Institutional rules, labour demand and disability
programme participation∗
Ossi Korkeamäki and Tomi Kyyrä†
May 6, 2009

Abstract
We use matched employer-employee data from Finland to model transitions out ofwork into sick leave and disability retirement. To identify the role of institutional factors we exploit a law change that made the medical requirements for disability pension
eligibility tougher for a certain group, as well as partially experience-rated employer
contributions that vary with the firm size. We find evidence that employers exploit
disability retirement as a way of adjusting their workforce at times when dismissals
are diﬃcult to justify. We also show that the transition rate to disability retirement
depends on the stringency of medical screening and the degree of experience rating
applied to the employer.
Keywords: Disability pension, sickness benefits, early retirement, experience rating, labour demand.
JEL-codes: J14, J23, J26.

∗
Financial support from the Finnish Centre for Pensions is gratefully acknowledged. We are grateful to
Mikko Kautto, Raija Gould, and Juha Rantala for helpful comments.
†
Government Institute for Economic Research (VATT), PO Box 1279, 00101 Helsinki, FINLAND.
Email: tomi.kyyra@vatt.fi

1

1

Introduction

The disability benefit scheme is one of the largest social security programmes in many
countries and therefore of particular interest. In Finland, disability is the most common
reason for early retirement, and disability expenditure accounted for some 3.5% of GDP
in 2003, which was the third highest share in the EU after Sweden and Denmark (BörschSupan, 2007). Disability enrolment rates of older employees vary strikingly across theEuropean countries and the US. These cross-country diﬀerences cannot be explained bydemographic or health-related factors, but are attributable to institutional diﬀerences inthe disability schemes (Börsch-Supan, 2007). During the past two or three decades, many
countries have also experienced an expansion of disability benefit enrolment. This is aserious concern given the common goal to induce people to retire later. The widespread useof disability benefits as an early retirement instrument has been argued to be a particularly
serious problem in Finland (e.g. OECD, 2008).
Disability benefits are designed to provide insurance for employees’ labour income
against the risk of becoming disabled and incapable of regular work. In practice, it may
be diﬃcult to identify employees who are truly disabled, which suggests the possibility that
disability benefits can distort labour supply and demand in some cases. Autor and Duggan(2003, 2006), for example, argue that rapid growth in disability benefit rolls in the US
cannot be explained by changes in health, but is driven by a combination of labour demandconditions and changes in the disability scheme itself (in terms of generosity, coverage,
and screening intensity). Other authors have also found evidence of the importance ofthe generosity of disability benefits, the stringency of medical screening, and the economic
environment when explaining participation in disability programmes (e.g. Gruber, 2000,
Black et al., 2002, Campolieti, 2004). A majority of this literature has been motivatedby a simple labour supply framework, in which an employee chooses whether to apply fordisability benefits, while the employer has no role at all. Surprisingly little eﬀort has been
made to study the labour demand side (some exceptions are Hassink et al., 1997, andKoning, 2005).
When employment reductions are necessary, firms often get rid of their oldest employees first. If health requirements for disability benefit eligibility are weak, early retirement
via the disability scheme can be a useful strategy in eﬀective downsizing. For both theemployer and employee, disability retirement can be a more attractive way of terminating
the employment relationship than a dismissal. Early retirees avoid the stigma attached tobeing unemployed and may suﬀer from smaller income losses, whereas the employer is able
to reduce workforce in a "soft" way. Encouraging disability retirement can even be a more
attractive strategy for an employer that wants to change the composition of the workforce
during an expansion period when dismissals are diﬃcult to justify. Moreover, the employer
and employee do not typically bear the full cost of early retirement, suggesting that theearly retirement benefits serve as a subsidy for early withdrawal from the labour market(Hutchens, 1999).
This study aims to shed some light on the relationships between labour demand, institutional factors and disability retirement. We consider the importance of the labourdemand side by examining the relationship between the establishment’s growth and re-structuring rates and its employees’ disability entries. In addition, we assess the eﬀectiveness of two policy instruments: the strictness of medical requirements for disability
pension eligibility and the experience rating of disability expenditures. Using matchedemployer-employee data from Finland, we model transitions out of work into sick leaveand disability retirement. To identify the role of institutional factors we exploit a law
change that made the medical requirements for disability pension eligibility tougher for acertain group, as well as partially experience-rated employer contributions that vary withthe firm size. We find some evidence that employers exploit disability retirement as a wayof adjusting their workforce when not downsizing. We also show that the transition rate
to disability retirement depends on the stringency of medical screening and the degree ofexperience rating applied to the employer.
The paper proceeds as follows. In the next section, we give a short overview of theexisting literature. Section 3 describes the Finnish social security system for sickness
benefits and disability pensions. We discuss our data and report descriptive statistics in
section 4. The results of our econometric analyses are reported and discussed in section
5, which is followed by a concluding section.

2

Related literature

Disability benefits are typically determined as a function of past earnings, which are likely
to be correlated with the employee’s preferences for work. The resulting endogeneity problem has hampered attempts to quantify the impact of disability benefits on labour supply.
Gruber (2000) and Campolieti (2004) overcome the endogeneity problem by exploiting
policy changes in the Canadian disability benefit scheme that had diﬀerential eﬀects on
people living in diﬀerent parts of the country. While Gruber estimates that the elasticity of nonparticipation with respect to disability insurance benefits is between 0.28—0.36,
Campolieti finds no statistically significant relationship. In the late 1980s, which is theperiod analyzed by Gruber, nonmedical factors related to the availability of suitable jobs
in the region and personal skills were taken into consideration when determining benefit
eligibility. Campolieti considers an earlier reform that took place in the early 1970s whenthe eligibility requirements and the stringency of medical screening were tougher. This led
Campolieti to argue that the generosity of the disability benefits may not distort working decisions when it is diﬃcult to qualify for such benefits because of a strict screening
process.
Using aggregate data for the US, Black et al. (2002) and Autor and Duggan (2003,
2006) find evidence of the relationship between disability participation and business cycle
conditions. Black et al. use data from the coal boom and bust in the 1970s and 1980s,
which aﬀected only a few coal-producing counties, to construct instrumental variables
for local labour market shocks. According to their county-level analysis, participationin disability programmes falls during economic upturns, and this relationship is muchstronger for permanent than for transitory economic shocks. Autor and Duggan discussa dramatic expansion of disability insurance enrolment during the past two decades in2the US.1 They argue that this growth cannot be explained by a true increase in theincidence of disabling illness. Instead, they claim that the reduced stringency of thescreening for disability benefits after 1984, an increase in the earnings replacement rate,
and an increase in female labour force participation have played important roles. As aresult of the liberalization of disability benefits in 1984, the disability application rates
were found to become more responsive to adverse labour demand shocks. This result
supports Campolieti’s (2004) interpretation of Canadian evidence. Autor and Duggan(2003) estimate that the unemployment rate of workers aged 25—64 in 1998 was a half
percentage point lower than it would have been otherwise. They argue that the US
disability system has begun to "function much like a long-term unemployment insurance
program for the unemployable" (Autor and Duggan 2006, p. 74).
Unlike the US studies based on aggregate data, Vahtera et al. (2005) and Rege et al.
(in press) analyze individual-specific disability risks. Using matched employer-employee
data for Norway, Rege et al. explain the likelihood of being on a disability pension withdummy variables indicating various degrees of plant downsizing during the past six years.
They find a substantial increase in the transition rate to disability retirement following
plant downsizing or plant closure.2 Whereas Rege et al. do not make a distinction between
those who kept their jobs and those who lost their jobs in plant downsizing, Vahtera et al.
consider a risk of disability retirement among Finnish municipal employees who kept theirjobs after the reduction of personnel in their organisation. These employment reductions
were carried out between 1991 and 1993, during a period of severe recession in Finland.
They found an almost twofold risk of being granted a permanent disability pension in thenext five years after a major downsizing (more than 18% reduction in the personnel) thanafter no downsizing (less than 8% reduction). Thus, not only employees who lose theirjobs, but also those who keep their jobs after the employment reduction are subject to anincreased disability risk.
Börsch-Supan (2007) points out that disability expenditures and enrolment rates vary
notably across diﬀerent countries. In Europe, disability expenditures are highest in Finland, Sweden and Denmark.3 Börsch-Supan analyzes the cross-country diﬀerences in the
disability enrolment rates of people aged 50 to 65 years, using harmonized survey data for
12 European countries and similar survey data for the UK and US. He finds very little
explanatory power for demographic and health-related diﬀerences across the countries. By
contrast, three quarters of the cross-country variation were explained by the institutionalvariables that describe the generosity and the ease of access of disability insurance. The
most influential institutional factor turned out to be the strictness by which vocational
considerations are applied when determining eligibility.
The studies discussed above do not pay much attention to the employer’s role. Hutchens1

