Author

Wonku Hong

Date of Award

12-15-2006

Degree Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Department

Risk Management and Insurance

First Advisor

David P. Richardson - Chair

Second Advisor

Julie L. Hotchkiss

Third Advisor

Bruce A. Palmer

Fourth Advisor

Martin F. Grace

Abstract

This study examines the effect of pensions on the timing of retirement, focusing on the differences between defined benefit (DB) plans and defined contribution (DC) plans. I find that DC plans have different effects on the accumulation of retirement wealth, the incentives for retirement and the risk of retirement benefits than DB plans. Thereby, DC plans have different effects from DB plans on the decision to retire. This paper is the first empirical study to investigate the effect of longevity risk in pension plans on retirement. It is an important addition to the literature on retirement behavior since longevity risk will become more important as individuals have longer life expectancies and bear more longevity risk due to increasing likelihood of coverage by DC plans or Social Security personal accounts. Previous research has found that DB plans have an age-incentive effect on retirement. That is, the structure of DB plans may induce individuals to retire at a specific age. By contrast, the structure of DC plans does not have age-incentive effects. Thereby, individuals with DC plans may retire either earlier or later on average than individuals with DB plans because of the absence of age-related incentives in DC plans. To shed further light on these issues, this study introduces risk factors, and particularly longevity risk, to an option value model of the retirement decision. Longevity risk is important to DC participants since DC plans usually offer a lump-sum benefit at retirement. Since payouts are not guaranteed over life expectancy, retirees with DC plans bear a greater risk of outliving their resources, i.e., longevity risk. The additional risks in DC plans may make workers save more, and retire later. This paper extends a standard intertemporal model of consumption and retirement by incorporating risk factors for different pension types into the retirement decision problem. Comparative statics from the optimal solution show that increases in risk factors (i.e. longevity risk) during retirement induce workers with DC plans to retire later than workers with defined benefit (DB) plans. This study then test the predictions of this model empirically, using the data from the Health and Retirement Study (HRS). Empirical results confirm the predictions of the theoretical model. First, workers with DC plans expect to retire later than workers with DB plans. Next, increase in pension option value, measured as the difference between the maximum pension value and the pension value of 1992, decreases the probability of retirement, thereby increasing the expected retirement wage. By contrast, greater pension wealth increases the probability of retirement, reducing the expected retirement age. Considering that pension wealth in DC plans is about half of pension wealth in DB plans, it is reasonable to conclude that workers with DC plans retire later than workers with DB plans. Finally, longevity risk, as measured by the Annuity Equivalent Wealth (AEW), decreases probability of retirement, increasing the expected retirement age.

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