How Social Security and Medicare Affect Retirement Behavior in a World of Incomplete Markets

This paper provides an empirical analysis of how the U.S. Social Security and Medicare insurance system affect the labor supply of older males in the presence of incomplete markets for loans, annuities, and health insurance. Using data from the Retirement History Survey, we estimate a detailed dynamic programming (DP) model of the joint labor supply and Social Security acceptance decision, focusing on a sample of males in the low to middle income brackets whose only pension is Social Security. Comparisons of actual vs. predicted behavior show that the DP model is able to account for wide variety of phenomena observed in the data, including the pronounced peaks in the distribution of retirement ages at 62 and 65 (the ages of early and normal eligibility for Social Security benefits, respectively). The peak at 62 is a result of borrowing constraints that prevent individuals with relatively little tangible net worth from retiring prior to the age of first eligibility for early retirement benefits. The peak at age 65 is a result of incomplete markets for annuities and health insurance and the fact that Social Security benefit formula is actuarially unfair for retirements after age 65.