Revisiting the consumption puzzle at retirement

Abstract

Purpose The purpose of this paper is to explore consumption dynamics around retirement for Spanish households, following the approach of Banks et al. (1998). The authors test two central hypotheses. First, consistent with life-cycle theory, consumption should evolve smoothly around retirement, without discontinuities. Second, if the life cycle/permanent income hypothesis holds, then retirees’ consumption should be insulated from contemporaneous pension reforms. Design/methodology/approach The authors estimate an Euler equation for consumption along the lines of Banks et al. (1998) and examine the link between the interest rate and consumption growth. They assess the quantitative and qualitative responses of consumption growth to retirement and pension reform measures. To handle potential endogeneity, GMM methodology is used when possible (for subperiods 1977–1983 and 1985–1996). The authors also analyze data for 2016–2022, organized in cohorts. The econometric tools for this subperiod are 2SLS and GLS. They undertake several robustness tests. Findings Consumption growth is negatively correlated with retirement, suggesting a discontinuity in consumption which implies a departure from the life cycle model. The drop in consumption at retirement is around 10%–13.5% in 1977–1983, 5% in 1985–1996 and 2% in 2016–2022, in line with the literature and the macroeconomic scenario in Spain at that time. Neither work-related expenditures nor health expenditures seem to explain consumption dips. Instead, the evidence suggests that the consumption decline is largely driven by uncertainty, particularly about future pension income. Limited financial literacy, regulatory opacity and the complexity of pension rules may constrain individuals’ ability to form accurate expectations. Research limitations/implications The analysis for 2016–2022 relies on synthetic cohorts because of the lack of true panel data, which reduces the granularity and statistical power of the estimations. Future work should exploit complementary data sources and identification strategies, such as difference-in-differences or regression discontinuity designs, to better isolate causal effects. Moreover, the relative role of uncertainty, especially that related to pension predictability, deserves further scrutiny. Developing formal measures of pension complexity and incorporating direct indicators of financial development would allow for a more precise assessment of their impact on consumption behavior. Finally, analyzing heterogeneity across subpopulations, by income, education or family composition, could refine our understanding of the underlying mechanisms and support more targeted policy recommendations. Practical implications Measures intended to clarify the pension scheme and reduce the uncertainty associated with the future stream of income accruing to pensioners may entail smoother consumption paths for individuals and, therefore, for the whole economy. These measures are especially important in countries with pay-as-you-go systems where future pensions are closely linked to political and regulatory stances. Programs aimed at improving the financial planning of individuals over their life cycles may also be useful. Strategies that lower the effective tax burden for retirees may also help maintain a smoother consumption path in old age and avoid reductions in aggregate consumption, which can be detrimental to the economy. Social implications The fall in economic activity potentially associated with an ageing population in many countries may be circumvented with appropriate measures intended to enhance the purchasing power of retirees (such as fiscal deductions). Originality/value This paper contributes to the literature on different dimensions. First, it documents the presence of a drop of consumption upon retirement in Spain over 1977–1983, 1985–1996 and 2016–2022, robust to various specifications and comparable to those found by other authors for other countries; the dip of consumption at retirement is on average 10%–13.5% in 1977–1983, 5% in 1985–1996 and 2% 2016–2022. Moreover, the authors isolate the impact of retirement on consumption from other contemporaneous effects, such as pension reforms, suggesting that these effects display opposite signs and may offset each other in the empirical estimations.