Rational Decision Rules for Early Retirement Inducements Contained in Corporate Pension Plans

Abstract

Rational Decision Rules for Early Retirement Inducements Contained in Corporate Pension Plans ABSTRACT This article present a net present value (NPV) model of early pension subsidies. The model's theoretical basis is the compensating differentials--lifetime contracts framework of the labor market setting which gives rise to pension plans. The NPV model effectively integrates early pension subsidies into the shareholder wealth maximization framework of corporate finance. Within this framework, the article develops rational decision rules for early pension subsidies, and employs these rules to provide a corporate finance perspective on the pension-wage tradeoff of the firm's labor force. Many researchers have noted the significant and steady increase, since the 1960s, in the number of private pension plans of the defined-benefit type, which have formally liberalized their provisions for early retirement benefits (see Conference Board, 1971; Lazear, 1979; Burkhauser, 1979; Clark and McDermed, 1982; Ippolito, 1986; Mitchell and Luzadis, 1988; Hogarth, 1988; and Pesando and Gunderson, 1988). Typically, firms grant this liberalization through the collective bargaining process in response to workers' demands (McGill, 1984, p. 120), and it is commonly effected by adopting less-than-full actuarial reduction factors for determining pension benefits payable upon early retirement. As a result, eligible (older, long-service) workers who choose early retirement receive a pension subsidy, in the form of benefits above and beyond their actuarially equivalent benefit credits accrued to the early retirement date. In this manner, the corporate pension plan serves in part as a mechanism for inducing specific age-and-service cohorts of workers to retire early. Ippolito (1986, p. 148) notes that such inducements for orderly and homogeneous retirement have become major characteristics of the U.S. private pension system. Similarly, Pesando and Gunderson (1988, p. 260) report a significant expansion of such inducements in the Canadian pension system over time. Economic research on this inducement function of pension plans has for the most part been focused on its public policy implications and on its role as a determinant of workers' acceptance of early retirement. Ippolito (1986, p. 120) notes, by contrast, that much less work has been done to demonstrate why firms choose to use their pension plans in this way. This is a pointed observation, especially if one considers the fact that the pension cost to a firm which offers such early retirement inducements may well be several times the cost of providing actuarially equivalent early retirement pension benefits (Winklevoss, 1977, pp. 148-9). This article presents a financial model which integrates early pension inducements into the framework of shareholder-wealth maximization, through the net present value (NPV) criterion. The model's primary contribution is its provision of a conceptually well-founded and useful framework for determining the conditions under which a shareholder wealth maximizing firm should build an early retirement inducement mechanism into its pension plan design. Two theoretical insights from labor economics, which are instrumental for developing the NPV model, are first presented. The model is then formulated, its economic implications for the firm and its labor force are discussed, and some of the model's implications for future research are presented. Theoretical Insights from Labor Economics The labor market literature provides numerous insights into the nature and role of occupational pension plans as appendages of the sponsoring firms. Two such insights are particularly relevant for the purposes of this article. The first insight is provided by the compensating differentials (CD) model (Smith, 1937; and Rosen, 1974), for which empirical support based on wage and pension data has been mounting in recent years (Ehrenberg, 1980; Schiller and Weiss, 1980; Smith, 1981; and Allen, Clark, and Summer 1986). …