Testimony

Mandatory Retirement Age Rules: Is It Time To Re-evaluate?

Special Committee on Aging
United States Senate

Thank you very much for this opportunity to testify on mandatory retirement age regulations in the United States. I am very honored by it.1

Ideally, the decision about when to retire should be made voluntarily by workers in response to labor market conditions. Mandatory retirement age rules have been eliminated in most private sector jobs as a result of anti-age-discrimination laws that were introduced beginning in the 1960s. Were they allowed, however, private sector employers would likely incorporate them in employment contracts designed for ensuring and improving worker-efficiency. Instead, private firms structure long-term incentive contracts including features of defined benefit pension plans, other non-wage benefits, and severance packages to induce early job terminations. Retirement incentives incorporated in such long-term incentive contracts appear to have spurred the trend toward earlier retirement in the United States.

Mandatory retirement age rules still prevail in some private and public-sector occupations: State and local police (55-60) and firefighters (55-60); federal firefighters (57); federal law enforcement and corrections officers (57); and air traffic controllers (56, if hired after 1972); and commercial airline pilots (60). These are “earlier-than-normal” retirement ages compared to the vast majority of other occupations.

Mandatory retirement age restrictions were introduced in these occupations several decades ago, primarily for ensuring their safe and effective conduct. Under today’s conditions, however, these retirement age rules appear to be outdated. The need to revise these rules appears urgent due to impending worker shortages. It appears desirable to introduce long-term incentive compensation structures in these jobs similar to those in the private sector. However, the manner in which they should be introduced and whether they would deliver retirement choices to workers while simultaneously ensuring safe and effective job performance requires further examination.

My testimony is comprised of several parts. First I report findings on private sector compensation structures that are designed to elicit worker efficiency and loyalty, and yet induce timely retirements. The findings suggest that these contracts involve divorcing current productivity from current compensation—by postponing compensation from workers’ early- to late-career stages. Such contracts would not be profitable if workers stayed on the job to collect wages in excess of their productivity for too long. Thus, it appears that private firms could put mandatory retirement age rules to good use.

However, these “incentive” contracts would become infeasible if employers terminated workers too early to avoid paying them seniority rents. This makes the case for anti-age discrimination rules. As explained below, it turns out that prohibitions against age discrimination are more useful than mandatory retirement age rules in making such contracts feasible. Evidence on U.S. firms suggests the prevalence of long-term incentive contracts. Thus, in the United States, firms induce workers to retire early by appropriately structuring non-wage elements of compensation, while anti-age discrimination laws provide an external commitment mechanism against premature discharges—thereby inducing workers to accept long-term incentive contracts.

Employment contracts are structured differently in the academic sphere. The recent removal (in 1994) of the age-70 mandatory retirement rule has resulted in many older and highly compensated faculty members remaining on university payrolls. Universities have not since been successful in inducing earlier retirements via pension plan and other incentives because these are costly to offer to faculty who are already close to retirement. However, universities may over time adopt long-term incentive contracts for younger employees similar to those prevalent in large private companies.

Second, health and longevity of the U.S population generally has been improving. This may mean that jobs that could not be conducted effectively by workers after their late fifties, now can be. A historical comparison of mortality rates suggests that those aged in their early sixties today are as healthy as were those in their mid fifties a few decades ago—when the mandatory retirement age rules were first imposed in the occupations under consideration.

Existing mandatory retirement age rules appear unfair for some categories of workers—such as pilots and air-traffic controllers that are subject to such rules. Because they spend their careers in jobs requiring specific, non-transferable skills, early job separation now results in longer spells of unemployment or forced retirement despite possessing the ability to conduct their jobs competently. Evidence suggests that independently of their tenure in earlier jobs older workers have greater difficulty in finding jobs in the private sector.

Third, improvements in technology imply that, other things equal, federal police, firefighting, and air-traffic-control jobs may have become physically easier to conduct. Evidence also suggests that health is now much less important as a consideration for the decision to retire than was the case several decades ago because of both, lower physical job demands and improvements in the treatment of chronic conditions.

Fourth, better technology and equipment increase the need for trained and experienced personnel to operate and coordinate activities. Hence, although better technology makes the jobs easier to perform, it could require more rather than fewer skilled workers.

