Drivers of rising labour force participation – the role of pension reforms

Prepared by Katalin Bodnár and Carolin Nerlich

Published as part of the ECB Economic Bulletin, Issue 5/2020.

1 Introduction

Labour supply developments are a major determinant of potential output and are therefore also relevant for monetary policy. Labour supply developments in the euro area are strongly affected by population ageing, among other things.^[1] Against this background, it is crucial to have a good understanding of how demographic changes in the various working-age cohorts, together with structural factors such as policy changes, will affect the labour market. Looking ahead, this understanding will be relevant when assessing the potential growth outlook, even though uncertainty has considerably increased recently due to the coronavirus (COVID-19) pandemic.

With the ageing of the baby boom generation, the population share of the older working-age cohort, i.e. those between 55 and 74 years, has been gradually increasing. This would suggest a decline in the overall labour force participation rate, given that the participation rate of these older workers has usually been considerably lower compared to other working-age cohorts.^[2] However, this is not what we have observed during the past two decades. Instead, most euro area countries have experienced an increase of labour supply since the early 2000s, largely explained by developments in the labour force participation rate. Moreover, the steepest rise in the labour force participation rate was observed for older workers, following a seminal decline before the turn of the century.^[3]

This raises the question: what has been driving this increase in the labour force participation rate of older workers? Deciding on when to exit the labour market and enter retirement is a complex individual choice. Factors that influence this choice include: the relevant labour market situation; the set-up of the national social security system; and each individual’s health status and personal preferences. The net wealth position of older workers, and in this context the increasing role of occupational pensions, is also likely to, at least indirectly, influence their retirement decisions – not least because higher net wealth might help to partly compensate for possibly shrinking pension entitlements. Many of these factors have improved over time. In fact, better health conditions, rising life expectancy, higher educational levels – mainly among women – and rising net wealth reflect long-term trends that had already started well before the turn of the twenty-first century. As such, those factors, though they have likely contributed to the rise in participation, cannot be used to fully explain the particularly sharp rebound in the participation rate of older workers since 2000. This sharp rebound may, in fact, have been supported by more recent policy changes, such as pension reforms, which incentivised older workers to remain in the labour market for longer by postponing retirement. Against this background, the focus of this article will mainly be on the role of pension reforms.

Most euro area countries adopted substantial pension reforms in the last two decades to reduce risks to long-term fiscal sustainability. Pension reforms are essential in view of the challenges that population ageing poses for financial sustainability of the public pension systems, which are predominately pay-as-you-go schemes in the euro area. At the same time, pension payments need to ensure that pension benefits are socially adequate. The adopted pension reforms mainly sought to reduce the generosity of retirement schemes and to limit eligibility criteria, in particular for early retirement; it can be expected that this does encourage older workers to participate in the labour market for a longer period of time. These pension reforms were in some cases complemented by labour market reforms tailored towards older workers – for example, incentivising job searches or supporting the retention of older workers.

However, the COVID-19 shock – if prolonged – may bring into question whether this increase in the labour force participation rate of older workers will continue. Experiences drawn from some earlier shocks suggest that older workers – predominantly those with lower education levels – may be particularly exposed to prolonged negative macroeconomic shocks.^[4] When labour demand drops significantly and workers are dismissed they may become discouraged from job searching and withdraw from the labour market. For older people, this withdrawal may not be reversed when the economic conditions improve again, thus, their labour force participation rate may be permanently affected. In the current macroeconomic shock resulting from COVID-19, some factors may amplify this effect. First, the direct health shock related to the rise of fatality rates with age may make older workers less willing to prolong their employment. Second, sectors where older people might have longer careers – for instance, service sectors – are significantly exposed to the shock. However, short-time work schemes implemented across the euro area are contributing to preserve employment relationships and thus are likely to mitigate the possible subsequent discouragement effects.^[5] Furthermore, the current crisis may negatively affect disposable income and – through pension funds and other personal investments – worker’s net wealth. This may incentivise older workers to prolong their working careers. This may counterbalance some of the negative impact mentioned above.

