Disability Testing and Retirement

We study the design of retirement and disability policies and illustrate the often observed
exit from the labor force of healthy workers through disability insurance schemes. In our model,
two types of individuals, disabled and leisure-prone ones, have the same disutility for labor and
cannot be distinguished. However, they are not counted in the same way in social welfare. We
determine first- and second-best optimal benefit levels and retirement ages. Then we introduce
the possibility of testing that can sort out disabled workers from healthy but retirement-prone
workers. We show that such testing can increase both social welfare and the rate of participation
of elderly workers; in addition disabled workers are better taken care of. It is not optimal to test
all applicants. Surprisingly, the (second-best) solution may imply later retirement for the disabled than for the leisure-prone. In that case, the disabled are compensated by higher benefits.