Finally, as the baby boomers exit the workforce, the burden on working generations to support a larger and longer lived retiree population will increase. Baby boomer retirements will likely create skilled- and experienced-worker shortages in many occupations. The shortages are likely to become more acute in occupations that impose relatively early mandatory retirement age restrictions.

Overall, impending worker shortages in occupations with mandatory retirement age restrictions motivate the revision of these rules. However, as experience in the U.S. academic sphere indicates, addressing the shortages by immediately removing these restrictions may lead to other problems—such as a disproportionately older workforce. Introducing long-term incentive contracts to improve worker efficiency and yet provide flexibility in retirement decisions appears to be desirable. However, such employment contracts “pay off” only in the long-term and should be restricted to younger workers and new hires. Worker shortages in the near term could be addressed by revising mandatory retirement age rules upward. The decision to elimate these rules may never become necessary if younger worker and new hires are offered long-term incentive contracts. As these contracts become more widespread they may improve worker efficiency and induce timely retirements. Mandatory retirement age rules will automatically fall by the wayside as workers who remain subject to them leave the workforce.

Section 1: Mandatory Retirement Age Rules vs. Anti-Age-Discrimination Laws in the Private Sector

Anti age discrimination laws and mandatory age retirement rules are polar opposites. Would private employers enforce mandatory retirement age rules in the absence of anti-age discrimination rules? The answer to this question appears to be in the affirmative for those jobs and occupations requiring firm-specific skills—that is, full knowledge of company policies, operating rules, personnel, technology, on-going innovations and specific features of the work environment. These job requirements arise in managerial positions where staff must learn the nature of the business over several years. These requirements also apply in occupations requiring special on-the-job training—coordinating activities on a construction site, scheduling to run a factory work-shops etc. On-the-job acquisition of specific skills is also needed in varying degrees from a safety and job-effectiveness perspective, as is the case with air-traffic-controllers, pilots, law enforcement officers etc.

Whenever workers are required to possess “specific human capital,” it is in the employers’ interest to ensure that workers don’t quit immediately after acquiring those skills. However, because slavery is illegal, firms must induce workers to stay on the job by incorporating appropriate incentives in employment contracts, which may involve implicit agreements on some elements. For example, workers may be paid less than their productivity during the early part of their tenure in exchange for (the implicit promise of) being paid more than their productivity during the later periods of their tenure with the firm. This implies the creation of “seniority rents.”

Several studies have found evidence consistent with the existence of long-term incentive contracting in the private sector. Overall, the evidence generally points against the “spot” market explanation of how compensation generally varys with age. In particular, the evidence suggests that compensation exceeds productivity at older ages providing a basis for employers to treat older workers differently.

Thus, in occupations requiring firm-specific skills, workers’ compensations may rarely, if ever, match their current productivity. Instead, the employers seek to match prospective productivity with prospective compensation over the workers entire tenure with the firm.

Apart from wages and salaries, compensation includes pensions, health insurance and other benefits. Employers generally use non-wage elements of compensation to design work and retirement incentives. Such incentives address multiple firm objectives: Ensuring worker bonding with the firm over long periods; ensuring that workers do not shirk on the job; inducing older workers to leave the firm at the “right” time, and so on.

Pension vesting and benefit accrual patterns of defined benefit pension plans can be designed to achieve all of these objectives. Vesting rules in DB pension plans generally require workers to be with the firm for 5 or 10 years before pension benefits begin to accrue. Pension accruals—the annual additions to the present value of pension benefits from additional years of work—are also designed to provide early retirement incentives.

Pension accrual patterns produce age-profiles of compensation that are initially steeper than workers’ age-productivity profiles. Pension accrual begins upon vesting and increases sharply at the early retirement age—usually age 55. The steep increase in pension accrual at age 55 arises because the eligibility to retire early and collect benefits immediately is associated with a smaller than fair reduction in benefits—compared to retiring at age 65 with full benefits. Moreover, delaying retirement beyond age 55 reduces pension accruals sharply-possibly making accruals negative.

These features of pension accurals create incentives for workers to retire early-keeping them from collecting seniority rents by staying on the job for too long. Firms can fine tune their compensation structures with other non-wage compensation elements, including severance packages. Thus, jobs involving the acquisition of significant firm-specific skills may exhibit productivity and compensation patterns such as those shown in Figure 1.

