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13.1 What Is Social Security, and How Does It Work
13.2 Consumption-Smoothing Benefits of Social Security
13.3 Social Security and Retirement
13.4 Social Security Reform
13.5 Conclusion
Social Security
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The aging of the huge “baby boom” cohort will lead to a large rise in the number of retired elderly relative to the number of workers.
The Social Security program faces a stark financing problem: over the next 75 years, the program has promised $10.6 trillion more in benefit payments than it plans to collect in taxes from workers.
During the 2011 Republican presidential debate, Governor Perry called the Social Security program a “monstrous lie” to future generations.
The Social Security Debate
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Opposing Republican candidate Mitt Romney rebutted Perry’s opposition to the status quo by saying, “You can’t say that to tens of millions of Americans who have lived on Social Security.”
Perry proposed a return to how the Social Security program operated before 1983, when state and local workers were free to opt out of Social Security and instead pay into state or locally run retirement programs.
Romney proposed a two-fold approach to Social Security reform that involves increasing the retirement age by a year or two as well as slowing benefit growth for higher-income recipients.
The Social Security Debate
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Perry’s opt-out policy also stands in contrast to the proposal of President Obama’s bipartisan debt-reduction commission, which would enroll all newly hired state and local government workers in Social Security after 2020.
Over the past decade, little progress has been made on Social Security reform.
It is the largest single source of income for the elderly population in the United States.
Any reform that is perceived as reducing the generosity of the program is politically dangerous.
The Social Security Debate
13.1
Social Security: A federal program that taxes workers to provide income support to the elderly. It is paid according to their lifetime earnings, and it is not based on current financial need like social welfare programs.
How Is Social Security Financed
Through the Federal Insurance Contributions Act (FICA) tax on their earnings.
Who Is Eligible to Receive Social Security
A person must have worked and paid this payroll tax for 40 quarters (10 years) over their lifetime, and must be age 62 or older.
What Is Social Security, and How Does It Work
13.1
Beneficiaries receive annuity payments.
Annuity payment: A payment that lasts until the recipient’s death.
Payment size depends on the recipient’s average earnings over the 35 highest earning years, called the Average Indexed Monthly Earnings, or AIME.
Benefits are a redistributive function of past earnings, as the replacement rate falls with AIME.
Replacement rate: The ratio of benefits received to earnings prior to the entitling event.
How Are Social Security Benefits Calculated
13.1
Social Security Benefits as a Function of Earnings
Past earnings are translated to increased benefits at a slower rate as earnings rise.
13.1
Using the 35 highest years reflects multiple concerns.
No penalty for low-earning years early in career.
Not too large a benefit for high earning years late in career.
Too short a window leads to abuse:
Bus driver working 25-hour shifts to maximize pension payment.
Brazilian public employees receiving promotions right before retirement.
APPLICATION: Why Choose 35 Years
Can claim at early entitlement age, but it reduces benefits by 6.67% for each year before full benefit age.
Full Benefits Age (FBA): The age at which a Social Security recipient receives full retirement benefits (Primary Insurance Amount).
Early Entitlement Age (EEA): The earliest age at which a Social Security recipient can receive reduced benefits.
Delaying beyond FBA increases benefits by 8% per year, called the Delayed Retirement Credit (DRC).
13.1
How Are Social Security Benefits Paid Out
13.1
Can you work and receive Social Security
The earnings test reduces the benefits of 62- to 64-year-olds by $0.50 for each dollar of earnings they have above $15,480.
These benefits are returned later when the worker’s earnings fall below this threshold.
Can family members receive benefits
Spouses of claimants, children of deceased workers, and spouses who survive a Social Security recipient all receive benefits.
How Does Social Security Work
13.1
Review: Social Security Terms
AIME is Average Indexed Monthly Earnings.
PIA is the Primary Insurance Amount.
FBA is the Full Benefits Age (currently age 65, rising to 67).
EEA is the Early Entitlement Age (currently age 62).
DRC is the Delayed Retirement Credit amount (8%).
13.1
Pension systems can be funded or unfunded.
Funded: Refers to retirement plans in which today’s savings are invested in various assets in order to pay future benefits.
Unfunded: Refers to retirement plans in which payments collected from today’s workers go directly to today’s retirees, instead of being invested in order to pay future benefits.
Social Security is partially funded: Today’s taxes fund some but not all of future benefits.
This leads to redistribution from young to old.
How Does Social Security Work Over Time
13.1
How Social Security Redistributes Income: Social Security in a Two-Period World
Population and earnings grow by 5% per year.
Unfunded system with 10% payroll tax.
13.1
The very first beneficiary of Social Security was Ida May Fuller.