The current shock may be unlike the financial crisis. In fact, after 2008, unlike in earlier shocks, the trend increase of the labour force participation rate continued for older workers^[6], while today the older workers’ labour market situations, their willingness to work and thus their labour force participation rate might be at greater risk. This may be due to the specificities of the health shock, the differences in sectoral developments, as well as differences in terms of governments’ willingness to carry out further pension reforms. Given that recently older workers provided the largest contribution to the recent labour force participation rate increases, the impact of the macroeconomic shock on their labour market situation may have a large impact on the overall labour force participation rate.

The article is organised as follows. Section 2 gives a broad overview of developments in the labour force participation rate across euro area countries in the past two decades. Section 3 examines indicators of when older workers retire in the euro area. Section 4 discusses various factors that potentially determine the participation rate of older workers from a conceptual point of view, including pension reforms. Box 1 complements the analysis by looking at the role of labour market reforms for older workers, while Box 2 discusses the composition of net wealth of older age cohorts. Section 5 provides an overview of the pension reforms that have been adopted and implemented by euro area countries since the early 2000s and discusses their possible impact on the participation rate of older workers. Finally, Section 6 concludes with a tentative outlook for participation rate developments in euro area countries, examining how this could affect future labour supply and potential growth, also in the light of the COVID-19 shock.

2 Changes in labour force participation rates in the euro area

Labour force participation rates increased across euro area countries in the past two decades. In the euro area, the overall labour force participation rate of the working-age population (defined as the population aged between 15 and 74 years) increased by almost 5 percentage points in the last two decades, reaching 64.5% in 2019. This follows an earlier period where the labour force participation rate was flat overall (see Chart 1).^[7] Instead, the participation rate of older workers is u-shaped because it declined until 2000 before increasing strongly between 2001 and 2019.

Since 2000, the labour force participation rate of older workers showed the largest increase in the euro area when compared to other age cohorts. The participation rate has been increasing for almost all age groups. In contrast, while it has been rising only modestly for those below the age of 55, and even slightly decreasing for the 15-24 age group, the participation rate has increased since 2000 by around 15 percentage points for those in the euro area aged between 55 and 74. For those aged between 55 and 64 years, the rise has been well over 20 percentage points. In 2019 most labour market withdrawals happened in the 65-69 age group, whereas they occurred in the 60-64 age group in 2000. Two decades ago 20% of the male population withdrew from the labour market when they were between the ages of 55 and 59, while 38% withdrew when aged between 60 and 64. These figures are at 7% and 30% as of 2019, respectively. A similar pattern can be observed in the female population. The participation rates of women aged between 55 and 59 years is now as high as the participation rate of those aged between 45 and 49 years two decades ago (Chart 2). These figures indicate major changes that happened in the older age cohort of the working-age population.

The positive contribution from the rise in the labour force participation rate of the older workers exceeded, by far, the negative impact due to population ageing. The population share of the 55-74 age group increased considerably, from about 27% in the early 1980s to 32% in 2019 (Chart 1). This increase is mainly the consequence of the baby boom generation reaching this age group. Given the generally lower participation rate of older workers compared to prime-age workers (Chart 2), this exerts a negative compositional effect on the overall participation rate. However, this has been more than compensated by the rise in the participation rate of older workers, resulting in a significant net positive overall impact. The age group with the largest increases in its labour force participation rate, i.e. those aged between 55 and 64 years, accounts for 3.8 percentage points of the overall 4.7 percentage point change observable for the entire working-age population (Chart 3).

This pattern of older workers being the main drivers of labour force participation rate increases is evident across all euro area countries. The overall labour force participation rate has been increasing in all euro area countries in the last two decades, although to varying degrees. In most countries, a major part of the overall increase can be explained by the 55-74 age group remaining active for longer. The contribution of the rest of the working-age population remains more diverse across the euro area countries. For example, it is strongly negative in Slovakia and strongly positive in Malta. The age compositional effect tends to be negative in more than half of the euro area countries, mainly reflecting the ageing of the baby boom generation (Chart 3).

The rise of labour force participation rate of older workers is more pronounced for women. In the euro area, the recent increase in the female participation rate in the 55-74 age group (19 percentage points) exceeded that of men (15 percentage points). Still, women in this age group continue to participate in the labour market less than men (Chart 2). This is true for all euro area countries. Between 2000 and 2019, the difference between the increase in the male participation rate and the female participation rate was particularly pronounced in Latvia, Estonia, Ireland, Slovakia, Cyprus and Spain.