Figure 1: Compensation and Productivity by Age--Mail Managers

The productivity and compensation profiles of Figure 1 are estimated for male managers based on employment and compensation data from a Fortune 500 firm with over 300,000 employees. It shows several features:

  1. Managerial workers at this firm are compensated by less than their productivity during the early part of their careers and compensated by more than their productivity later. This induces worker retention because early quitters lose the “bond” they have posted with the firm by accepting compensation less than their productivity. They also forfeit the opportunity to collect seniority rents later in their careers.

  2. Managers’ productivity is estimated to be hump-shaped, increasing during the early part of their careers but declining at older ages.

  3. Pension accrual commences in the 10th year (vesting) and spikes up sharply at age 55.

  4. Compensation declines gradually after age 55 although it is maintained above productivity throughout the later phase of a manager’s tenure. This excess compensation constitutes the seniority rent mentioned earlier.

Not all workers may be compensated under long-term incentive contracts. Routine office workers, support staff, sales agents, and so on appear to be compensated on a “spot” basis rather than under long-term incentive contracts. For example, we estimated annual productivity and compensation to be aligned more closely for salesmen in the above firm—as shown in Figure 2.

Figure 2: Compensation and Productivity by Age--Male Salesmen

It should be noted that the adoption of long-term incentive contracts does not obviate the need to monitor worker performance. Indeed, the threat of being caught shirking and discharged is an integral part of the incentive structure.

Workers may also prefer contracts with rising compensation by age—if they can obtain them. One possible reason is their inability or lack of discipline to save — as is suggested by some psychological studies of saving behavior. They may prefer to receive lower compensation in the near term and higher compensation in the future as a forced saving mechanism.2

For long-term incentive contracts to be feasible, however, workers must also be convinced that employers will not arbitrarily discharge them as soon as they begin accruing seniority rents.

One conjecture is that firms’ incentives to “cheat” in this manner are reduced by the need to maintain their reputations—in order to continue hiring workers. However, purely reputational effects need to operate extremely strongly to effectively police against mid-career job terminations by employers. In addition, evidence suggests that early worker terminations can occur through other mechanisms — for example, after hostile takeovers of corporations. In one of my studies I find that post-hostile takeover managements discharge older workers, implying little or no negative reputational consequences.

The weakness of reputational effects in preventing premature worker terminations provides a possible rationale for anti age discrimination laws. A law prohibiting terminations purely on the basis of age can serve as external, and therefore more credible, commitment mechanism-an external check against the temptation to discharge workers prematurely—and makes long-term incentive contracts easier to implement.

How effective are long-term incentive contracts in inducing early retirements? Table 1 contains an answer based on data from the firm mentioned earlier. It shows retirement “hazard” rates—that is, the fraction of those employed at the beginning of the year that leave the firm within the year. The rates are shown by age and tenure with the firm.

Table 1: Empirial Retirement Hazard Rates by Age and Tenure (percent)

The table suggests that because of the inducement to retire early (at age 55) provided through the pension accrual pattern, retirement rates step up to the 10-12 percent range between ages 55 and 59. Without the retirement incentives, they would remain at about the 3 percent level that prevails prior to age 55. Note that those aged 55-61 who are not yet fully vested in the pension plan (that is, those with less than 10 years of service) exhibit separation rates around 3 percent annually. Job separation rates at 10-12 percent per year rather than 3 percent per year can have substantial cumulative effects on overall labor force participation between the ages of 55-61. It is noteworthy that job separation rates increase even more dramatically at age of 62 and 65. These increases in retirement hazards probably occur as workers not subject to long-term incentive contracts respond to the retirement incentives provided by the Social Security program at these ages.

Prior to the 1980s, defined benefit (DB) plans covered two-thirds of workers and defined contribution (DC) plans covered about one-third. As is well known, defined benefit pension plan coverage has been declining and defined contribution plan coverage has been growing during the last two decades. Evidence shows that DB plans’ usefulness has declined for both employers and employees in an environment of rapid technological and structural changes in the economy. Under such conditions, the desirability of long-duration employer-employee matches has declined. Employers attempting to adapt to new technologies may require greater flexibility in workforce composition. Employees may prefer greater portability of pension assets if expected job-durations are shorter.3

However, the surge in DC pension plans since the early 1980s has not extinguished the use of DB plans: About one-third of the workforce continues to be covered under DB plans. Moreover, because early retirement incentives are not incorporated into DC plans, retirement rates among those in their early sixties have declined—a reversal in the trend established over several decades.