Worked for only three years after the establishment of the Social Security system, and paid a total of $24.75 in Social Security taxes:
The first Social Security check in U.S. history was issued to her on January 31, 1940, for $22.54.
Ida May went on to live for 35 more years, dying at age 100 in 1975. Over those 35 years, she collected a total of $22,888.92 in Social Security benefits.
Ida May Fuller
13.1
Unfunded Social Security systems redistribute from young to old, and the first generation are the big winners.
Unfunded systems create legacy debt.
Legacy debt: The debt incurred by the government because early generations of beneficiaries received much more in benefits than they paid in taxes.
Lessons Learned
13.1
To see how Social Security redistributes in practice, we study the Social Security Wealth of different generations.
Social Security Wealth (SSW): The expected present discounted value of a person’s future Social Security payments minus the expected present discounted value of a person’s payroll tax payments.
How Does Social Security Redistribute in Practice
13.1
SSW is computed as follows:
Calculate the entire future stream of benefits that a person expects to receive before he or she dies.
Use a discount rate to calculate the present discounted value (PDV) of that stream of benefits.
Calculate the entire future stream of taxes that a person expects to pay before he or she dies.
Compute the PDV of that stream of taxes.
Take the difference between these two to get the SSW.
How Does Social Security Redistribute in Practice
13.1
How Does Social Security Redistribute in Practice
SSW for a Single Male
Earnings Turns 65 in 1960 Turns 65 in 1995 Turns 65
in 2030
Low earner $70,024 $47,340 $21,986
Medium earner 99,640 26,141 69,321
High earner 106,874 196 205,882
Redistribution from younger to older cohorts due to:
First cohort didn’t pay in until 1937.
Payroll tax has increased over time.
Benefits increased over time.
13.1
Some examples of how SSW varies within groups that are the same ages include the following:
Females have more SSW than males because they live longer.
Married couples have more SSW than single people.
Single-earner couples have more SSW than two-earner couples.
Black recipients have a lower life expectancy than whites, so their SSW is lower.
The gains to the poor relative to the rich from Social Security are overstated because the length of life rises with income.
How Does Social Security Redistribute in Practice
13.2
The fundamental motivation for Social Security is the notion that the elderly will not have sufficient income to support themselves in retirement or to support their dependents when they die.
Evidence on this front is reviewed by Poterba (2015), who shows, for example, that for those in the bottom half of the income distribution there is little source of retirement support other than Social Security.
The government needs to force workers to provide for their retirement years by paying taxes when working that entitle them to benefits when retired.
Consumption-Smoothing Benefits of Social Security
13.2
One justification for Social Security is market failure in the annuities market.
The longer a person lives, the less money the insurer makes from an annuity contract.
This could lead to such a high price for annuities that most people would not want to buy them.
True reason: paternalism.
Policy makers worry that people won’t save enough.
Most workers have very little savings other than Social Security (and private pensions).
Rationales for Social Security
13.2
Key question: Does Social Security smooth consumption
Perhaps Social Security just crowds out savings that individuals would otherwise set aside for their retirement.
Social Security might crowd out private savings by allowing people to count on a government transfer to support their income in old age.
The larger this crowd-out is, the less consumption smoothing Social Security provides for retired individuals.
Consumption-Smoothing Benefits of Social Security
13.2
Living Standards of the Elderly, 1959 2013
There is a striking negative correspondence over time between the poverty rates of the elderly (which have fallen) and the size of the Social Security program (which has risen).
13.2
Social Security benefits in the United States depend on age and earnings, both of which could be correlated with savings habits.
In Italy, reforms in 1992 cut benefits of younger public-sector workers, relative to older public-sector workers and private-sector workers.
Results show partial crowd-out: 30 40% of the reduction in SSW was offset by higher private savings.
EVIDENCE: Measuring the Crowd-Out Effect of Social Security on Savings
13.3
What are the costs and benefits of working an additional year at age 62
Costs: Implicit tax
Pay an extra year of payroll taxes on earnings.
Receive one year less of Social Security benefits.
Benefits: Benefit adjustment
Higher Social Security benefit level through the actuarial adjustment
Increase AIME
Social Security and Retirement: Theory
13.3
Social Security and Retirement: Evidence
Elderly Work and Social Security, 1959 2013
In the 1960s and 1970s, the program grew rapidly and LFP decreased. Both flattened in the mid-1980s, and in recent years, both are on the rise.
13.3
Social Security and Retirement: Evidence
Spike in Retirement Hazard at EEA
The male hazard rate, or exit rate at each age given that a man has worked to that age, has a distinct spike at age 62 (the Early Entitlement Age, EEA) and 65 (the previous Full Benefit Age, FBA), which are key ages for the Social Security system.
