This paper postulates the existence of an “employment insurance contract” in which firms insure the employment of workers, at a predetermined wage, against potential, age related declines in productivity. To limit its liability the firm establishes an age limit to its promise ––– the mandatory retirement age. It is demonstrated that Pareto‐efficient contracts exist which involve mandatory retirement at a specific age. The existence of these contracts, including mandatory retirement, increases workers' life‐time utility and encourages the accumulation of human capital. Empirical results are consistent with the predictions