In the current context, offerring efficiency enhancing compensation structures to federal and state and local workers similar to those adopted in the private sector appears to be desirable—to the extent such incentive contracts are not offerred today. This recommendation is motivated by the need to elicit worker efficiency, and is independent of the fact that public operations are not driven by a profit maximizing motive. Moreover, such incentive compensation structures would provide greater retirement flexibility and help achieve employers’ objectives of safety and effectiveness in job performance.

However, any revision of public sector employment contracts along these lines would require a careful examination of whether such compensation structures are feasible, the manner in which they should be introduced, and how effective they could be as substitutes for the mandatory retirement age rules currently in force.

Section 2: Mandatory Retirement Ages, Occupational Development, and Personnel Abilities

For the occupations under consideration, adopting a single mandatory retirement age is not necessarily better or cheaper than adopting flexible compensation-based incentives to retire.

A fixed retirement age potentially introduces two types of errors from the perspective of retaining qualified workers. First, those who are less qualified than others would remain on the work force because they are younger than the mandatory retirement age. Second, those who are better qualified than others are forced to retire because they are older. The mandatory retirement age could be set to minimize the sum of both types of errors. For example, if the mandatory retirement age were set at 40, we would force many qualified workers to retire prematurely. Similarly, if the retirement age were set at 80 many workers who are no longer competent would be retained. These errors would be minimized by setting the mandatory retirement age between these extremes.

The mandatory retirement age rules in the occupations under consideration were set several decades ago. Assuming that they were initially set optimally to minimize the sum of the two types of errors-they are probably obsolete today for a number of reasons.

Improving Health and Fitness

The significant progress achieved in medical innovation and health care have increased the longevity of the U.S. population in general.4 People in their early sixties today enjoy similar health and lifestyles today with greater frequency as did those in their mid fifties several decades ago. One indication of the better health of today’s workers is the downward trend in mortality rates.

For example, mortality information from the Social Security Adminstration suggests that 55-year-old men in 1960 faced the same likelihood of dying within the year as do 62 year-old men today. And today’s 66 year old men have the same chance of dying as did 60 year old men in 1960. For women, mortality improvements are somewhat smaller. Women aged 55 in 1960 experienced the same average mortality as do 60 year old women today. And the same fraction of 60 years old women died in 1960 as do 64 year old women today.

Evidence that health among 50-60 year olds is improving can also be gleaned from surveys of self-reported health. Figures 3 and 4 show calculations based on the Panel Survey of Income Dynamics (PSID).5 The calculations reported below are based on weighting each household to convert the survey’s sample into a representative U.S. household population.

Figure 3 shows that by 1997, a sizable majority of men and women were in good or better health. Over a 14 year period between 1985 and 1997, the fraction of men aged 56 through 65 who reported being in good or better health increased by almost 5 percentage points to 71 percent. Figure 4 shows that for women, the share of those in good or better health increased by about 7 percentage points to 67.4 percent.

Figure 3: Self Reported Health--Males Aged 56-65

Figure 4: Self Reported Health--Females Aged 56-65

Although these data are based on self-reported health by survey respondents and spouses, a study (based on a different survery) shows that such responses are representative of the type of information used in professional evaluations of health and disability status.6

These data go back only through 1985. Projecting them further back in time would presumably reveal even more substantial gains in the health and fitness of those in their mid-fifties and early sixties. Indeed, other studies have indicated that health is now much less important as a consideration for the decision to retire than was the case several decades ago.7 This is because of both, lower physical job demands and improvments in the treatment of chronic conditions.

Finally, the data indicate sizable gains in longevity and health for the general U.S. population. I do not have direct evidence of similar health gains for the subset of the population that forms the base for recruitment into the occupations under consideration. To the extent that such gains have occurred, revising mandatory retirement ages upward by a few years may be feasible.

Technology Induced Demand and Projected Worker Shortages

The technology used in executing jobs in many of the occupations under consideration is much better today compared to 3 or 4 decades ago. The largest improvement has occurred in communications and information technology, and in all occupations; firemen have better heat resistant and fire-retardant materials; pilots have planes that are easier to fly an land; police officers have better investigative, forensic, and interdiction techiques, better body armour, DNA analysis, computerized laboratories etc. Not only does newer technology allow jobs to be executed faster and more efficiently, they can be executed with lesser exertion of effort.