13.3
Spike in Retirement Hazard at EEA
In 1960, before the EEA of 62 was introduced for men, the hazard rate for men was highest at age 65 (the FBA), with no spike at age 62. By 1970, the spike at 62 had begun to emerge, and by 1980, it was larger than the spike at age 65.
13.3
Social Security and Retirement: Evidence
Retirement Hazard Rate in France
In France, there was an enormous exit rate from the labor force at age 60, which is both the EEA and FBA.
13.3
Social Security and Retirement: Evidence Retirement Age in Germany, 1968 1992
Benefits entitlement age lowered from 65 to 60 in 1973. Within 7 years, average retirement age fell by 5 years.
13.3
APPLICATION: Implicit Social Security Taxes and Retirement Behavior
Gruber and Wise (1999) calculated the implicit tax from Social Security for a series of countries.
Across countries, there is a great deal of variation in the implicit tax rate.
Implicit tax close to zero for 62-year-olds in the United States
91% in the Netherlands
And countries with higher taxes have less elderly labor force participation.
13.3
Implicit Social Security Taxes and Retirement Behavior
There is large variation across nations in the social security disincentives to work at older ages. Those nations with greater disincentives to work tend to have much higher nonwork among older workers.
13.3
Evidence suggests that it is potentially very costly to design Social Security systems that penalize additional work beyond the retirement age.
Adjusting systems to more fairly reward work at old ages can mitigate much of the moral hazard effect of Social Security.
Implications
13.4
Social Security Reform
Social Security faces a major fiscal imbalance as it is increasingly difficult for young generations to pay for the benefits of older generations.
Rising life expectancy
Falling birth rates
Reduction in wage growth rates
13.4
Social Security Reform
The number of persons over age 65 per working-age person age 15 to 64 almost triples over the century, from 13 per 100 in 1950 to 38 per 100 in 2050.
13.4
Commission in 1983 to improve Social Security’s finances.
Primary recommendation:
Social Security system should move away from an unfunded system to some extent.
The government should accumulate savings in the Social Security trust fund so that, when the baby boomers retire, there would be enough money to pay their benefits.
Reform Round I: The Greenspan Commission
13.4
In theory, one benefit of the partial funding of Social Security through the build-up of the trust fund is an increase in national savings.
The trust fund is “off budget,” not supposed to be part of budget discussion.
But typically the government reports the deficit/surplus from the “unified budget,” which incorporates off-budget categories.
Makes it easy to treat trust fund as an asset, avoid fixing the deficit.
APPLICATION: The Social Security Trust Fund and National Savings
13.4
Many possible additional reforms:
Raise social security tax revenues collected.
Raise the tax rate on taxable wages.
Extend the base of taxable wages.
Reduce social security benefits paid out.
Raise the retirement age to match increasing life spans.
Lower benefits to all eligible recipients.
Change to a welfare program where recipients’ benefits decrease with higher incomes.
Incremental Reforms
13.4
Fundamental reforms have also been proposed.
Invest the trust fund in stocks.
One problem with the Greenspan Commission’s solution was that the trust fund is very inefficiently invested.
Privatization
A proposal to reform Social Security by allowing individuals to invest their payroll taxes in various assets through individually controlled accounts
Fundamental Reforms
13.4
401(k) plans are an important feature of retirement savings in the United States.
These plans allow individuals to save in self-directed investment choices.
But there are several problems with them.
Some workers have as much as 80% of their assets in company stock.
If the company fails, they will lose their job and their savings.
APPLICATION: Company Stock in 401(k) Plans
13.4
Middle ground between fundamental and partial reform: government regulated accounts.
Each person would get an account…
…but the government would limit investment choices and force annuitization.
Over the long run, an efficient retirement portfolio should contain some stock investments.
The Trade-Offs Between Fundamental Reforms
13.4
A 2001 commission proposed three mixed systems for partial privatization.
One plan let people invest up 2% of wages in a personal account.
But all plans were expensive since they diverted payroll revenue away from current benefits, requiring other revenue to finance.
APPLICATION: Mixed Proposals for Social Security Reform
13.4
Leibman, McGuiness, and Samwick’s (2005) proposal:
Cut Social Security benefits:
Reduce the values of the rate at which the PIA is converted to the AIME and raise the Full Benefits Age to 68 and the Early Entitlement Age to 65.
Raise new revenue:
Mandatory contributions to retirement accounts, increase in maximum taxable earnings.
Establish individual retirement account with five broad options.
APPLICATION: Mixed Proposals for Social Security Reform
13.5
Social Security is the largest social insurance program in the United States, and the largest single expenditure item of the federal government.
Social Security faces a long-run financing problem to which there are no easy solutions.
The question of how to resolve this problem will be one of the most contentious sources of political debate for at least the first part of the twenty-first century.
Conclusion

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