The increase in the participation rate is largely independent of education levels. While participation rates are usually higher for workers with higher education levels compared to low-skilled workers, the steep increase in the participation rates of older workers was observed across all education levels. At the same time, the population share of people with low education is declining (in the 55-64 age group, from 51.9% in 2000 to 33.5% in 2018 for the euro area), which means that the compositional effect according to education level contributes positively to the change in the participation rate. A shift-share analysis suggests that this compositional effect is moderate for older workers (explaining about one-fifth of the change for the 55-64 age group), while the major part of the rise in the participation rate seen in the last two decades would have happened even with unchanged education levels.

The rise of the participation rate of older workers has been a major driver of the increasing labour supply. Recent labour supply developments have been dominated by older workers: between 2000 and 2019, 98% of the increase in the overall labour supply came from those aged between 55 and 74. This mainly reflects the increasing participation rate (explaining about two-thirds of the rising labour supply of older workers) and, to a smaller degree, the rising population of this age group.^[8]

In the last two decades the rising labour force of older workers combined with a strong increase in their employment, while unemployment remained moderate. The rise of the labour force participation rate of older workers transformed almost entirely to a higher employment share (increasing by around 15 and 19 percentage points for men and women, respectively), while the number of unemployed changed only a little. Older workers are generally characterised by a lower unemployment rate than the younger cohorts, partly reflecting that often they move to inactivity in case of a loss of job.^[9] However, the moderate change of the unemployment rate of older workers following the strong increases in the labour force participation rate is remarkable. This, in turn, reflects that the 55-74 age group was the main contributor to employment growth in the period examined. This does not seem to have been accompanied by a rise of potentially precarious contracts (such as temporary contracts, underemployed part-time workers, self-employed) in this age group. Indeed, most of the increase of the employment of older workers was due to permanent, full-time positions (Chart 4). Part-time employment has also increased somewhat, mainly for women, mostly in line with the preferences of older workers.

3 When do older workers retire?

When do older workers actually retire in the euro area? The timing of older workers exiting the labour market does not necessarily fully align with their entry into retirement. While comparable data on the actual average retirement age is not publicly available for all countries, several indicators could serve as proxy. One of them is referred to as “effective retirement age”, which corresponds to the age at which people withdraw from the labour market. It is defined by the Organisation for Economic Co-operation and Development (OECD) “as the average age of exit from the labour force during a five-year period for workers initially aged 40 and over”. The effective retirement age may well differ from the statutory retirement age, which defines the age at which people become eligible for a full pension.^[10]

The effective retirement age has changed considerably over time and across countries – broadly in line with the dynamics of the participation rate of older workers, as shown in Chart 1. The average effective retirement age within the euro area constantly declined towards the end of the last century to a level of as low as 61 years for men and below 60 years for women (Chart 5). From 2000 onwards, the effective retirement age started to rise, even though the recovery was briefly interrupted during the financial crisis. By 2018, the effective retirement age for men stood at more than 64 years and for women at almost 63 years, which corresponds to an increase by 3 years since 2000.^[11] Despite the wide-spread improvement in the effective retirement age since 2000, the changes and the current levels differ across countries (Chart 6). The highest effective retirement ages are currently seen in Estonia, Latvia, the Netherlands (only men) and Portugal. These countries also observed the strongest increases in the effective retirement age since 2000. In a few countries, however, the effective retirement age declined, partly reflecting the (lagged) impact of the financial crisis as well as in anticipation of substantial changes to (early) retirement schemes, as discussed in Section 5.

Analogous developments were observed for the duration of working careers, in particular among women. The length of working careers is another indicator for the actual retirement age. Since 2000, the duration of working life increased for men by 2 years and for women by almost 6 years, standing at almost 39 years and 33 ½ years in 2019, respectively (Charts 7). This has to be seen in the context of rising education levels, particularly for women. Women work longest in Estonia, Lithuania, the Netherlands and Finland, while the most substantial improvements since 2000 were achieved in Spain, Luxembourg and Malta. Overall, the rising duration of working careers seem to broadly coincide with the sharp rise of the participation rate of older workers.

