Does Work Pay at Older Ages?

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.

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

Executive Summary

One way of relieving the economic pressures created by an aging population would be to encourage workers to delay retirement. People who work an extra year produce goods and services that can support their current consumption and help cover the costs of both retirement programs and other government efforts, while at the same time reducing tax pressures on younger workers to support them in retirement.

Enticing workers to delay retirement depends critically on the individual returns to work at older ages. As work pays more, in terms of current after-tax earnings and increments to future retirement benefits, people become increasingly willing to sacrifice leisure and remain at work to obtain richer consumption opportunities both today and later in retirement. Rising tax rates, however, discourage work by reducing the share of output that workers take home. Earnings at older ages can be taxed in the traditional way, with payments to the Internal Revenue Service, or they can be "taxed" through reductions in future Social Security and other retirement benefits. Generous Social Security and employer-provided pension benefits can also discourage work since many people are reluctant to remain in the labor force if they could receive nearly as much by retiring as by working.

To illustrate work incentives at older ages, this report estimates the returns to work for prototypical adults between the ages of 55 and 70. The analysis focuses on a base case, defined as an unmarried man age 55 in 2005 with some post-secondary education. He receives health benefits from his employer and participates in a defined contribution (DC) retirement plan. The report also examines incentives for workers in traditional defined benefit plans, those with access to retiree health benefits, and those who contribute generously to their DC plans.

Key findings include the following:

• The implicit tax rate on work increases rapidly with age, rising for our representative worker from 14 percent at age 55 to 50 percent at age 70. In addition to income and payroll taxes, the estimated tax rate accounts for changes in the value of future Social Security benefits, gains from access to the group health insurance market, and the loss of Medicare coverage after age 65 for workers with employer-sponsored health benefits. In fact, the loss of Medicare benefits alone causes the tax rate to rise by 15 percentage points at age 65.
• Many people in their mid 60s can receive nearly as much income in retirement as they could by working. By age 66, for example, the replacement rate reaches 90 percent for our base-case worker, 126 percent if he contributes 8 percent of his salary to his DC plan, and 111 percent if he instead participates in a traditional DB plan.
• Older individuals could substantially increase their financial resources in retirement by working longer. For example, our representative worker could nearly double his real annual income at age 75, net of health insurance premiums and federal taxes, by stopping work at age 65 instead of age 55. By waiting until age 68 to retire, he would accumulate enough wealth to finance a consumption stream of $60,000 per year from age 55 onward, nearly three times as much as he could finance if he retired at age 55.

I. INTRODUCTION

One way of relieving the economic pressures created by an aging population would be to encourage workers to delay retirement. As society grows older, there is increasing concern about the ability of workers to pay enough taxes to support future retirees and other government functions. Over the next 50 years, for example, the number of Social Security beneficiaries per 100 workers will rise from 30 to 50, assuming current employment patterns persist (Board of Trustees 2004). By working longer, older Americans could limit the impact of these demographic trends. People who work an extra year produce goods and services that can support their own current consumption and help cover the costs of both retirement programs and other government efforts, while at the same time reducing tax pressures on younger workers to support them in retirement.

Enticing workers to delay retirement depends critically on the individual returns to work at older ages. As work pays more, in terms of current after-tax earnings and increments to future retirement benefits, people become increasingly willing to sacrifice leisure and remain at work to obtain richer consumption opportunities both today and later in retirement. Rising tax rates, however, tend to discourage work, by reducing the share of output that workers take home. Earnings at older ages can be taxed in the traditional way, with payments to the Internal Revenue Service (IRS), or they can be "taxed" through reductions in future Social Security and other retirement benefits. Generous Social Security and employer-provided pension benefits can also discourage work, since many people are reluctant to remain in the labor force if they could receive nearly as much by retiring as by working.

The complex interaction between wages, benefits, and taxes determine how much work pays at older ages. Working an additional year will generally increase future Social Security benefits, for example, but the relationship between work history and Social Security is complex, and sometimes depends on the spouse's employment. Those who have earned much less over their lifetimes than their spouses might not gain any additional Social Security benefits from an additional year of work, because they receive benefits based solely on their spouses' earnings. In addition, many traditional defined benefit (DB) plans penalize those who continue on the job after they qualify for full retirement benefits, reducing the lifetime benefits they receive from the plan. Many workers receive valuable health benefits from their employers, and the loss of these benefits when they retire can provide strong incentives to remain on the job, especially before they qualify for Medicare benefits at age 65. In addition, generous Social Security and private pension benefits can provide some retirees with as much income as they would take home if they were working, in part because Social Security benefits are not generally subject to federal taxes (except for those with high incomes). Workers, on the other hand, must pay income and payroll taxes on most of their earnings, reducing the returns to work.

This paper describes the combined impact of Social Security, typical employee benefits, and the tax system on the financial incentive to work for representative adults ages 55 and older. We construct three alternative measures of work incentives, each of which captures a different dimension of the returns to work. Our first measure is the tax rate on work, broadly defined to include traditional income and payroll taxes as well as changes in future Social Security benefits, employer-provided pension benefits, and health benefits associated with an additional year of employment. We then compute replacement rates, comparing net retirement income at particular ages with the level of net income people would receive if they remained employed. Our final measure reports the impact of an extra year of work on total retirement wealth, which shows how much additional resources people could accumulate by delaying retirement. We also examine how work incentives vary by sex, Social Security take-up age, savings behavior, pension plan type, education, access to employer-sponsored health insurance and retiree health benefits, health status, and marital status.

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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