Does Means Testing Exacerbate Early Retirement? ∗ James Sefton † and Justin van de Ven ‡ It is quite clear that the message has gone out to all too many of our constituents that savings can damage their retirement income. We cannot explain the collapse in savings in this country in any other way than by saying that people are being very rational and that about 40 per cent of working people cannot now save to make themselves a penny better off — let alone substantially better off — through forgoing income now and trying to push it into their retirement. Frank Field, MP for Birkenhead, Commons Hansard Debates, 4 June 2003. 1 Introduction Means testing of pension benefits has been heavily criticised for discouraging savings and work effort, and consequently creating a dependence on the welfare state. Yet means testing does enable the government to target welfare benefits on those who need the benefits most, and consequently to acheive a more equal society. This study considers the trade-off. The analysis presented here reveals that, although targeting of pension benefits does generate disincentives to save and to work, it need not lower aggregate saving and employment participation. This is because the incentive effects of means testing vary accross the income distribution. The Government’s motive for its reliance on means testing is obvious; it promises a way of ensuring that everyone has an adequate income, while at the same time controlling costs by reducing eligibility to benefits. Means testing of pension benefits is also an effective way of redistributing income. By focussing state pensions on poorer households, the aggregate costs associated with pension provision can be limited, which enables a more generous state pension to be offered — money that is, in effect, taken from richer households. The more precise the focus of pension provision, the smaller the associated burden on the public’s purse. As the costs of pension provision are set to increase with the aging of the population, it is likely that means testing will remain an integral part of pension policy for the foreseeable future. A means tested pension policy does, however, introduce incentive traps that could both increase reliance on benefits and exacerbate the problems of early retirement. This is because means testing of pension benefits erodes ∗ Draft - Preliminary and Incomplete. Please do not quote without the prior permission of the authors. † The Business School, Imperial College London, and NIESR. jsefton@niesr.ac.uk ‡ NIESR. jvandeven@niesr.ac.uk 1