In Latin America and the Caribbean, where 55% of workers labor informally, some individuals face a crucial decision throughout their lives: whether to work in the formal or informal sector. This decision has important implications for their wages, the amount of taxes they pay, and their overall financial well-being. It is also crucial in determining whether they qualify for government benefits.
Our research from Ecuador shows how public pension programs, which are typically among the largest government programs based on expenditures, impact workers’ decisions about when to work formally versus informally decades before retirement. It reveals a surprising result: because of the design of the pension program, many people switch from informal to formal employment right when they turn 50 years old. This allows them to receive government benefits without having paid the decades of social security contributions that formal employment from an early age would have entailed, increasing the fiscal burden and making the retirement system less equitable.
Those findings reveal how important it is for policymakers to get the incentives right if they are to increase formal employment and ensure fairness for all contributors.
Jumps to Formality at Age 50
Ecuador’s pension system allows workers to retire and claim old-age benefits at 65 if they’ve contributed to the system for at least 15 years. This setup means that someone who starts contributing to social security at 50 can reach 65 with just enough contributions to qualify for pensions.
Using detailed survey data, we found a sudden increase in the probability of transitioning to formal employment right at age 50. This means that some individuals appear to affiliate to social security around the time they turn 50. The increase is about 1.8 percentage points. While that may sound small, it represents 4.5% of the share of people affiliated with social security around that age. Moreover, we show that these transitions to formality often don’t involve changing jobs or employers: they are often made by simply switching the nature of one’s labor contract, especially when the employee has family or other connections to the employer that allows them to do so.
Ecuador’s pension system is generous. Workers who contribute for 15 years and retire at 65 can receive pensions that amount to over half of their wages during their highest-earning years. The pension system is also heavily subsidized: it ranks among the top two most subsidized systems in Latin America and the Caribbean according to an IDB study.
These features create a powerful incentive: delay making contributions for as long as possible to minimize payments into the system and then switch to formal work just in time to qualify for generous benefits.
Such strategic behavior sounds profitable, but not everyone can pull it off. We show that these transitions are concentrated among small firms and family-run firms, where employees and employers can more easily coordinate to change a worker’s contract status from informal to formal.
Those likely working informally in family firms (specifically people who live with the owner of a registered business) around the age of 50 differ from the average worker in Ecuador in a few key ways. They are more likely to be women, to have a university degree, and to live in households with higher incomes.
Interestingly, despite the fact that Ecuador’s pension system creates similar incentives to switch to formal employment at 30 (for people targeting retirement at 60) and 60 (for people targeting retirement at 70), the study found no jumps in transitions to formality at these other ages.
We argue that switching to formal work at 30 years of age with the idea of contributing to the system for three decades without any interruptions that might trigger the loss of benefits might be too risky for most workers, especially in informal economies. As for switching right at 60, health risks and job market barriers at older ages may make a 10-year continuous stint in formality until 70 unrealistic.
But at 50? The timing appears to be just right— it’s close enough to retirement to plan for, and individuals are young enough to avoid substantial health risks.
Rethinking Pension Design
The behavior uncovered by our study has important implications:
- For pension sustainability: Strategic informal-to-formal transitions increase the fiscal burden. If many workers contribute only the minimum required amounts, the system becomes more expensive and less equitable.
- For pension reform: Policymakers might consider adjusting incentives—like adjusting the link between contribution histories and benefits or reducing subsidies for late entrants—to encourage earlier and more sustained formal employment.
- For labor market analyses: The conventional view in many economic analyses is that informality and formality are substitutes, and that workers move between them based on the incentives to do so. But, from a dynamic perspective, informality and formality can be complements. Workers move strategically between these two types of employment over the life cycle, with pension rules influencing those moves.
Creating the Right Incentives for Formality
This study offers unique perspective into how forward-looking workers respond to pension programs and social protection incentives in economies with high degrees of informality. It challenges the idea that informality is purely a matter of constraints or lack of legal enforcement. Sometimes, it can be a calculated choice.
It also points out that pension policy isn’t just about retirement. It can shape labor market outcomes throughout the entire life cycle. In pay-as-you-go systems like the one in Ecuador, where the contributions of younger workers finance current benefits for the elderly, the policy debate should not be only about how these programs affect retirement ages, but also about how they create incentives for workers to contribute earlier in life.
[Editorial note: The authors thank the Ecuadorian Social Security Institute (IESS) for providing the information for this analysis and for the valuable opportunities they provided for discussion with the team.]
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