See McVicar (2008) for discussion about the growth in disability benefit rolls in the UK.
They also find an increase in mortality rates among workers whose plants downsized.
3
Disability schemes represent only a part of the social security system. How people who are unable, or
unwilling, to work are allocated between sickness, unemployment, disability, and early retirement schemes
depends on relative compensation levels and eligibility criteria, which vary from country to country. Hence,a low disability enrolment rate may be associated with a high rate of sickness absence, long-term unemployment or voluntary early retirement. This kind of spillovers should be kept in mind when interpreting
the results from cross-country comparisons.
2

3

(1999) develops a theoretical framework that helps to understand why employers may be
actively involved in early retirement decisions. He introduces an implicit contract modelof a firm that uses early retirement benefits, provided by the government, as a form ofunemployment insurance. Within this framework, the public early retirement benefits effectively subsidize workforce reductions. Therefore, the firm responds to slack demand byencouraging early retirement, which leads to an ineﬃciently high level of early retirements.
Hutchens also discusses two alternative policies: actuarial adjustments and experience rating. An actuarial adjustment places costs on early retirees by reducing their future benefits
compared to the case where retirement occurs at a later day, whereas experience rating
places costs on firms by directing part of the early retirement expenditure to the former employer. While both of these policies can be used to reduce the implicit subsidy,
and thereby restore early retirement to the eﬃcient level, their implementation is subject
to some practical drawbacks. Namely, an eﬀective early retirement scheme should varywith individual characteristics, like wages and survival probabilities. Since the real-world
scheme cannot account for all individual heterogeneity, the implicit subsidy will exist atleast for some groups even if the scheme eliminates the subsidy "on average".
Theoretical insights of Hutchens (1999) are supported by empirical findings of two
studies for the Netherlands. Using data on the dismissal and disability rates of Dutch
firms, Hassink et al. (1997) examine to what extent separations into disability are used as
an alternative to dismissals. They estimate that about one-tenth of the observed inflow
into disability were eﬀectively dismissals. The data used by Hassink et al. covered the years
1988 and 1990 when the experience rating of disability benefits was not yet introduced in
the Netherlands. In the later years, the Dutch employers have been fully responsible forsickness benefit costs and partly responsible for the cost of disability insurance benefits
collected by their former employees via an experience rating system. Koning (2005) finds
evidence that the experience rating system decreases the flow into disability benefits withinfirms.
In sum, we can draw the following lessons from the existing literature: 1) the generosity of disability compensation and negative demand shocks increase the entry rates todisability benefit schemes, 2) the strength of this relationship depends on the stringencyof medical screening, and 3) the experience rating of disability benefit costs can be used
to reduce the moral hazard problem. Our study complements this literature. In addition
to studying transitions from work to disability retirement, we also consider transitions
from work to sick leave and from sick leave to disability retirement. In this way, we candiﬀerentiate between factors aﬀecting the incidence of sickness or injury (ex ante eﬀects)
and those aﬀecting the intensity or success of medical and occupational rehabilitation (expost eﬀects). This distinction helps us to detect the point in the disability pension track
when certain policy instruments are eﬀective. When analyzing the role of labour demand,
we pay particular attention to excess worker turnover, which describes a degree of restructuring for a given employment change. This helps us to show that disability benefits are
not used as a downsizing instrument, but to adjust the structure of the workforce at thetimes of stable or growing employment when dismissals would be diﬃcult to use. Finally,by accounting for a firm’s financial position, we show that experience rating has a heterogeneous eﬀect, being less eﬀective for those employers that can easily incur their share of4the disability pension costs.

3

Institutional framework for Finland

The Finnish social security system has been subject to continuous changes over time.
Below we describe the features of the system that were in force from the mid-1990s until
2004, which is the time period covered by our empirical analysis.

3.1

Sickness and disability benefits

An employee who is unable to perform his job due to illness or injury is entitled tocompensation for income losses. The applicant needs a statement by a doctor or hospital
certifying that he or she is not capable of work. For the first ten working days the applicant
is fully compensated by the employer, after which he can claim a sickness benefit fromthe Social Insurance Institution (KELA). Depending on the collective labour agreement,
many employers continue to pay wages or salary after the mandatory waiting period of ten
working days, in which case the allowance is paid to the employer. As a result, the timeout of work until receipt of a sickness benefit directly from the Social Insurance Institution
is typically one to three months. The sickness benefit is determined by the past taxable
earnings, and it can be received for a maximum of about one year (300 working days,
Saturdays included). Depending on illness or disability, the applicant’s rehabilitationneeds and possibilities are assessed in a more extensive medical examination during the
sickness benefit period. In case of a prolonged illness or permanent disability, the employee
can apply for a disability pension.
An ordinary disability (OD) pension is payable to individuals aged 16 to 64 whose
working capacity has significantly decreased. A full benefit is conditional on the working capacity loss of at least 60% and a partial benefit for a loss of 40 to 59%. When
determining eligibility, an individual’s capability to support him/herself by regular work,age, education, occupation, and place of residence are taken into account along with the
medical assessment. The OD pension can be granted either indefinitely (if return to work
is not likely) or for a specific period. In the latter case, the OD pension is also referred toas a rehabilitation subsidy or a cash rehabilitation benefit, and its receipt is conditionalon a rehabilitation plan. An OD pension may be discontinued if the working capacity of
the recipient improves, but this rarely happens among older recipients (e.g. OECD, 2008,
p. 116). There is no automatic retesting of the disability status except for new periods ofthe rehabilitation subsidy.
An individual early retirement (IER) pension is another disability pension which isavailable for employees who have a long working career and are unable to continue in theircurrent job because of deteriorated health. Compared with the OD pension, eligibility for
the IER pension is subject to less strict medical criteria. The minimum degree of working
incapacity is not defined, and occupational factors like the length of service and working
conditions carry greater weight. It suﬃces that working capacity has reduced to such an
extent that the person cannot continue in his or her present job or occupation, so that
other working possibilities are not considered. Unlike the OD pension however, the IER

5pension is payable only to employees above a certain age threshold. In the private sector,
there was a uniform age threshold of 58 until 1999. For people born in 1944 or later it
was raised to 60 in 2000 and subsequently abolished entirely in 2004. At the same timethe medical criteria for OD pension eligibility were somewhat relaxed for people aged 60
and over.
Saurama (2004) provides some survey evidence that bad health is not the only reason for entering into a disability pension in Finland.4 As expected, disability pensioners
reported bad health as one of the main reasons for retirement, but many of them said
that straining work played an important role as well. In particular, 62% of OD pensioners
and 74% of IER pensioners had felt that their job had become too exhausting or they
could not handle their job any more. A notable fraction of the respondents had also felt
pressure to retire from the management or colleagues: 14% of OD pensioners and 24%
of IER pensioners were partly forced out of their job. Hence, diﬃculties in performing
job tasks and the pressure from the workplace are important factors aﬀecting disability
pension entry.
The purpose of the gradual abolition of the IER pension in 2000 and 2004 was to reducethe disability enrolment rates at higher ages. This reform made the medical requirements
for disability pension eligibility tougher for the younger cohorts who have been able toapply only for the OD pension, and thereby should reduce the flow into disability pension
benefits among those who are not truly disabled. Because only those employees born after
1943 were aﬀected, the reform provides us with a quasi-experimental setting for studying
the importance of the stringency of medical screening.

