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Unemployment insurance (UI) in some countries is one of the most widely used routes to early retirement. Accordingly, firms lay off elderly workers whose wages exceed their productivity. These workers then receive unemployment benefits until they enter formal retirement, even though they have effectively already exited the labor market. To persuade them into finding the deal acceptable, they quite often may also receive some additional compensation from their employers. In this paper we consider three routes of transition from work to formal retirement that rely on UI: (i) standard unemployment compensation, (ii) public early retirement program yielding benefits higher than the unemployment compensation and (iii) unemployment compensation along with an income supplement provided by the former employer. The study examines under which conditions these three alternative practices can occur.

In a number of countries (including France, Italy, Germany, The Netherlands and Belgium) there is a fairly wide gap between statutory and effective retirement age. This gap undermines the financial viability of social security systems in a world of aging populations.1 It can be explained by a number of provisions in various social protection programs. First the retirement system itself allows, and effectively often encourages, people to retire before they have reached the statutory age. Early retirement may imply a reduction in benefits. However, they usually remain quite generous and the adjustment is often less than the actual fair level. Several studies have shown that the structure of retirement benefits has a significant impact on inactivity rates among the 60–64 age group in OECD countries.2 Second, there are professions where the official retirement age is lower than the standard age. Third, there are specific early retirement programs usually targeted at sectors experiencing economic difficulties. Finally, disability insurance and unemployment insurance are used in some countries to allow elderly workers to retire well ahead of the standard age, even though they are not suffering from a serious disability and not unable to find a job. The Netherlands for instance is known for its disability insurance (DI) schemes which are not just used to provide insurance against the disability risk. Employers have often considered DI as a “decent” way to get rid of elderly workers whose productivity may be low compared to their wages. As a result, in 1999 the number of DI enrollments was as high as 10.4 per 1000 insured workers whereas in Germany and in the US it equaled 5.3 and 6.0 respectively. 3 In the neighboring country of Belgium, unemployment insurance (UI) is a popular avenue to early exit. A similar phenomenon can be observed in a number of other countries. Disability insurance tends to be generous. Unemployment insurance, on the other hand, is much less attractive. This may lead one to wonder why so many elderly workers take this exit route? To better explain this phenomenon, let us take the example of the Belgian social security system for private sector salaried workers. In the window 60–64, workers can retire through the standard pension system with some penalty if their working career is not complete. In the window 55–59, they cannot draw any benefit from the pension system, but they can exit the labor force through unemployment insurance. There are effectively three ways to retire through UI. First, there is the UI scheme that people use when they do not have any other choice. They receive rather low benefits with just one advantage: they are no longer considered as actively seeking employment. We shall label this route UC. Second, they can exit through an early retirement scheme that offers both the unemployment benefit and extra compensation from the former employer with the consent of the government. These early retirement schemes are found in specific sectors, often for reasons of downsizing or restructuring. We shall denote this route ER. Third, workers can be persuaded by their employers to take unemployment and receive a side-payment making up for some of the difference between their salary and the unemployment benefit. 4 This package may appear to be a regular pension, but in fact is not. We shall label this scheme a Canada Dry (CD) pension, as it is known in Belgium. 5 Fig. 1 illustrates this situation. Full-size image (20 K)These practices are highly questionable. Unemployment insurance is not intended to aid elderly workers who exit the labor force. Further, the extra compensation paid by employers effectively widens the use of UI for early retirement. The attitude of public authorities towards these practices is often ambiguous. In this paper we consider the three different types of UI use and misuse, and how these policies can be rationalized as “optimal” policies within a specific setting and given “plausible” informational and institutional restrictions.6 The three ways to retire via UI we consider are (i) a standard unemployment benefit scheme which exempts beneficiaries from job-search obligations (UC), (ii) an early retirement scheme that consists of unemployment benefits plus an allowance paid by the employer but approved by the government (ER), and (iii) “Canada Dry” arrangements (CD) that consist of unemployment benefits plus a lump-sum payment from the employer which is not formally approved by the government. Belgium is undoubtedly the country where the three ways to retire early via the UI system are the best known.7 What makes the two latter schemes attractive is that the top-up payments are taxed at a preferential rate and