Disability insurance in an optimal pension scheme

"Disability" or "poor health" is traditionally associated with a complete loss of earnings capacity and/or prohibitive increases in the disutility of labor. Thus, it invokes a necessity to withdraw from the labor market. A number of empirical and theoretical studies have questioned this conventional view and suggested instead that the use of disability-contingent allowances for early retirement mainly reflects the leniency of the eligibility rules. This raises the issue of designing incentive-compatible health-contingent retirement rules and questions concerning the resulting characterization of optimal pension systems. The study shows that the presence of moral hazard induces an overinsurance of normal retirees, raises the optimal contribution-rate, and lowers the optimal normal benefit level and the normal retirement age. Moreover, even if the realization of an ex-ante uncertain health shock increases the disutility of labor only slightly, the disability-contingent retirement age and the date when this health shock occurs will coincide - given that the system entails normal retirement provisions as well. Thus, minimum eligibility ages and other arrangements to induce prolonged work of actually disabled persons can very generally be demonstrated to be suboptimal.