3.2

Experience rating of disability pension benefits

A particular feature of the Finnish disability scheme is that employers are liable for disability pension expenditures via partially experience-rated employer contributions. Experiencerating is not applied to firms with fewer than 50 employees, but larger firms have to pay
a given proportion of the disability pension benefit stream received by their former employees. This cost share is determined as a linear function of firm size. It increases withfirm size from 0% (fewer than 50 employees) to 80% (over 800 employees). Until 1999 thecost share continued to increase up to 100%, which was applied to firms with over 1000
employees. Disability pension costs incurred by the employer can accumulate over several
years until the former employee reaches the age of 65 and transfers to an old-age pension.
Hence, disability retirement can become very costly for the former employer, especiallyin the case of a large firm. Moreover, the employer must pay its share of the expected
future costs as a lump sump payment at the time when a disability pension is granted toits employee.
The aim of experience rating is to minimize the employer’s moral hazard problem
by placing costs on those firms whose employees enter the disability pension schemes.
When an employee applies for a disability pension, the employer has no direct control
4
The targer population of the survey was all people who received early retirement benefits at the endof 1998. The early retirees were asked for their reasons of retiring. The response rate was quite low — only
51.3% — and young disability pensioners were under-represented. The numbers referred to in the text weretaken from table 12 in Saurama (2004, p. 132).

6

over the decision made by the pension institution. Nevertheless, the employer has themeans to indirectly aﬀect the flow into sick leave and the likelihood that recipients ofsickness benefits will return to work rather than retire via a disability pension scheme.
If eﬀective, experience rating should induce the employer to take preventive measures tominimize the flow into sick leave (the ex ante eﬀect), as well as to put eﬀort into getting
its employees back to work from sick leave (the ex post eﬀect). The preventive action may
involve reallocation of the workload to minimize stress-related illness and arrangementsthat reduce accidents at the workplace. When helping people come back to work from sickleave, occupational rehabilitation and job modifications that allow the switching of jobs
within the firm are crucial for those who cannot perform their old tasks despite medical
rehabilitation.
There is hardly any empirical evidence on the consequences of the experience ratingon the incidence of disability retirement (Koning, 2005, is an exception). This is because
disability pension expenditures are subject to experience rating only in a few countries.
Still, the topic should be of considerable interest as many countries suﬀer from high andstill growing rates of disability programme participation. We extend Koning’s (2005)
work by diﬀerentiating between the ex post and ex ante eﬀects of experience rating and by
studying how the eﬀectiveness of experience rating depends on the firm’s financial position.

4

Data and descriptive evidence

4.1

Data

Our data set is drawn from the records of the Finnish Longitudinal Employer-Employee
Database (FLEED). Employee information in the database has been obtained by merging
information from over 20 administrative registers with unique personal identity numbers.
The database covers eﬀectively everyone with permanent residence in Finland. Alongwith standard socio-demographic background variables, the database includes detailed
information on annual income (from the tax authorities), job spells (from the pension
institutes), unemployment spells and participation in labour market programmes (fromthe employment oﬃces). For people who are employed in the last week of a given year,
the ES database also includes the unique identification code of the firm and establishment.
This allows us to identify individuals who are working for the same employer and provides
a link to firm records. Thus we are able to measure labour turnover and employmentchanges at establishment and firm levels.
The principal source of firm records in the FLEED is the Financial Statements Statistics (FSS), which is an annual survey conducted by Statistics Finland. The survey
contains corporate income statement and balance sheet data on firms in manufacturing,
construction, retail and wholesale trade, business services, hotel and restaurant services,and transportation. Since 1994, all firms above a certain size threshold, which varies between the sectors, have been included in the survey. These data have been complemented
by adding firm records from the Business Tax Register with more limited information content but covering all firms in all industries. As a result, the FLEED includes informationon the universe of the private-sector firms over the period 1994—2004, which we use to7

construct measures for firms’ financial position.
Some key variables in the employee data contain information on sickness benefits, paid
by KELA during the year, and on the types of pension benefits received at the last weekof the year. These are used to detect transitions into sick leave and disability retirement.
As discussed above, employees on sick leave are fully compensated by their employers forthe first ten days to three months, depending on the collective labour agreement underwhich they are employed. Hence, receipt of sickness benefits directly from KELA indicatesa prolonged illness.
We can distinguish between OD and IER pension benefits, but we do not know thecompensation level (partial or full benefit), nor whether a disability pension was granted
indefinitely or for a specific period. We classify an employee as being on a disability
pension if he or she received either OD or IER pension benefits at the last week of the
year.

4.2

Incidence of disability retirement

We begin by considering the extent of the disability problem in Finland. While the oﬃcial
retirement age was 65 until 2005,5 the eﬀective retirement age — the average age of new
pensioners — has been around 60 due to early retirement schemes, of which the disability
schemes are the most important ones. In 2007 a roughly equal number of new pensioners
were granted a disability pension and an old-age pension, but a few years earlier thedisability pension was the most common reason for retiring. This explains why disability
expenditures are so high in Finland compared with other industrialized countries.
A high incidence of disability is illustrated in figure 1 where the disability enrolment
rates (including both OD and IER pension recipients) are shown as a function of age forfour birth cohorts by sex.6 Within all birth cohorts, women have lower enrolment rates at
each age. Compared with the later cohorts, employees born in 1940 are more likely to bedisabled at all ages. Close to 30% of this cohort were on a disability pension at age 60,
which is a strikingly large figure. There are no notable diﬀerences in disability rates at agiven age between the 1945, 1950 and 1955 cohorts. The lower disability rates for thesecohorts may to some extent be related to their ineligibility for the IER pension scheme.

4.3

Outcome variables for analysis of transitions

We distinguish the likelihood of entering into sick leave, which often means only temporary
absence from work, from the likelihood of being granted a disability pension, which almost
surely means a permanent withdrawal from the labour market. The determinants of these
events can diﬀer and be aﬀected by experience rating in diﬀerent ways. Hence, we shallmodel transitions from work to a disability pension, from work to sick leave, and from sickleave to a disability pension.
5
The ordinary old-age pension was available for people older than 61 but only those entering at age 65
received the full benefits. Since 2005, employees have been able to choose freely at which age between 63
and 68 they begin to collect the old-age pension benefits.
6
Statistics Finland changed its procedure of merging register data on pension benefits in 1995. This led
to an unexplained (small) drop in the number of disability pension recipients in the FLEED for that year,
reflecting some technical problems. For that reason we chose to break the time series in 1995.

8

0.35

Share of disability pensioners

62

64

63

61

0.30

60
59

0.25

58
56

0.20

57

59
58
57
56

54

0.15

55

53

54

52
51

0.10

49

48

44
39
34

0.05 43
38
33

0.00
1988

51

50
45
40
35

46
41
36

1990
1940 men

47
42
37

1992

48
43
38

49
46

44
39

41

1994

1996

1945 men

52
47
42

54

53
48
43

50

49

45

44

1998

2000

1950 men

1940 women1945 women1950 women
Note: age at the end of the year used as a marker for men.

51
46

52
47

53
49

48

2002

2004

1955 men
1955 women

Figure 1: Population share of disability pensioners by birth year (Source: Authors’ calculations from the FLEED. Note: Numbers for 1995 are not shown due to data errors)
In all of our models the risk set in year t includes employees who (i ) were 55 to 62
years old at the end of year t − 1, (ii ) held a job at the end of year t − 1 in a private-sector
firm with at least five employees, (iii) had been working, without receiving any pension
benefits, at least for three consecutive years (i.e. from the beginning of year t − 3 until theend of year t − 1),7 and (iv ) did not receive sickness benefits during year t − 1.8 We exclude
the younger and older employees because their transitions into disability retirement arevery rare. Moreover, for younger employees it is probably very diﬃcult to be granted adisability pension without serious injury or illness, whereas the older employees can retire
via other early retirement schemes, suggesting that the misuse of the disability pension
schemes is not a serious issue for these groups. We also exclude employees from firms withless than five employees, as the data on very small firms is noisy.
Transitions to disability pension. Because receipt of a disability pension typically follows a sick leave and/or rehabilitation measures, there is a gap between the job
withdrawal, which is of our primary interest, and actual entry into disability pension benefits. To detect the year when the process towards disability retirement started, we follow
each person at risk in year t for the next three years (two years from 2002). The employee
7
The cost of a disability pension is borne by the former employer (according to the experience-rating
rules concerning firm size) only when the employment relationship has lasted for a minimum of three years.
We also include workers who changed their jobs within the three-year period but control for job tenure in
the probability models. Excluding these workers from the analysis does not notably aﬀect our results.
8
Our results for transitions from work to disability retirement are not sensitive with respect to thisrestriction. We exclude those on sickness benefit in year t − 1 to be able to analyze also the entry rate into
sick leave.

