Wage Profiles and Pension Rules

The paper presented in this Mannheim Applied Seminar shows that defined benefit (DB) pension rules linking retirement benefits to terminal earnings create incentives for workers and firms to distort wage profiles. The authors develop a model in which workers negotiate with firms to backload wages beyond what productivity warrants, trading current consumption for higher pension benefits. The firm extracts a share of the resulting surplus as compensation for the costs of manipulation. When workers experience unexpected job losses, the model yields two testable predictions: average wage growth at the last firm before retirement increases with the age at which that firm is joined, and pension benefits decline with later job starts conditional on total contributions. They test these predictions using Italian administrative data covering the universe of private-sector workers, leveraging mass layoffs as a source of exogenous variation in the age at which workers join their final firm. The authors find empirical support for these predictions and that firms appropriate 10-37% of the surplus generated by DB rules. They also show that wage backloading imposes substantial fiscal costs. Descriptive evidence from cohorts transitioning to defined contribution (DC) system shows that the distortion in terminal wage profiles largely disappears, suggesting an important and previously overlooked efficiency argument for DC pension design.