4 Why do older workers remain in the labour market for a longer period of time?

From a conceptual point of view, there are many possible reasons for older workers to postpone retirement and remain in the labour market for a longer period of time. Entering retirement is a complex individual decision, influenced by many factors including the attributes of relevant labour markets, the set-up of national social security systems, peoples’ net wealth, their health status and their individual preferences. While most of these factors have changed considerably in the past two decades, the extent to which they serve to explain the steep increase in the labour force participation rate of older workers can be expected to differ.

Healthy ageing is likely to encourage longer working lives. Healthy ageing not only implies an increase in life expectancy, but also better health conditions of older cohorts, both reflecting long-term trends. Since 2000, life expectancy at age 65 in the euro area increased on average by 2 ½ years, reaching almost 21 years in 2018, with a stronger improvement for men compared to women.^[12] The number of healthy years expected at older ages has also improved in many countries. Several factors might have positively affected the health of individuals, and a person’s health is an important prerequisite for older workers to stay longer in the labour force. Healthy ageing might be positively influenced by higher educational levels, as life expectancy is found to be higher for people with higher education.^[13]

Structural changes of labour markets, labour market policies and cyclical labour demand have supported the improvement of the labour market situation for older workers. While labour demand has likely contributed to the improvement seen before the financial crisis and during the euro area recovery (between early 2013 and end-2019), the increase in the participation rate of older workers does not seem to have been strongly distorted by cyclical developments. At the same time, structural changes in the labour markets – for example a rising share of jobs in the service sector – has likely supported longer working careers due to higher overall labour demand and by offering physically less demanding working conditions than manufacturing and construction. In addition, several labour market reforms have influenced the labour market for older workers – these are summarised in Box 1.

The characteristics of pension schemes are important determinants of the retirement behaviour of older workers. Pension schemes provide for a range of circumstances, from old-age pensions to disability pensions, and can be designed in different ways, from public pensions to occupational pensions, and from pay-as-you-go systems to fully funded private systems. With respect to old-age pensions, including early retirement schemes, age eligibility parameters for pensions are a decisive factor in determining the participation rate of older workers. Statutory and early pension ages may serve either as constraints, after which working is not possible,^[22] or at least as an indicator of when to retire. Moreover, incentives to stay in the labour market for a longer period are seen to be negatively correlated with the generosity of pension payments. In case pension entitlements are cut, for example by raising the malus applied in case of early retirement, this is likely to encourage prolonged working lives. This also has to be seen against comfortable net wealth positions of households in retirement on average (see Box 2). In addition, moving to actuarially fairer adjustments for delayed retirement, for example in the form of a bonus, can be expected to have a positive impact on the duration of working lives. Furthermore, more flexible pension arrangements which allow combining work and retirement are expected to positively affect the decision to postpone retirement. In case of more restricted access to programmes that offer alternative pathways out of the labour market, such as disability pensions (see Box 1), this might also encourage old-age workers to retire later.

Against this background, pension reforms can be expected to play a key role in the changes in the participation rate of older workers. While better health conditions, rising education, and more favourable labour market conditions are expected to support a higher labour participation rate of older workers, these common long-term trend factors alone are not able to explain the recent increase in the participation rate and its large variation across countries. This shifts the focus on to how pension reforms might have affected the old-age participation rate.

5 Recent pension reforms across euro area countries and their labour market impact

While all euro area countries adopted pension reform measures during the past two decades, they varied across countries in terms of intensity and frequency. The pension reforms comprised in particular increases in the statutory retirement age, more flexible retirement arrangements to combine work and retirement, financial incentives for prolonging working lives beyond the statutory retirement age, less generous (early) retirement schemes and stricter eligibility criteria for early retirement for instance due to more required contributory years.^[28] The pension reforms implemented in the last decade were particularly substantial in countries subject to adjustment programmes, such as Greece, Spain, Cyprus and Portugal.

Pension reforms are important not only for fiscal sustainability but also for labour supply. Population ageing is placing upward pressure on mostly already elevated levels of age-related public spending, including old-age pension expenditures.^[29] The recently adopted pension reforms have helped to strengthen the robustness of the countries’ public pension systems in view of population ageing and to contain long-term fiscal sustainability risks.^[30] Moreover, pension reforms are seen as an important factor of prolonged working lives.