9A: D = 1, S = 1
B: D = 1, S = 0
C: D = 1, S = 1
D: D = 0, S = 1

t- 4

t-3
Employed

t-2

t-1

t

Sicknesst+ 1
Disability

t+ 2

t+ 3

t+ 4

Other / irrelevant

Figure 2: Examples of labour market histories for persons at risk in year t
is classified as becoming disabled in year t if her or his working career was interrupted
during that year and he or she was granted a disability pension by the end of year t + 2,
without being unemployed or employed in the another firm in the meantime. That is,
we are interested in transitions from a given workplace to disability retirement, but allow
for periods of sick leave and rehabilitation between these two events. The majority ofdisability pensions following job withdrawal in year t are granted during year t (35%) ort + 1 (57%), while the number of entries into disability retirement drops sharply in yeart + 2. A few pensions are also granted at the later periods but we think that assigningthem to the employer at the end of year t − 1 is too unreliable and hence we discard thosecases.
Transitions to sick leave. Receipt of an OD pension typically follows a one-year
period on sickness benefits, and therefore almost all OD pensioners have been on sick leave
before retiring. However, some employees have retired directly via the IER scheme without
being on sickness benefits first. Since deteriorated health is a prerequisite for receipt of an
IER pension as well, also these employees are classified as entering a sick leave in the year
when the pension was granted. Thus, an employee at risk in year t moves into a sick leave
during that year if she or he started to collect sickness benefits or was granted a disability
pension during year t even without actually receiving sickness benefits.
Transitions from sick leave to disability pension. When modelling the likelihood of being granted a disability pension conditional on being on sickness benefits, therisk set in year t includes only those employees who started to collect sickness benefits
during year t, including also those who were granted a disability pension without a periodof sick leave.
Illustration. Four possible labour histories are shown in figure 2. Each of these
persons is at risk of making a transition to disability retirement and to sick leave in year t.
Employees A, B and C withdrew from work in year t and were granted a disability pension
by the end of year t + 2. According to our definition, they made a transition from work
to disability retirement in year t (Dt = 1). Since employees A and D received sickness
benefits and employee C started to collect disability pension benefits in year t, they are10

also classified as entering a sick leave in that year (St = 1). When modelling transitions
from sick leave to disability retirement, employees A, C and D would be included in therisk set in year t, but not employee B who was out of work for an unknown reason.

4.4

Sample design for modelling transition rates

The transition probabilities (or rates) defined above are closely interrelated but not perfectly. Namely, it holds that
Pr(Dt = 1) ≥ Pr(St = 1) Pr(Dt = 1 |St = 1) ,t = 1997, 1998, ...2002,

where Pr(Dt = 1) denotes the likelihood of starting disability retirement (by the end ofyear t + 2) due to job withdrawal in year t, Pr(St = 1) is the likelihood of entering asick leave in year t, and Pr(Dt = 1 |St = 1) is the likelihood that a sick leave startingin year t eventually lead to disability retirement. It should be stressed that employees
whose working career was interrupted without receipt of sickness benefits in year t and
who were granted a disability pension in year t + 1 or t + 2 contribute to the event on theleft-hand side of the equation but not to the events on the right-hand side (e.g. person
B in figure 2). As a result, the product of the two probabilities on the right-hand side istypically less than the overall disability probability on the left-hand side. Nevertheless, theproduct of Pr(St = 1) and Pr(Dt = 1 |St = 1) gives a useful decomposition for Pr(Dt = 1),
although its approximate nature should be kept in mind when interpreting the results. By
comparing the determinants of Pr(St = 1) and Pr(Dt = 1 |St = 1), we aim at making a
distinction between the ex ante and ex post eﬀects of the covariates of interest.
Our estimation samples include all employees who are at risk of making a transition ofinterest between the years 1997 and 2002. The sample period ends in 2002, because when
detecting the timing of job withdrawals, we have to be able to follow employees at risk
at least for the next two or three years. The period begins in 1997 because the FLEED
covers all firms from the year 1994 onwards and we need firm records from the past three
years to construct some control variables. Our samples are rotating panels, where in eachyear new employees enter the risk set while some old ones leave it.

4.5

Raw transition rates

Table 1 reports the sizes of the risk groups and the raw transition rates by age. Alltransition rates increase almost uniformly with age. The likelihood of a transition to sickleave doubles while the likelihood of being granted a disability pension triples from age 55
to 62. This is explained by the fact that employees are less likely to return to work fromsick leave at older ages, as seen in the last column. The transition rate from sick leaveto disability retirement is strikingly high at all ages; one-half of sickness benefit recipients
aged 55 or 56 years and three in four of those older than 56 do not return to work but end
up in disability retirement.
It is noteworthy that the size of the group at risk of entering a sick leave or becoming
disabled declines rapidly with age. While the total number of employees at risk is about
61,000 at age 55, the group at risk halves by age 58 and includes only 8000 employees atage 62. A similar pattern is seen for the number of employees on sickness benefits. These11

Table 1: Transition rates and the size of risk groups by age
Age
55
56
57
58
59
60
61
62
All

N
61,28949,95238,40629,22922,26916,241
12,405
8,068
237,859

Pr(D = 1)
0.017
0.020
0.028
0.032
0.044
0.048
0.056
0.050
0.029

Pr(S = 1)
0.025
0.024
0.031
0.033
0.038
0.040
0.047
0.051
0.031

R
1,507
1,223
1,206
950
853
650
589
411
7,389

Pr(D = 1 |S = 1)
0.491
0.512
0.598
0.654
0.728
0.778
0.752
0.786
0.623

Notes: N is the size of the risk group for transitions to disability retirement and sick leave. R is the sizeof the risk group for transitions from sick leave to disability retirement. Pr(D =1) is the probability of atransition to disability retirement. Pr(S =1) is the probability of a transition to sick leave. Pr(D=1|S =1)
is the probability of a transition to disability retirement conditional on being on sick leave.

declining age patterns reflect the fact that people tend to withdraw from employment
quite early. In particular, it is rather common for private-sector employees to end up in
long-term unemployment at older ages because employees aged 55 years (and 1 month)or older at the time of unemployment entry can collect earnings-related unemployment
insurance benefits until retirement at age 60 via the unemployment pension scheme (seee.g. Kyyrä and Wilke, 2007).
Because of the experience rating system, variation in the transition rates across firmsof diﬀerent sizes is of particular interest. In table 2, employees are classified into fourgroups according to the size of their employer at the end of year t − 1. As seen in thelast column, there are no systematic diﬀerences in the transition rates to sick leave or
disability retirement in firms with 1000 or fewer employees. However, in the largest firms
the transition rate to both sick leave and disability retirement is a quarter higher thanin the smaller firms. The experience rating of disability pension expenditures, which
devotes higher cost shares for larger firms, would have implied the opposite. Moreover,
the transition rate from sick leave to disability retirement does not vary with firm size,
giving no support for the ex post eﬀect of experience rating.
There are reasons why disability and sick leave entries may be associated with current
or past employment changes at the workplace. The past employment reductions can leadto added stress at the workplace, such as reduced control over one’s chores and increased
workload and job insecurity. This could cause health problems for those who kept theirjobs (e.g. Vahtera et al., 2005). Encouraging disability retirement of older employees canbe a helpful strategy in downsizing and restructuring endeavours of a firm, suggesting that
there might be a relationship between the current growth rate and disability incidence.9
Since the diﬃculties of laying oﬀ older employees probably vary with business conditions,the disability entry rates can also vary between downsizing and expansion periods.
9
A recent study by Gielen and Van Ours (2006) analyzes age diﬀerences in job reallocation and labour
mobility using matched worker-firm data for the Netherlands. They find that firms adjust their workforce
mainly via entry for young and prime-age workers, but via separations for older workers. Furthermore,
employment of old workers is found to be more responsive to firm-specific employment changes.

