set by the balance in the worker's account. Another year of work increases the account balance and future benefits. However, Internal Revenue Service (IRS) regulations governing cash balance plans have not been in effect since 1999, and Congress has been slow to act. One federal court has ruled that cash balance plans violate age discrimination prohibitions, but other federal courts have found no violations. Social Security discourages work at older ages by not rewarding additional employment much for workers who have spent more than 35 years in the labor market. Like everyone else, older workers must pay Social Security payroll taxes equal to 12.4 percent of earnings (up to $94,200 in 2006) split between employers and employees. These taxes discourage employment at older ages, because older people with many years of work experience do not gain much more in Social Security benefits by remaining on the job.

The availability of relatively generous Social Security benefits at age 62 creates early retirement incentives. Most people can begin to collect Social Security benefits at 62, and some can also receive benefits from their employer pension plans as early as age 55. It is generally difficult to convince people to remain on the job if they could stop work without having to reduce their standards of living. Some people in their early 60s could receive nearly as much after-tax income by retiring as by remaining at work, even after accounting for the loss of employer-provided health benefits. And some people in their mid- to late 60s could actually receive more after-tax income by retiring than by working.

Medicare rules forcing employer health benefit plans to pay for older workers discourage employers from retaining and hiring them. Federal law establishes employer-sponsored health insurance as the primary payer of health care costs for active workers age 65 and older. Medicare becomes secondary coverage, paying only for services not covered by the employer plan that are included in the Medicare benefits package. Medicare secondary payer rules add thousands of dollars per year to the cost of employing each older worker at firms that offer health insurance.

Tax, pension, and age discrimination laws discourage employers from establishing phased retirement programs. Phased retirement programs would encourage workers to gradually transition into full retirement, reducing their hours and job responsibilities but remaining on the payroll. Although many older workers express interest in phased retirement, tax and pension rules discourage it. These rules forbid employers from making payments from defined benefit pension plans to participants who still work for them. Many workers cannot afford to reduce their hours without receiving at least part of their pensions. Some participants retire, begin collecting their pensions, and then return to work with the original employer, but these arrangements often violate at least the letter of the law. Phased retirement programs could also run afoul of existing age discrimination laws by providing preferential treatment to a select group of older workers.

As the baby boom cohort nears retirement, policymakers are beginning to focus on employment at older ages. The IRS recently proposed new regulations governing phased retirement, and legislation is pending in Congress that would promote phased retirement and address the controversy surrounding cash balance plans. Recent Social Security reforms have also reduced some work disincentives in the system.

• Proposed IRS regulations would allow workers to draw partial pensions from their defined benefit plans if they reduced their hours by at least 20 percent, but employer groups complain that these proposals do not go far enough;
• Legislation passed by both houses of Congress in late 2005, but not yet law, would allow defined benefit plan participants age 62 and older to receive plan benefits while still at work;
• The same congressional bill specifies that cash balance plans do not ordinarily discriminate against older workers under federal law;
• Pending congressional legislation would provide tax credits to employers that offer flexible or phased work to older adults and would improve access at older ages to federally funded employment and training services;
• Social Security recently raised the rate at which it increases payments for those who wait to claim their benefits, better compensating them for the reduced number of payments they will receive; and
• Social Security no longer reduces payments to working beneficiaries age 66 and older with substantial earnings.

Note: This report is available in its entirety in the Portable Document Format (PDF).

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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