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.

Employers who hire or retain older workers can substantially ease the economic pressures created by an aging population. Employees who work an extra year increase national output and further support their own needs before dipping into government programs for retirement and other needs. At the same time, each extra year of work increases taxes contributed to pay for government and to reduce the pressure on revenues from other social programs.

Generous Social Security and employer-provided pension benefits can discourage work, since many people are reluctant to remain in the labor force if they appear to be able to receive a substantial portion of their current pay merely by retiring. The word "appear" is deliberate: many people have adequate resources in their year of retirement, but after a couple of decades, their public and private sources of income often either stay constant in real terms or actually decline. In effect, up-front benefit payments operate as a disincentive to work. Private annuities indexed for inflation, for instance, would pay less in early years of receipt—thus encouraging more work—and more in later years, when needs are greater.

One problem for older workers comes from the design of traditional defined benefit plans. These plans typically provide benefits based on a formula consisting of number of years of service, times some fixed percentage, times salary for the highest years (often five or three), up to some maximum percentage of that salary. For example, a worker might be granted 1 percent of pay, times years of service, times salary in the highest five years, up to a maximum of 30 percent. However, payments usually won't commence until either age 65 or the attainment of many years of service (such as 30 years) with the employer.

The economic value of the annual benefit accrual in these pension plans can be calculated as the change in the present value of all future pension benefits for staying on the job one more year. During the accrual stage, an additional year on the job increases pension benefits, not only because it adds an additional year of pay, but also because the pay on which the benefits are based is likely to grow with inflation and real wage increases. This creates a compounding effect. On the other hand, at certain points (e.g., normal retirement age or early eligibility age due to attaining some maximum number of years of creditable service), one more year of work implies that the pension is received one year less. Furthermore, after reaching some maximum percentage of salary to be replaced, future annual benefit increases are limited. Consequently, economic accruals often turn negative.

In a paper discussing these and related issues, Rudolph Penner, Eugene Steuerle, and Pamela Perun examine some 340 private pension plans (including those from most of the largest employers in the country) and find that, on average, the benefits they provide by age resemble a hill. The present value of the pension accrual rises along a slope that becomes increasingly steep as the worker gains age and time on the job and then, after peaking, suddenly falls dramatically. Peak accrual typically occurs after about 30 years—for example, at age 55 for a worker who starts at age 25. For this worker, staying on the job for additional years beyond the peak can result in negative pension accruals—for example, an average of -13.9 percent from ages 60 to 65.

Partly to get around these problems, the private sector has been moving steadily away from a traditional defined benefit structure, either by adopting defined contribution plans or converting traditional defined benefit plans to so-called cash balance plans. Both defined contribution and cash balance plans usually base retirement plan contributions on a relatively constant percentage of salary, regardless of age. However, many traditional defined benefit plans remain, especially in the public sector. In that sector, the incentive to retire early can be even stronger than in the private sector.

Health benefits also vary in value by age. A 1996 panel study revealed that private health costs rose from between $500 and $1,000 for workers age 20 to 40 to close to $2,000 for most workers over age 55. For employees who stay with a job, health costs rise as a proportion of pay mainly when they come close to old age, rather than in middle age when both pay and health costs are going up together.

When people try to take a new job (as opposed to staying on the same job), age disparities in pay are again present—making it more difficult for older workers to find new jobs and stay in the labor force. Take a set of workers who start a new job and stay for five years. In a typical defined benefit plan, on average, someone who works from ages 25 to 30 accrues about 2.1 percent of pay in pension benefits, but the accrual rate rises to 8 to 10 percent of pay for those between the ages of 50 and 65. When it comes to health insurance, the difference in health costs by age now comes into play more perceptibly than when older workers were assumed to have increased productivity from more time on the job. Here the large rise in health costs from younger to older workers makes the older employee much more expensive in terms of health insurance benefits, without any necessary productivity offset.

One clear-cut tax on older workers is a result of the federal government's requirement that Medicare be a secondary payer when an employer offers health insurance to other employees. The older employee in such a firm has to give up several thousand dollars worth of Medicare benefits every year just to work past age 65. An employee might or might not be able to get around the tax by taking a job with an employer offering no health insurance.

Policymakers who want to elicit more years of work from older Americans might consider:

• encouraging benefit payments that either increase over retirement or at least do not decline (e.g., through price indexing of benefits, which might be made easier through the provision of price-indexed bonds of various maturities);
• making reparation of defined benefit contribution plans to remove the hill shape that (1) encourages employers to rid themselves of an older workforce in the high economic accrual stages; (2) discourages employers from hiring older workers; and (3) discourages employees from staying on the job once economic accrual rates turn low or negative.
• eliminating the requirement that Medicare serve as the secondary payer for workers with employer-sponsored coverage. The high cost of medical insurance for older workers discourages employers from retaining or hiring workers over age 65. Allowing Medicare to be the primary payer would lower employment costs and reduce disincentives faced by older workers.
• allowing more flexible compensation structures that remove some of the disincentives for work at older ages. In the future, workers at older ages might shift into a structure where benefits are in line with compensation—not so high that employers won't hire them or so low that older workers suffer economic discrimination relative to other workers.
• making clear, safe harbors in the law so that employers do not face threat of suit under labor, tax, and age discrimination laws.

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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