Dynamic Incentives in Retirement Earnings-Replacement Benefits

Abstract

We analyze dynamic incentives created in pension systems by the use of a small set of final years of earnings to compute benefits. Using social security administrative records and house- hold surveys from Uruguay, we show that self-employed workers and employees of small firms respond to these incentives by increasing reported income in the benefit-calculation window. We find that these responses are explained by decreases in underreporting of earnings and not changes in total earnings or hours worked. Back of the envelope calculations estimate this behavior increases the cost of pensions for these workers by between 1.9% and 2.4%.