Discontinuities in Pension Benefit Formulas and the Spot Model of the Labor Market: Implications for Financial Economists

Abstract

When analyzing tax and related issues, financial economists typically invoke the simplest and the most tractable model of the labor market. This is the spot model, in which the worker's cash wage plus accruing pension benefit must equal the value of the worker's marginal product in each and every period. This paper first identifies the discontinuities in a worker's cash wage that must occur under the spot model if the pension plan has typical"cliff" vesting and early retirement provisions. The paper then calculates the pension benefits actually accrued, at and around the dates of eligibility for these benefits, by members of five pension plans in Canada. Both exercises serve to discredit the spot model. The paper reviews the underfunding puzzle, the measurement of pension liabilities, and the recapture of surplus assets in overfunded plans in light of these findings.