They also call for a workforce with a wider range of skills—which implies that the availability of new technology is not necessarily labor-saving overall. It requires more training to operate and maintain newer equipment and requires more experienced personnel to coordinate job activities. On the other hand, as the baby-boomer generation retires, many jobs requiring trained and experienced workers will begin to experience shortages. Those jobs where retirements are mandatory at younger ages will experience acute shortages earlier.

Personnel shortages in key jobs that must be executed on time provoke the imposition of mandatory overtime. However, forced overtime over long periods imposes additional burdens and is likely to lower worker morale. A high-stress atmosphere is likely to induce additional accelerated retirements and make worker shortages even more acute. Hence, worker shortages in crucial occupations can be self-reinforcing unless dealt with in a timely manner. The prospect of increased shortages because of the impending surge in retirements along with an increasing demand for security and aviation efficieny in a new post-9/11 world makes it necessary to revisit mandatory retirement age rules in the occupations that currently enforce them.

Conclusion

Private sector enterprises get by without the imposition of mandatory retirement age rules: They successfully hire high skilled workers under long-term incentive contracts. Indeed, anti age-discrimination laws—the polar opposite of mandatory retirement age rules — appears more important for making such contracts feasible. An important element of private long-term incentive contracts are defined benefit pension plans and other non-wage compensation to achieve firms’ objectives of eliciting worker efficiency and ensuring timely retirements. Similar compensation arrangements could be usefully considered in the public sector as well, despite the lack of a profit-maximizing objective.

Mandatory retirement age rules in certain private, federal, and state and local occupations have been in place for several decades. Their revision appears worthy of consideration for several reasons.

The improvement in general health and abilities of those aged between 55 and 65 in general may imply that mandatory retirement at these ages is unfair for a growing number of workers who retain the ability to execute their jobs competently but cannot transfer their skills to other occupations—such as pilots and air-traffic controllers. Evidence suggests that older displaced workers find it much harder to find jobs compared to younger workers and suffer larger wage declines upon re-employment. 8

Better technology makes the conduct of these jobs physically less taxing. Moreover, newer technologies are likely to require a larger workforce with a broader set of skills to fill these positions. And, the onset of baby-boomer retirements is likely to create acute shortages of experienced personnel, especially in occupations with mandatory retirement set at younger ages.

Summarily eliminating mandatory retirement age rules to prepare for upcoming worker shortages may not, however, be the correct policy response. Doing so may create other problems as in the U.S. academic institutions where retirement rates have plummetted after mandatory retirement at age 70 was abrogated. That has led to slower turnover of teaching staff and aging faculties. Because long-term incentive contracts pay off only when introduced at the beginning of worker careers, implementing such contracts for older workers becomes expensive.

Hence, existing mandatory retirement age rules should be revised in two steps. To deal with impending shortages, existing mandatory retirement ages could be advanced by a few years. Long-term incentive contracting should be introduced for younger workers and new hires. The workforce subject to long-term contracting should be designed to both provide retirement choices to workers and satisfy employers’ objectives of work-safety and efficiency. The revised mandatory retirement age rules will be automatically phased out over time as the workers to which they apply retire over time.

Notes

1. I am Jagadeesh Gokhale, Senior Fellow at the Cato Institute in Washington D.C. I have conducted studies on labor market contracting in the private sector and the effects of long-term employment contracts and worker tenure on the market for corporate control. I have also written on demographic and retirement issues relating to the sustainability of the federal budget.

2. R. H. Frank and R. M. Hutchens, 1993, Economic Journal, Vol. 21.

3. See Friedberg and Owyang, National Bureau of Economic Research, Working Paper No. 10714.

4. Frank Lichtenberg “Sources of U.S. Longevity Increase: 1960-1997,” National Bureau of Economic Research, Working Paper No. 8755, February, 2002.

5. The PSID is conducted by theUniversity of Michigan’s Survey Research Center. This survey’s sample contained just over 10 thousand U.S. households in 1985 and it attrited to about 6,700 households by 1997.

6. Hugo Benitez-Silva, Moshe Buchinsky, Hiu Man Chan, Sofia Cheidvasser, and John Rust, National Bureau Economic Research Working Paper No. 7526.

7. Costa (1994), NBER Working Paper No. 4929.

8. See David Shapiro and Steven L. Sandell, 1985, Southern Economic Journal, Vol. 52.