Retirement decisions

Retirement decisions are an increasingly important aspect of household behavior from an applied point of view. In the life cycle of an individual, retirement is the point in life from which on no labor income is received anymore; the income an individual receives after retirement stems from some social security system or from her own savings. The retirement decision is important because it the timing of retirement determines the amount of saving and dis-saving during both working life and old age, and hence the aggregate level of saving in an economy. Also, retirement decisions affect the financial situation of the social security system that provides pensions. The point of retirement affects the balance of years during which the individual contributes to the system and the number of years during which she receives a pension.

In the most simple case (where complications such as partial retirement are ignored), retirement is a classical example for an intertemporal decision under uncertainty. The main source of uncertainty is, of course, the point of death, because the individual has to assess the remaining life-time utility that she can derive from the choices (whether to retire or not in a given year) she has. Formally, the basic intertemporal trade-off is to compare the present value of future utility when retiring now with the utility of working at least one year longer and retiring then. If the individual does not retire now, she faces the same decision again next year. Therefore, the mathematical formulation of the problem has a recursive structure, a fact that makes the problem more tractable.

Of particular interest in applied work are the incentives to retirement that are provided by the institutional arrangements of the social security systems. In empirical studies it has been shown that individuals react quite strongly to these incentives (e.g., Börsch-Supan & Schnabel, 1997), and this in turn can be seen as evidence for rational behavior in a seemingly quite complicated decision situation.

Literature: Feldstein (1974), Lumsdaine, Stock & Wise (1992), Börsch-Supan & Schnabel (1997)

Entry by: Joachim Winter

June 17, 1999
Direct questions and comments to: Glossary master