Statutory retirement ages have been raised in almost all euro area countries. Since 2000, the age limits for receiving a full pension increased by on average more than two years for men and almost four years for women in the euro area countries (Chart 8). Increases of 5 years or more were implemented in two countries, France and Slovenia, both for men and women, and in six countries, namely Germany, Estonia, Italy, Greece, Latvia and Lithuania, only for women. The generally more pronounced increase of eligibility ages for women reflects a common trend in Europe towards equalising the retirement ages of men and women. Only a few countries, namely Belgium (only men), Luxembourg and Austria, left the eligibility age unchanged during the past two decades. Most countries have also restricted access to old-age pension payments by making them contingent on a higher number of contribution years, which is particularly relevant for the sustainability of predominately defined benefit schemes. The trend of rising statutory retirement ages is expected to continue, as several countries decided to automatically link the retirement age to changes in life expectancy.

Stricter eligibility criteria for statutory pensions were often complemented by restrictions on early retirement. All euro area countries, except Ireland and the Netherlands, have early retirement schemes in place.^[31] Some countries even operate several early retirement schemes in parallel which target specific groups of workers. Most early retirement schemes entail deductions to allow for more actuarial fairness. Since 2000, the early retirement age limit was raised on average by 3 ½ years for men and by more than 4 years for women, reaching around 61 years for both men and women in 2019 (Chart 9). Some countries, mainly those that implemented an automatic link between retirement age and changes in life expectancy, also broadened this instrument to their early retirement schemes. In addition, six euro area countries (Belgium, Germany, Greece, Spain, France and Austria) allow receipt of full pension without any deductions before reaching the statutory retirement age. However, entitlements are usually made conditional on specific criteria, such as long working careers. Since 2000, these requirements were significantly increased to currently around 40 contributory years or more. By requiring very long working careers, such early retirement schemes have implicitly become predominantly tailored towards workers with earlier career starts and lower educational levels.

Most countries have embedded in their pension schemes some (financial) incentives for older workers to prolong their working careers. To incentivise older workers to stay in the labour market for a longer period, sometimes even beyond the statutory retirement age, several countries tuned their pension systems in the past two decades by more strongly rewarding delayed retirement or by allowing retirees to continue working (Chart 10). However, the concrete set-up of these measures is very country-specific. Financial incentives are mostly provided in the form of a pension bonus for delayed retirement and through age-dependent tax credits for older workers. Some countries allow older workers to claim pension payments while working up to a certain age limit, while others do not set any upper boundary. Against the background of generally rising statutory retirement ages, these measures have also been increasingly affecting the participation rate of age cohorts beyond 65 years.

Reducing the generosity of pension benefits can be expected to encourage older workers to retire later. Many euro area countries reduced the generosity of their public pension systems mainly with the aim of improving the financial sustainability of their pension schemes. Older workers might postpone their retirement date to compensate for the pension shortfall, which might have a positive side effect on the participation rate. In the euro area, pension entitlements were cut through various means, such as by lowering the accrual rate by which pensionable earnings are transferred into pension entitlements; by calculating the reference wage for pension payments on the basis of a full career rather than a subset of best years which usually imply higher salaries; and by strengthening the indexation of pensions to inflation developments rather than wage developments.^[32] Moreover, several countries raised the pension tax rates and made early retirement financially less attractive by increasing penalties for early retirement.

All these pension reforms can be expected to incentivise older workers to delay their retirement decision. The reform impact can be captured by the implicit tax rate of working one year longer, which reflects the changes in the present value of the future stream of pension benefits of a standardised worker in comparison to the additional earnings gained by working one year longer.^[33] A high positive value of the implicit tax rate for working longer reveals incentives for retiring earlier, while a negative value can be considered to be a kind of subsidy for working longer – this is because the additional earnings from working one year longer exceed the shortfall in the present value of pension benefits. The value of the implicit tax rate depends on the underlying parameters of the respective pension scheme and therefore varies across country, age cohort and time. For example, in the case of an early retirement scheme, the implicit tax rate tends to increase in the year before reaching the earliest age at which one is eligible for early retirement, while flattening somewhat thereafter. Pension reforms that affect the generosity of the pension system and postpone the retirement age are expected to result in a lower implicit tax rate. The few available studies on euro area countries suggest an overall decline of the implicit tax rate for both men and women. In fact, a recent study shows that the implicit tax rate for workers at age 62 more than halved for a group of euro area countries, from above 45% on average in 2000 to around 20% in 2015, notwithstanding large cross-country differences.^[34]