not in the same manner as regular earnings. Furthermore, under the three schemes individuals accumulate pension rights in the same way as active jobs seekers. There is evidence that both early retirement (ER) and unemployment insurance include UC and CD schemes. The confidential nature of the employee/employer relationship, unfortunately prevents any accurate accounting of use in relation to these two schemes. This lack of accountability is acknowledged by the OECD (2003). Other OECD countries8 have similar exit routes related to unemployment insurance. In France, the number of dismissals for personal reasons has increased over the last two decades.9 These are often accompanied by severance compensation and viewed as more attractive than formal early retirement schemes. As to the importance of these dismissals, which look very much like the Belgian Canada Dry pensions, it can only be speculated. To mitigate its unemployment problems, Macedonia offers its elderly workers a package that includes unemployment compensation combined with a generous up-front payment that is either private (employers) or public (early retirement fund).10 In Germany, there are also arrangements that resemble the Belgian Canada Dry pension. Riphahn (1997), for instance, shows that German workers aged 57 years and 4 months can retire through an agreement between employers and employees that gives employees topped-up unemployment benefits. Unfortunately, in Germany and many other countries, there exists no evidence outside of estimates on the utilization of this indirect early retirement mechanism. In this paper we do not try to gather evidence on this elusive practice. Instead, we want to investigate whether it makes sense theoretically and if so, under which assumptions. We use a stylized model of the labor market for individuals who are approaching the end of their active workforce life, and for whom early retirement is a conceivable option. In the Belgium case, the age group we have in mind would be somewhere in the range of 55–60. In other cases the exact scope or range would be country specific. There are three types of individuals: high ability workers, low ability workers, and permanently unemployed individuals. Individuals of this latter type are unable to find a job and are unemployed regardless of the compensation they might obtain. All workers are paid the same wage. Consequently, low ability workers are paid above their productivity and this provides their employers with an incentive to get rid of them. For reasons of labor market rigidities, they cannot simply be fired. However, they may opt to quit if the unemployment compensation is large enough and/or if they are persuaded into accepting their layoff through a supplement.11 The informational assumptions are also crucial. The government cannot prevent high ability individuals from claiming unemployment insurance. Canada Dry pensions, on the other hand, are awarded by firms who do observe workers' productivities and who can target the low ability individuals. Consequently, Canada Dry pensions, though relying on a misuse of unemployment benefits, can act as a screening device that may mitigate policy imperfection in a world of asymmetric information. Depending upon parameters, the optimal policy may correspond to one of the three different uses or misuses of unemployment insurance. In the first use (UC), no supplement is needed. In the second, a supplement is needed to make retirement acceptable to the workers and it is paid by the firm in the open. This is equivalent to a scheme of early retirement (ER). In the third, the compensation is paid by the employers. This is referred to as a Canada Dry pension (CD). While government is unable to control the CD pension, it has indirect leverage on the workers labor market status through the level of unemployment compensation.

In this paper we have considered the use of unemployment insurance when firms want to get rid of unproductive workers who cannot be paid according to their productivity. We have assumed that in the first-best scenario these workers should continue to work. However, for reasons of redistribution and asymmetric information, they can be driven out of the labor force via three different ways: the standard unemployment insurance UC, early retirement, ER, offering benefits that are higher than those of UI, and standard unemployment insurance with additional compensation paid by the company or what we refer to as a CD (Canada Dry) pension. Table 3 and Table 4 illustrate the different uses of UI in Regime 0. The CD case is clearly one of misuse. Referred to as Canada Dry pensions in Belgium, these have been heavily criticized by the OECD. The UC case is also one of misuse. Firms can easily get rid of allegedly unproductive workers through UI because the government does not force these workers to find another job. These workers can expect to receive unemployment compensation until the standard age of retirement without being forced to search for other employment. Finally, the ER case can be assimilated with the standard early retirement scheme that exist in many European countries and that are addressed to workers laid off before the age of standard early retirement. Canada Dry pensions, in our setting, are shown to be socially desirable but only under the assumption that labor disutility is higher for workers with higher productivity. This is a bold assumption, and could well be the outcome of bad policy. As we have shown above, the evidence for CD is elusive. It is said to exist but it can be difficult to measure. In this paper, we show that at least theoretically there are some grounds for it to exist.