12Table 2: Transition rates by firm size and establishment growthFirm size

Establishment’s growth category
Past period from t − 4 to t − 1
Current period from t − 1 to t + 2
Contracting Stable Expanding
Contracting Stable ExpandingAll

From work to disability retirement, Pr(D = 1)
5-50
0.026
0.029
0.024
51-300
0.026
0.027
0.028
301-1000
0.023
0.028
0.027
> 1000
0.032
0.033
0.035
All
0.027
0.030
0.029

0.024
0.025
0.024
0.030
0.026

0.025
0.028
0.028
0.033
0.029

0.030
0.027
0.026
0.036
0.031

0.026
0.027
0.027
0.034
0.029

From work to sick leave, Pr(S = 1)
5-50
0.030
0.028
51-3000.026
0.028
301-1000
0.027
0.031
> 1000
0.038
0.035
All
0.031
0.031

0.026
0.027
0.026
0.032
0.028

0.029
0.029
0.032
0.037
0.032

0.031
0.029
0.028
0.038
0.032

0.029
0.028
0.029
0.036
0.031

From sick leave to disability retirement, Pr(D = 1 |S = 1)
5-50
0.636
0.668
0.585
0.632
51-300
0.659
0.629
0.632
0.620
301-1000
0.578
0.601
0.628
0.651
> 1000
0.591
0.634
0.620
0.658
All
0.615
0.632
0.614
0.640

0.621
0.641
0.589
0.602
0.611

0.633
0.635
0.603
0.637
0.630

0.628
0.635
0.605
0.622
0.623

0.028
0.030
0.028
0.037
0.031

Notes: Establishments were divided into contracting, stable and growing ones according to 3-year growth
rates from t—4 to t—1 and from t—1 to t+2. In contracting establishments the growth rate was below —0.1,
in stable ones between [—0.1, 0.15) and in growing ones greater or equal to 0.15.

To address these questions we examine the relationship between the transition probabilities and the past and current growth rates of employment. The growth rates aremeasured over three-year periods to smooth out annual noise in employment variation,and because retirement decisions are hardly based on yearly variation. Following the job
and worker flow literature, we define the growth rate as ∆et,s /et,s , where ∆et,s is the employment change from year t to year s in a given establishment, and et,s is the average
employment level in years t and s. The growth rates defined in this way can take values
on the interval [−2, 2] . Employment is measured by the number of employees in the establishment at the end of the year. Since employees at risk in year t were by construction all
still employed at the end of year t − 1, the past growth rate is computed over the period
from year t − 4 to year t − 1. With the current growth rate we refer to the employmentchange from year t − 1 to year t + 2, as the possible transition to disability retirement
must take place by the end of year t + 2.
We believe that labour demand conditions are best described by employment changes inthe establishment for those who are employed in large firms with multiple establishments.
So we consider employment variation at establishment level, even though we control thesize of the personnel at firm level. In table 2, employees are further divided into groups

13according to the past and current growth rate of the establishment at which they worked
at the end of year t −1. Establishments whose growth rate lies on the interval [−0.10, 0.15)
are labelled to be ’stable’ as opposed to contracting and expanding ones.
First of all, note that our finding that the transition rates to sick leave and disability
retirement are highest for the employees of firms with over 1000 employees holds also
when we are conditioning on the past or current employment growth category. Somewhat
surprisingly, none of the transition rates does seem to be sensitive with respect to past or
current growth rates. Diﬀerences in the transition rates between employees at contracting,expanding and stable establishments are generally very small, and do not exhibit consistentpatterns. These results should not be taken as conclusive, however, since it is possiblethat compositional diﬀerences in the older workforce across firms of diﬀerent size, andestablishments in diﬀerent growth categories mask the underlying true relationships.

5

Determinants of transition rates

We apply pooled-data logit models to study the determinants of the transition rates.
The results from our baseline specification for individual-specific and employer-specificcovariates are shown in tables 3 and 4, respectively. We report the odds ratios for dummy
variables and the marginal eﬀects for all covariates along with standard errors that arerobust to clustering to account for correlation across individuals working in the same
establishment. The marginal eﬀects are computed for an average person of the risk group.10
We begin our discussion with the eﬀects of some individual characteristics, and then we
proceed to the eﬀects of the covariates of primary interest, including firm size, growth
rates, employer’s financial position, and strictness of the medical criteria.

5.1

Individual characteristics

As seen in table 3, the transition rate to sick leave and disability retirement increases
strongly with age. For example, the likelihood of entering a sick leave is 1.7 percentage
points higher at age 62 than at age 55. The diﬀerence in the likelihood of becoming disabledis almost the same, being 1.8 percentage points. These are relatively large increases as
the general level of the transition rates is rather low. The average probabilities of entries
into sick leave and disability retirement are around 2.5% and 2.3% per year, respectively,
as shown in table 4. Interestingly, the eﬀect of age on the transition rate from sickleave to disability retirement is quite diﬀerent. While diﬀerences in the transition rate
are statistically insignificant until age 57 or 58, there is a discrete increase of about 1.3
percentage points close to age 60.
Women are less likely to move into sick leave and more likely to return to work fromsick leave, leading to a lower transition rate to disability retirement. This finding is in linewith women’s lower incidence of disability in figure 1. The likelihood of being granted adisability pension decreases uniformly with education. The odds of becoming a disability
10
The risk group for transitions from sick leave to disability retirement is diﬀerent compared with thatfor other transitions, and thereby the marginal eﬀects are evaluated at the diﬀerent values of the covariates.
This does not, however, alter our interpretation of covariate eﬀects.

14

Table 3: Odds ratios and marginal eﬀects for individual-specific covariates from baseline
logit models

Relaxed medical criteria1)
1(sickness benefits > 0 at t − 2)
Sickness benefit share2) at t − 21(sickness benefits > 0 at t − 3)1(sickness benefits > 0 at t − 4)
Age 56
Age 57
Age 58
Age 59Age 60Age 61
Age 62
FemaleHigh school
Lowest tertiary
Bachelor
Master’s or higher
Foreign language
Wage position2)
Spouse working
Spouse retired

Probability of a transition to
Disability
Sick leave
Db from sick
Odds
M-eﬀ.
Odds
M-eﬀ.
Odds
M-eﬀ.
1.625
0.011
1.227
0.005
1.614
0.109
(0.106) (0.002) (0.064) (0.001) (0.180) (0.025)
1.912
0.020
2.125
0.026
0.901
-0.024(0.124) (0.003) (0.129) (0.003) (0.116) (0.030)
0.030
0.020
0.362
(0.009)(0.010)(0.207)
1.989
0.021
2.218
0.028
1.031
0.007
(0.114) (0.002) (0.112) (0.002) (0.104) (0.023)
1.561
0.012
1.747
0.018
0.923
-0.019(0.100) (0.002) (0.099) (0.002) (0.095) (0.024)
1.203
0.004
1.002
0.000
1.070
0.015
(0.056) (0.001) (0.040) (0.001) (0.089) (0.019)
1.169
0.004
1.130
0.003
1.067
0.015
(0.078) (0.002) (0.055) (0.001) (0.109) (0.023)
1.292
0.006
1.186
0.004
1.249
0.050
(0.095) (0.002) (0.066) (0.002) (0.151) (0.026)
1.645
0.014
1.310
0.007
1.519
0.091
(0.135) (0.003) (0.090) (0.002) (0.233) (0.031)
1.799
0.017
1.404
0.009
1.839
0.127
(0.149) (0.003) (0.100) (0.002) (0.297) (0.030)
2.037
0.022
1.526
0.012
1.888
0.132
(0.176) (0.004) (0.116) (0.003) (0.329) (0.032)
1.811
0.018
1.705
0.017
1.983
0.140
(0.168) (0.004) (0.136) (0.003) (0.368) (0.033)
0.779 -0.005
0.893 -0.003
0.610 -0.114(0.025) (0.001) (0.027) (0.001) (0.041) (0.016)
0.934 -0.002
0.955-0.001
0.984-0.004(0.026) (0.001) (0.028) (0.001) (0.058) (0.014)
0.555 -0.012
0.658 -0.008
1.035
0.008
(0.025) (0.001) (0.031) (0.001) (0.110) (0.024)
0.420 -0.015
0.493 -0.012
1.102
0.022
(0.029) (0.001) (0.035) (0.001) (0.184) (0.037)
0.338 -0.017
0.414 -0.014
1.157
0.033
(0.034) (0.001) (0.041) (0.001) (0.288) (0.054)
0.735-0.006
0.536 -0.011
0.589-0.128(0.128) (0.003) (0.110) (0.003) (0.244) (0.104)-0.008-0.007-0.001(0.001)(0.001)(0.025)0.919 -0.002
0.987
0.000
1.097
0.021
(0.026) (0.001) (0.029) (0.001) (0.067) (0.014)
1.195
0.005
1.315
0.007
1.351
0.067
(0.039) (0.001) (0.044) (0.001) (0.101) (0.016)