The implicit tax rate for working longer seems to be negatively correlated with the participation rate of older workers, as also confirmed in the literature. A decline in the implicit tax rate as a result of pension reforms can be seen as an indication that older workers postpone their entry into retirement. The positive effect of pension reforms on incentives to participate in the labour market for longer has been broadly confirmed in several studies. They find evidence that people react to changes in financial incentives (such as early retirement deductions, but also lifetime income and wealth effects) as well as to changes in the statutory pension age.^[35] Moreover, recent research has shown a statistically significant negative correlation between the implicit tax rate and the employment rate across several advanced countries, including six euro area countries.^[36] Pension reforms, in particular those restricting access to early retirement schemes, are found to have played a major role in driving up the employment rate of older people. In fact, based on pooled panel regressions, the results suggest an increase in the employment rate of older workers (at an average early retirement age of 62 years) by 6.7 percentage points for men and 4.6 percentage points for women in the case of a decline in the implicit tax rate (from 100% to zero). At the statutory retirement age, the positive impact on the employment rate is estimated to stand at 1.8 percentage points. These findings are broadly in line with other studies.^[37]

At the same time, disentangling the impact of pension reforms on the labour force participation rate across countries is far from trivial. First, pension schemes and the amount and scope of pension reforms differ considerably across countries, while the specific features of reforms are important with respect to their concrete impact on labour supply. Second, considerable variation exists with respect to the date pension reforms were adopted and the time period between announcement and implementation of reforms. In particular, long implementation delays have been found to have macroeconomic effects, not at least as people try to advance retirement to still benefit from the old regime.^[38] Third, the pace of reform implementation varied across countries. In some countries, such as Germany, certain pension reform elements were implemented very gradually, while in others, such as Italy, the increase in the statutory retirement age was implemented rather abruptly. This has implications for when the participation rate of older workers will be affected.

Furthermore, pension reform reversals may have adverse implications for labour supply. More recently, several countries are contemplating whether to reverse previously adopted pension reforms, in view of rising political pressure. In a few countries, such steps have indeed already been decided. However, as recent research has shown, undoing past pension reforms would not only pose challenges for fiscal sustainability, but would also generate substantial adverse macroeconomic costs, including for the labour supply.^[39] Thus, if this trend of reform reversals continues, it is likely to result in a declining participation rate of older workers.

6 Conclusions

This article argues that several factors played a role in the considerable increase in the labour force participation rate of older workers during the past two decades. The participation rate of older workers increased particularly strongly among women, although they were starting from a lower level than men. Various factors can determine the participation rate of older workers. Deciding on when to enter retirement is a complex choice, influenced by many factors, including: the labour market situation; the set-up of the social security systems; a person’s health status; their net wealth and its expected evolution; and their individual preferences. While many of these factors have changed considerably over time, most of them are long-term trends, such as better health conditions, rising life expectancy and higher educational levels, and therefore cannot explain the steep increase in the participation rate since 2000. In turn, pension reforms seem to have played a decisive role in driving the participation rate up. They comprise increases in the statutory retirement age, more flexible retirement arrangements to combine work and retirement, financial incentives for prolonging working lives beyond the statutory retirement age, less generous (early) retirement schemes and stricter eligibility criteria for retiring earlier, for instance due to an increase in the contributory years required.

Looking ahead, various factors will play a role in driving the labour force participation rate of older workers in future years, with the overall impact being unclear. First, the latest population projections suggest that the relative share of the cohort of older workers will shrink somewhat, once the baby boom generation has entered retirement. This would drive the overall participation rate up by itself, all other things being equal. Moreover, to further contain fiscal sustainability risks related to population ageing, governments would need to pursue further pension reforms with a potentially positive impact on the labour force participation rate of older workers. However, if the recent trend of pension reform reversals were to continue, this is likely to have an adverse impact on the labour force participation rate of older workers. Finally, in the shorter term all these effects are likely to be dominated by the impact of the COVID-19 pandemic and the severe macroeconomic implications, including on the labour market. The experience from past severe macroeconomic shocks suggests that the labour force participation rate of older workers is likely to be negatively affected, unless mitigated by policy intervention.