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 tiers

1) Basic State Pension

2) State Earnings-Related Pension Scheme (SERPS)/Second State Pension

3) Private Pensions

In 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-time

0.46x£11200+0.115XEarnings between £11200 and £25600+0.23Xincome between £25601 and £30940

A working life-time of forty years is assumed

Members 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