Notes: The models also include controls for industry, living region, and tenure. The reference employee isa 55-year-old single man who has completed only basic education, speaks Finnish or Swedish as his
mother tongue, and worked at the end of year t —1 in an establishment with no more than 50 employees.
Robust standard errors in parentheses. Significantly non-unit odds ratios and non-zero marginal eﬀects inbold (95%-confidence level) or in italics (90%-confidence level). 1) Dummy for those who may be
granted an IER pension by the end of yeat t. 2) The share of sickness benefits of taxable labour income.
3) Employee’s position in the establishment’s wage distribution, ranging from 0 for the lowest wage to 1
for the highest wage.
15

pension recipient is 0.34 for an employee with a Master’s degree or higher compared with anotherwise similar employee with a basic education, which corresponds to a 1.7 percentage
points lower annual risk of becoming disabled. This diﬀerence is of the same size as theeﬀect of an increase in age from 55 to 60. Education has no eﬀect on the likelihood of
returning to work from sick leave. Hence, the lower risk of disability for the educatedpeople is explained by their lower transition rates to sick leave.
Employees holding better jobs at the workplace, as measured by their position in thewage distribution, are less likely to end up on sick leave and, consequently, disability retirement. Family background also matters. Compared with singles, employees whose spouseis still working have a slightly lower probability of being granted a disability pension. It
appears that employees with a retired spouse are the most likely to enter sick leave andthe least likely to return to work from sick leave. This may indicate that employees witha retired spouse value their leisure time more than the other groups. Alternatively, theirspouses may require special attention at home if they suﬀer from health problems.
Unfortunately, our data do not contain directed measures of health. To approximate
health history we exploit information on the amount of sickness benefits collected in thepast years. By construction, the employee at risk in year t did not receive sickness benefits
in year t − 1. For year t − 2 we add a dummy variable indicating whether the employee
received sickness benefits, as well as the share of sickness benefits of taxable labour income
as a proxy for the fraction of the time spent on sick leave during that year.11 For the next
two years, we also add dummy variables indicating receipt of sickness benefits. Not surprisingly, receipt of sickness benefits in the past increases the transition rates to sick leaveand to disability retirement. Having been on sick leave in year t − 2 raises the likelihoodof becoming disabled at least by 0.2 percentage points, the overall eﬀect depending on thetime spent on sickness benefits. Conditional on being on sick leave, past sickness history
has hardly any eﬀect on the likelihood of being granted a disability pension. Only theshare of sickness benefits in year t−2 has a positive eﬀect, but it is inaccurately estimated,being statistically significant only at the 10% risk level.

5.2

Strictness of medical criteria

In 2000, the IER retirement scheme was removed from all private-sector employees who
were born in 1944 or later. Given a relatively low emphasis on medical factors when
determining eligibility for IER pensions, this reform can be viewed as an increase in thestringency of medical screening for the disability status. The oldest aﬀected employees
were 56 years old at the time of the reform and hence below the pre-reform age threshold of
58. This rules out anticipation behaviour towards IER pensions, providing us with a quasiexperimental setting for evaluating the impact of the medical criteria. More specifically,
we exploit the change in the eligibility criteria by adding a dummy variable for employees
born before 1944 who were at least 57 years old at the end of year t − 1 to our models(Relaxed medical criteria in table 3). This group of employees can potentially qualify for
11This is not an accurate measure because the waiting time until the receipt of sickness benefits from
KELA can vary between employees, and because the amount of a sickness benefit is determined as adecreasing fraction of the past earnings.

16

IER pension benefits by the end of year t, so that their disability pension applications are
subject to the less strict medical assessment compared with all other employees.
Being eligible to apply for an IER pension clearly raises all three transition rates.
The odds ratio of entering a sick leave is 1.2, implying a 0.5 percentage point higher
transition rate to sick leave for an employee who can apply for an IER pension benefit
than for an otherwise similar non-eligible employee. Conditional on being on sickness
benefits, the IER pension scheme increases the likelihood of being granted a disability
pension by 11 percentage points. Overall, the probability of moving to the disability
pension track is 1.1 percentage points higher for employees with an option to apply for an
IER pension. Our results are in accordance with Börsch-Supan’s (2007) conclusion thatthe strictness by which vocational considerations (at the expense of medical criteria) areapplied when determining eligibility for disability pension benefits is strongly related todisability pension incidence.
We also estimated model variants where the eﬀect of relaxed medical criteria wasallowed to vary across firms of diﬀerent size. The eﬀect was found to be essentially thesame in all the size categories, even though one might expect to find some variation
resulting from possible interactions with the experience rating system. Moreover, we tried
to detect diﬀerential eﬀects at diﬀerent ages, but did not find notable variation across age
groups.

5.3

Firm’s size and financial position

Next we turn to the firm characteristics that are supposed to be closely related to theexperience-rated contributions: firm size and equity ratio. The former determines thedegree of experience rating, whereas the latter describes the firm’s ability to incur disability
pension costs. The models include three dummy variables for the size of the employing
firm at the end of year t − 1. The smallest firms with 5 to 50 employees, which are notsubject to the experience-rated contributions, serve as the reference category.
As seen in table 4, the likelihood of a transition from work to sick leave increases
weakly with firm size, being significantly higher only for the largest firms. Namely, an
employee of a firm with over 1000 employees has a 0.8 percentage point higher risk ofentering sick leave per year than an otherwise similar person in a firm with 50 or fewer
employees. In fact, we should have found a negative association if the experience-rated
firms put more eﬀort in preventive measures to minimize their employees’ flow into sickleave (i.e. the ex ante eﬀect of experience rating). In the large firms many people aredoing similar work, making it easier to share the job tasks of a sick person between theremaining employees. This may induce the employees of large firms to apply for sickness
benefits more frequently, which could explain our finding.
There is no evidence of a significant relationship between firm size and the overall riskof ending up with a disability pension. It is noteworthy, however, that the likelihood of
disability retirement conditional on being a recipient of sickness benefits decreases with thefirm size. For the employees of the two largest employer groups, the odds ratios are about
0.6 and 0.7, corresponding to decreases of 13 and 9 percentage points in the disability
probability for the average recipient of sickness benefits. These relatively large estimates

17

Table 4: Odds ratios and marginal eﬀects for employer-specific covariates from baseline
logit models

Equity ratio1)
Past employment growthfrom t − 4 to t − 1
Recent employment growthfrom t − 1 to t + 2
Past excess worker turnoverfrom t − 4 to t − 1
Recent excess worker turnoverfrom t − 1 to t + 2
Log(turnover)Establishment closure at t
Firm size 51—300
Firm size 301—1000
Firm size > 1000
Mean age of employees

