Means Testing and Retirement Choices in Europe: a Comparison of the British and Danish Systems

National Instituteof Economic and Social Research

Means Testing and Retirement Choices in Europe: a Comparison of the British and Danish Systems

James Sefton, Justin van de Ven and Martin WealeNational Institute of Economic and Social Research

• Denmark like Britain is widely regarded as an employment success

• Its overall labour market participation rate is 72% for females as compared to 65.3% in the United Kingdom. For males the rate is 80% as compared to 78% in the United Kingdom

• Nevertheless among people older than 60 participation rates are lower than in the United Kingdom at only 1/3 of prime age levels compared to 40% in the United Kingdom

• How far can this difference in participation be explained by the different arrangement for the support of old and older people in the two countries?

• What would the UK look like with the Danish system of retirement benefits in place?

UK Pensions Structure• Three tiers1) Basic State Pension2) State Earnings-Related Pension Scheme

(SERPS)/Second State Pension3) Private PensionsIn addition incapacity benefit seems to be

used as a means of funding early retirement.

Incapacity Benefit• £54.50 per week in first year of incapacity• £72.15 in subsequent weeks

Basic State Pension• £77.45 for a single person• £123.80 for a couple after contributions for

90% of working lives (16-state pension age)

We have modelled this as a universal benefit

Second State Pension• Pension calculated from average earnings

over working life-time0.46x£11200+0.115XEarnings between

£11200 and £25600+0.23Xincome between £25601 and £30940

A working life-time of forty years is assumedMembers of private pensions schemes can

contract out.

Pension Credit• Guarantees anyone 60 or over income of

£102.10 per week (single person) or £155.80 (couple).

• A withdrawal rate of 40% on income above the basic state pension.

• An income of 10% p.a. is imputed to assets of more than £6000 and the withdrawal rate is applied to this.

• We model this as part of the tax system

Other Taxes and Benefits• In addition there is a range of other taxes

and benefits. We have rolled these up into tax functions which we estimate to explain post-tax household income as a function of initial income and circumstances

The Danish Pension System• Public Pension• Labour Market Supplementary Pension

Scheme

Public Pension• DKK 54,204 to each person (£1=DKK11)Taper rate of 30% on earnings above

DKK230,300 (couple) or DKK159,000 (single)

Pension supplement of DKK54,564 (single pensioner) with 30% taper on earnings above DK102,000

DKK25464 (couple) with 15% taper on earnings aboveDKK102,000

Labour Market Supplementary Pension Scheme• Contributions depend on labour market

relationship (normal contribution of DKK2684 in 2003). Annual annuity of DKK100 for each DKK396 contributed

• Additional defined-contribution scheme introduced in 1999. 1% of gross income used to buy annuity

Early Retirement Scheme• A separate early retirement scheme exists

for people aged 60-64 who are eligible for unemployment benefits

• In principle contributions are required for 25 out of the previous 30 years although there are some exceptions.

UK and Denmark Compared

Denmark United Kingdom

Single Person £188.95 £102.10

Couple £232.56 £155.80

Minimum Pensions

UK and Denmark Compared

Denmark United Kingdom

Single Person £235.42 £191.56

Couple £279.03 £237.91

One person with 40-year contribution record.In UK earnings equivalent to £18,000 p.a.

Simulation Analysis• Assume that households decide on their

labour supply and on their consumption/savings decisions in the light of the economic environment that they face.

• Assume that people make decisions taking full account of the way in which pension rules are going to affect them in the future.

Key Household Characteristics• Earning power is assumed to depend on a

random factor and on past employment experience (learning by doing)

• Without learning by doing it is difficult to understand why people work when young and incomes are low

• Most evidence suggests that people would like to spread their leisure over their life-time more evenly

• Death is a random event but people know the mortality tables.

• Household size varies exogenously; the question of choice of family size is an important one but economics has only a limited amount to say on the matter.

Implications• People choose whether to work or not and

how much to save in the light of their expectations of future earnings possibilities and also the uncertainty surrounding these.

• For the UK we find we can model both labour supply and consumption reasonably well as functions of age.

• We underestimate household wealth; we assume that this is because the real rate of return in the period up to 2000/01 (to which we relate our model) had been one of high returns.

• We find that based on the various benefits offered, the model shows employment tailing off among people aged 55 and over.

• We then apply the Danish tax/benefit system to the model designed to fit UK data.

• We find that there is an employment puzzle; benefits are so generous that we find many people would not bother to go out to work.

• We need to write down benefits by 25% in order to generate employment levels which fit the Danish data reasonably well overall.

• There is then some under-estimation of Danish employment of people over 55 suggesting a particularly strong work ethic among old and older workers

United Kingdom Denmark

Simulated OECD data

Simulated OECD data

50-54 0.94 0.94 0.95 0.94

55-59 0.81 0.79 0.80 0.88

60-64 0.45 0.46 0.33 0.39

Simulated Labour Force Participation Rates Measure Relative to Prime Age UK

Budgetary Costs(Net Life-time Tax Bill)

Denmark United Kingdom

Total Cost 5343.46 5694.96

Discounted to Age 20

3653.40 3255.97

These figures are weighted by cohort sizeThe discount rate used is 5% p.a.

Welfare Effects• Life-time welfare in UK- 411

with Danish system- 406• Preliminary findings suggest that life-time

welfare is less unequal in UK than with the Danish system

• Voter preferences:Median Voters prefer the UK system until their

mid-40s and then they prefer the Danish system• Should old and older people be allowed to vote

on issues of this type?

Conclusions• The UK system gives stronger incentives

for people aged 60-65 to work and is preferred by young people taking into account what they will experience when old.

• But it leads to poorer old and older people