An analysis of precautionary behavior in retirement decision making with an application to pension system reform

Abstract

We analyze how precautionary motives affect the decisions of a risk-averse agent on saving, labor supply and retirement. In a setting where there is a random shock which affects agent disutility from work, we show that uncertainty directly affects retirement age and saving, but leaves labor supply during working age unchanged. In particular, a precautionary motive for retirement always arises, which pushes the agent to bring forward retirement in the presence of a risk on the cost of work effort. Moreover, prudence and a sufficiently high level of absolute temperance are sufficient conditions for precautionary saving. In this setting, we also study the effects of two common reforms of the pension system: an increase in pension contributions and a cut in pension benefits. The conditions for the agent to postpone retirement and increase labor supply are studied. This makes it possible to characterize the circumstances when the financial soundness of the pension system improves after these reforms.