N observations
Pr(Y ) at mean(X)
N establishments
Pseudo R2

Probability of a transition to
Disability
Sick leave
Db from sick
Odds
M-eﬀ.
Odds
M-eﬀ.
Odds
M-eﬀ.
0.003
-0.0020.101(0.002)(0.002)(0.033)-0.0010.000-0.018(0.001)(0.001)(0.021)
0.003
0.002
0.007
(0.001)(0.001)(0.018)-0.009-0.006-0.020(0.002)(0.003)(0.056)
0.017
0.015
0.156
(0.002)(0.002)(0.057)
0.000
0.000
0.013
(0.000)(0.000)(0.007)0.939-0.0010.756-0.0064.008
0.234(0.220) (0.005) (0.151) (0.004) (2.402) (0.064)
1.005
0.000
1.072
0.002
0.849
-0.038(0.056) (0.001) (0.055) (0.001) (0.092) (0.025)
0.916-0.002
1.121
0.003
0.588 -0.127(0.079) (0.002) (0.084) (0.002) (0.097) (0.040)
1.135
0.003
1.356
0.008
0.685 -0.088(0.116) (0.002) (0.123) (0.002) (0.137) (0.047)
0.000
0.000
0.005
(0.000)(0.000)(0.002)
237,859

237,859
0.023

23,553
0.054

7,389
0.025

23,553
0.055

0.646
4,127
0.141

Notes: The models also include controls for industry, living region and tenure. The reference employee isa 55-year-old single man who has completed only basic education, speaks Finnish or Swedish as his
mother tongue, and worked at the end of year t —1 in an establishment with no more than 50 employees.
Robust standard errors in parentheses. Significantly non-unit odds ratios and non-zero marginal eﬀects inbold (95%-confidence level) or in italics (90%-confidence level). 1) Equity as share of assets (bottom
coded below the 5th percentile and top coded above 95th percentile).

18

give some support for the existence of the ex post eﬀect of experience rating, that is, thefirms subject to experience rating put more eﬀort in occupational rehabilitation to gettheir employees on sickness benefits back to work in order to avoid the disability pension
costs. On the other hand, the estimates may be related to the higher transition rate to sickleave for the large firms if their employees are more prone to apply for sickness benefits.
Our findings may also be driven by a ’true’ size eﬀect, which can result if the larger firms
have better possibilities to organize retraining and arrange alternative job tasks for theiremployees with reduced working capacity.
We tried to distinguish between these competing explanations by exploiting the change
in the experience-rated contributions in 2000 that reduced the cost share of firms with over
800 employees. We first included the interaction term for employees in the aﬀected firm
size category and the post-reform period. Then we added the cost share as an additional
covariate along with controls for firm size to an alternative specification. Neither of these
two exercises produced significant coeﬃcients for the experience rating variables. This
may not be very surprising given that the change in the cost shares in 2000 was rather
small. In our view, the reform in 2000 did not yield suﬃcient variation in the cost sharesfor reliable identification in the quasi-experimental setting. So we can interpret our firm
size eﬀects as evidence of the ex post eﬀect of experience rating on the transition rate fromsick leave to disability only under fairly strong assumptions.
Since experience rating aims to aﬀect employer behaviour through financial incentives,
the eﬀectiveness of such incentives should depend on the firm’s financial position. Whenthe experience-rated firm is short of liquid assets, it might try harder to deter exits todisability retirement to avoid the costs that in a dire financial situation might bankrupt
the firm. This is a relevant concern especially in the Finnish system where the employer
has to pay its share of the expected future disability pension costs as a lump-sum payment
at the time when a disability pension is granted to its employee. To address this question
we use the equity ratio as a proxy for a firm’s financial position.12 In table 4, the equity
ratio has a positive eﬀect on the likelihood that a sick leave will be followed by a disability
pension. Hence, a recipient of sickness benefits in a firm in a weak financial position returns
to work with a relatively high probability. Also the overall probability of a transition todisability retirement increases with the equity ratio, although the marginal eﬀect of 0.003
is of modest absolute value and statistically significant only at the 10% risk level.
Given that the experience-rated contributions depend on firm size, we should expect
the eﬀect of the equity ratio to vary across firms of diﬀerent size. We therefore extend
our baseline specification by adding interaction terms of firm size categories and equity
ratio. The results of this exercise are shown in table 5. There is no evidence of statisticallysignificant eﬀects in the smallest firms that are not subject to experience rating, which isconsistent with the claim that the eﬀect of the equity ratio is attributable to the experience rating system. We do not find statistically significant eﬀects in the second smallest
size category either. Although experience rating is applied to these firms, their share of
12

There are a few extreme values for the equity ratio. To deal with such outliers we bottom and top
coded the equity ratio at the 5th and 95th percentiles, respectively. That is, we use the threshold values
for observations below the 5th percentile or above the 95th percentile. As a result, the range of variation
shrank from [−8.24, 2.50] to [0.08, 0.82] .

19

Table 5: Marginal eﬀects for equity ratio by firm size
Probability of a transition to
Disability Sick leave Dd from sick
Equity ratio1) for group
Firm size 5—50
Firm size 51—300
Firm size 301—1000
Firm size > 1000

-0.003(0.003)0.001(0.003)0.011(0.005)0.011(0.004)-0.004(0.003)-0.001(0.003)0.006(0.005)-0.001(0.004)0.031(0.054)0.020(0.056)0.119(0.101)
0.296(0.072)

Notes: Other covariates as in the baseline specification. Robust standard errors in parentheses.
Significantly non-zero marginal eﬀects in bold (95%-confidence level) or in italics(90%-confidence level). 1) Equity as share of assets (bottom coded below the 5th percentile andtop coded above 95th percentile).

disability pension expenditures is rather small, perhaps too small to be eﬀective.
In firms that employ more than 300 employees, the likelihood of being granted adisability pension increases with the equity ratio. The marginal eﬀects in the first column
are found to be of the same size in the two largest firm size groups. In the case of the largest
firms, the likelihood of being granted a disability pension for a recipient of sickness benefits
increases clearly with the equity ratio: an increase of ten percentage points in the equity
ratio is related to a three percentage point increase in the disability pension incidence.
Put diﬀerently, large firms that can aﬀord the cost of disability pension expenditures seemto put less eﬀort into occupational rehabilitation compared with large firms in a weakereconomic position. The marginal eﬀect of 0.119 for the second largest firm group is also
relatively large but inaccurately estimated, and thereby statistically insignificant at theconventional risk levels.
In sum, our findings about the eﬀects of firm size, financial position and their interaction give some support for the hypothesis that experience rating aﬀects employer
behaviour. The lower transition rate from sick leave to disability retirement for the larger
firms is consistent with the hypothesis of the ex post eﬀect. But, without notable exogenous variation in the experience-rated contributions, this evidence alone is not very
convincing. Our results for the eﬀect of the equity ratio give further support for the existence of experience rating eﬀects. Namely, the financial position of a firm has an eﬀect
on the employees of the larger firms that are liable for a significant fraction of disability
pension expenditure of their former employees, whereas we find no relationship between
the equity ratio and transition rates in the firms that are not subject to (a notable degreeof) experience rating.

20

5.4

Employment growth and excess turnover

Our models include a control variable for excess worker turnover, which measures thedegree of restructuring at the workplace for a given net change in employment.13 Excess
worker turnover can be either voluntary or involuntary from the employees’ standpoint.
It may result from the restructuring measures through which the employer adjusts the
structure of the workforce. Or it may be driven by a high level of voluntary quits, perhaps
induced by poor working conditions, management or wage rates, which are compensatedby new hires.
As seen in table 4, employees in the establishments with high current levels of excess
worker turnover are more likely to enter a sick leave and less likely to return to work fromsick leave. Consequently, exits via disability retirement are more common in workplaces
with a high rate of excess worker turnover. It should be noted that the eﬀect of excess
worker turnover is conditional on a given change in the employment level, as we control
the employment growth rates. High turnover can result in extra training work for thetenured employees and cause other problems at the workplace, and thereby lead to anincrease in stress factors. When high turnover reflects an ongoing restructuring process,our estimates suggest the possibility that the employer encourages some older employees
to apply for a disability pension. For an employer that is adjusting the structure of theworkforce but is not downsizing, such a policy can be an eﬀective alternative for dismissals
that would be diﬃcult to justify.
Interestingly, the eﬀect of excess worker turnover over the past three years has an
opposite eﬀect on the transition rates to sick leave and disability retirement, while it does
not aﬀect transitions from sick leave to disability retirement. The restructuring measures
may improve the working conditions with some delay. If this is the case, the past measures
can decrease the current transition rate to sick leave.
In table 4, none of the eﬀects of the employment change during the past three years
diﬀer statistically significantly from zero. By contrast, the employment growth over the
next three years aﬀects the transition rates to sick leave and disability retirement. Compared with employees at the stable workplaces, the employees of growing establishments
are more likely to enter a sick leave and to exit via a disability pension scheme. This may
result from diﬃculties to use dismissals to adjust the structure of the workforce at growing
establishments. When the growth rate is negative, i.e. the establishment is cutting its
employment, transitions to sick leave and disability retirement become less frequent. The
magnitude of the eﬀect of the current growth rate is rather small, however. For example,
being employed in an establishment whose workforce increases by one-half by the end ofyear t + 2 (i.e. the growth rate of 0.4) increases the probability of being granted a disability pension by 0.12 percentage points (= 0.4 × 0.003 × 100) compared with the case of
13
Excess worker turnover in year t is defined as ht + st − |∆et | , where ht and st denote the number ofhires and separations during year t, respectively, and ∆et is the employment change from the end of yeart − 1 to the end of year t in a given establishment. This quantity is the worker flow in excess of whatis needed to explain the net change in the size of establishment’s workforce. Dividing it by the average
employment level at the end of years t − 1 and t, say et , gives the excess turnover rate: (ht + st − |∆et |)/et ,which takes a value on the interval [0, 2] . To smooth annual variation we take the average of the excess
turnover rates between years t − 4 and t − 1 (for the past period) and between years t and t + 2 (for thecurrent period) which are then used as covariates in our models.

21

Table 6: Marginal eﬀects for employment growth rates from extended logit models
Probability of a transition to
Disability Sick leave Db from sick
Past growth from t − 4 to t − 1when ≥ 0
when < 0Recent growth from t − 1 to t + 2
when ≥ 0
when < 0-0.001(0.001)0.000(0.002)0.000(0.001)0.001(0.002)0.008(0.029)-0.096(0.051)

0.002(0.001)0.006(0.002)0.002(0.001)
0.004(0.002)-0.023(0.022)
0.113(0.049)Notes: Other covariates as in the baseline specification. Robust standard errors in parentheses.
Significantly (95%-confidence level) non-zero marginal eﬀects in bold. 90%-confidence levelindicated with italics.

working in a stable establishment.
The underlying assumption of symmetric eﬀects for the expansion and contractionof the workforce is quite restrictive. In table 6 we therefore report results from model
specifications that do not impose such a restriction but allow for diﬀerent coeﬃcients for
positive and negative growth rates. The risk of being granted a disability pension remains
lower for those holding jobs in establishments that are currently downsizing, but thiseﬀect is now stronger. The marginal eﬀect of the current decline in employment on theprobability of disability pension receipt is 0.006, and increases to 0.113 if the employee isalready on sickness benefits. Thus, a 50% decrease in the workforce over the next three
years (i.e. the growth rate of −0.67) is estimated to reduce the disability pension entry
rate by 0.4 percentage points among all employees and by 7.6 percentage points among therecipients of sickness benefits, compared with the case of no change in the workforce. One
possible explanation is that employees with health problems are less willing to apply forsick leave and those already on sickness benefits return to work more easily at the times
when they are worried about their jobs. During slack demand employers may also use
dismissals to get rid of employees with reduced working capacity before they apply for asickness benefit or disability pension. Furthermore, it turns out that the estimated eﬀects
of the employment increases on the transition rates to sick leave and disability retirement
are close to the estimates obtained from the baseline specification in table 4. Note thatan expansion in the size of the workforce increases the transition rates clearly less thancontraction of the same size decreases it.
Black et al. (2002) find that negative (positive) demand shocks increase (decrease)
the entry rate to disability benefit schemes in aggregate US data. We have just shownthat the reverse relationship holds at the establishment level in the Finnish labour market. This is partly due to the fact that we are considering only transitions from work to
disability retirement. During economic downturns, transitions from nonparticipation andunemployment to disability schemes are likely to increase, and such transitions probably

22dominate the US data. Nevertheless, it is important to address the issue why employers may actively encourage early retirement when growing or when restructuring without
notable employment reductions.
Employees are protected against unjustified dismissals by the law. To dismiss someone,
the employer needs to show that the employee has failed to perform his tasks or his job has
become redundant. It follows that, when the establishment is not downsizing, dismissals
are diﬃcult to justify and thereby early retirement via disability schemes can be a helpful
strategy. Moreover, when new hires follow recent dismissals, the firm is obligated to rehire
its former employees if the job tasks are similar. A consequence is that the employer
cannot easily replace dismissed employees with new ones. This is a particularly relevant
issue for the older employees who tend to remain unemployed for a long time after job
loss. The employer may try to overcome this problem by inducing early retirement.
Also, the more flexible specification suggests that employment change during the past
three-year period has little eﬀect on the disability and sickness outcomes. The only statistically significant eﬀect (at the 10% risk level) is found for recipients of sickness benefits
in contracting establishments. They are less likely to return to work from sick leave or,
equivalently, more likely to end up in disability pension benefits. Our findings diﬀer fromthe results of Vahtera et al. (2005) and Rege et al. (in press), who found that a large
reduction of the workforce in the past leads to a notable increase in the entry rate to disability retirement. First of all, it is possible that our results are sensitive to the assumed
linear form for the eﬀect of employment changes in our model. To check the robustnessof our results with respect to this restriction, we also estimated model variants where thelinear growth rates were replaced with a set of dummy variables for employment changesof diﬀerent size. We did not find evidence of statistically significant increases in the disability pension entry rates following past mass layoﬀs either — on the contrary, the largest
layoﬀ categories were associated with negative marginal eﬀects. On the other hand, ourresearch design is quite diﬀerent. The risk set of Rege et al. also includes those who losttheir job as a result of plant downsizing. Vahtera et al. consider only employed workers
but their data come from the municipal sector and cover an exceptional period of deep
recession.

6

Concluding remarks

In this study we analyzed how labour demand and institutional factors aﬀect transitions
to sick leave and disability retirement. Using matched employer-employee data for the
Finnish private sector, we were able to measure the employment growth rates and excess
worker turnover at the establishment level. To study the role of the institutional setting,
we exploited the law change that aﬀected the medical requirements for disability pension
eligibility and the partially experience-rated employer contributions. Our main findings
can be summarized as follows:• For older employees a transition to sick leave is often a one-way street out of employment, leading eventually to disability retirement. Some two-thirds of the 55-62
year olds who are on sickness benefits end up in disability retirement within the23

next three years. This highlights the importance of preventive measures aimed atminimizing the flow into sick leave.
• Those employees who can apply for a disability pension under more lenient medical
requirements are much more likely to enter a sick leave and to exit via disability
retirement. Therefore, the abolition of the individual early retirement scheme in2000 eﬀectively reduced the flow into disability retirement among older people bornin 1944 or later.
• There is no evidence that experience rating would aﬀect the flow into sick leave (i.e.
the ex ante eﬀect). By contrast, experience rating appears to reduce transitions fromsick leave to disability retirement. Evidence of this ex post eﬀect is twofold. First,
recipients of sickness benefits in the large firms that are responsible for a notablepart of disability pension costs are less likely to end up in disability pension benefits.
Second, the large firms that can easily incur their share of early retirement costs
due to a strong financial position let their employees on sickness benefits exit moreeasily via disability pension schemes than firms in a weaker position do. Financial
situation does not matter for the smaller firms that are not subject to experiencerating or whose cost share is relatively low.
• The transition rates to sick leave and disability retirement are relatively large inestablishments that are growing or experiencing a high degree of excess worker
turnover. This suggests that employers induce exits to disability retirement as analternative to dismissals at times when it would be diﬃcult to lay oﬀ employees.
When the establishment is downsizing, transitions to sick leave and disability retirement become less frequent. Thus, during slack demand, either employees apply lesseasily for sick leave or employers target dismissals at those employees with reduced
working capacity due to health problems. Unlike some other studies, we find thatpast employment reduction has hardly any eﬀect on the current transition rate.

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