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Social Security and Reform: What it Does Now Will it be Around to Keep Doing It? Karen Holden, Ph.D. Professor of Consumer Science and Public Affairs Co-Interim Director Center for Financial Security Associate Director, La Follette School of Public Affairs

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Social Security and Reform: What it Does Now Will it be Around to Keep Doing It?

Karen Holden, Ph.D.

Professor of Consumer Science and Public Affairs

Co-Interim Director Center for Financial Security

Associate Director, La Follette School of Public Affairs

University of Wisconsin-Madison

holden@lafollette.wisc.edu


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Part of the Retirement “Three Legged Stool”

Earnings

Employer provided plans

Social

Security

Personal

Savings



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It isn’t all about Retirementor about you alone(New awards by type (2003))

MAJORITY OF AWARDEES ARE WOMEN—57.2%

Retired workers 44.5% are women

Disabled workers 45.5%

Widow(er)s 92.3%


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Important to Understand

  • Social Security is about different risks

    • Retirement (62+)

    • Disability (<65)

    • Death of a spouse (any age)

    • Death of a parent (child <18)

    • Disability of a child (disability < 18; lifetime benefits)

    • Low average wages—due to low wages or interrupted work lives

    • Effect of divorce of homemaker on retirement security

    • Job transition—(universal coverage)

  • Your benefits and your choices affect you and survivors


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Topics

  • Overview of program

  • What is this funding shortfall?

  • What are the major proposals?

    • “Modifiers”

    • “Reformers”-private accounts

  • Major challenges of each


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Program Benefit Basics and contrast to Employer Provided Pensions

1. Pay-as-you-go financing

2. Pays a mandatoryannuity (benefit for remaining life)

3. Annuity is fully inflation-adjusted

4. Benefit based on average covered wage adjusted earnings over highest 35 years (including zero years)

5. Progressive benefit formula: provides higher replacement to life-long low earnings

6. Survivor benefits financed by system rather than worker; no reduction in worker’s benefit


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Program Basic I —pay-as-you-go

  • Current FICA pays for current beneficiaries

  • Early program always has high ratio of

    payers / beneficiaries

  • As the program “matures,” ratio must fall

  • With a “stable population” it is

    Productivity growth, labor force and retirement timing increasingly matters


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Total Fertility Rates: U.S. is a relatively “young” country

U.S. 2.1 Germany 1.3

Sweden 1.8 Italy 1.2

Ireland 1.8 Japan 1.5

Canada 1.7 China 1.8

Britain 1.7 S. Korea 1.8

France 1.6 Thailand 1.8

Netherlands 1.5 Russia 1.3


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PAYGO—what is paid? country

FICA (as percent of taxable payroll)

Employer & Total employee, each

Old Age & Survivor5.30% 10.60%

Disability 0.90 1.80

Medicare (Part A) 1.45 2.90

Total 7.65 15.30


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At age 65 countrymalesfemales

Expectations of life 16.6yrs 19.5yrs

Percent alive at 85 36% 50%

Percent alive at 90 18% 29%

Program basics 2 & 3: Annuity guards against uncertainty about length of life & inflation

U.S. 2002 Life table


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Program basic 4: The importance of wage adjustments country

Example of indexing past wages for subsequent wage growth


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Program Basic 5 country

Average Indexed Monthly Wage = Indexed wages averaged over 35 years

Primary Insurance Amount (PIA)=

.90 of first $627 AIME +

.32 of $628 - $3779 of AIME +

.15 of Average Indexed Monthly earnings above $3,779


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100% PIA at countryFull Retirement age

Turning 62 Full Retirement Age

2005 - 2016 66

2017 66 and 2 months

2018 66 and 4 months

2022 and later 67

Reduction 5/9 of 1% each month for first 36 earlier than FRA;

5/12 of 1% each additional month to 62


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Program Basics 6: Survivor Benefit country

Up to 100% of amount primary beneficiary would have received as retired/disabled worker

Divorced survivor eligible if married 10 years

Survivor receive higher of own or survivor benefit;

but can begin survivor earlier and not have retired-worker benefit reduced

Reduced for earnings if < age FRA (above $1,000 per month)

Ineligible if remarried before age 60

If widowed again will receive the higher benefit from either spouse


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Redistribution: higher “rates of return” for lower wage workers, females, one-earner couples

  • Estimated internal rates of return:Person born 2004, retiring 2069


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QUESTIONS ON SOCIAL SECURITY AND YOU?? workers, females, one-earner couples

  • Benefits

  • Relationship to pensions

  • Reductions with age

  • What to expect during retirement

  • Retirement, remarriage, death, disability

  • Others


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How do we know what the next 75 years looks like? workers, females, one-earner couples

  • Actuaries review the past and project

    • birth rates, death rates, immigration, employment, wages, inflation, productivity, interest rates

    • Make assumptions for the next 75 years

  • Three scenarios: Low cost; High cost; Intermediate (best estimate?)


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Trust Fund: assets as a % of annual expenditures workers, females, one-earner couples


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Actuarial Status of OASDI 2005-80: workers, females, one-earner couplesAlternative cost projections(2005 Trustees’ Report)

1/. Fund is not estimated to be exhausted within the projection period


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Intermediate Projections: workers, females, one-earner couplesIn long-run 60-70% benefits paid


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Challenge: all proposals must bring any “pay as you go” component into balance

Modifiers do it with combination

Increased revenues and reductions in benefits;

Reformers

  • Private accounts divert 4-6 % FICA to IA

  • System out of balance by 1.92 + diversion %.

  • In short run funds must come from somewhere to finance this now larger shortfall (transition costs)

  • In long run benefit reductions to meet reduced (~employer-only) FICA revenue


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Reforms not simple because of “social insurance” and “defined benefit” components of current system.

  • Insurance protection against income risks and for all family members

  • Predictable and inflation adjusted benefits

  • Benefits not subject to market risks;

    private pensions increasingly shifting market, inflation, survival risks onto workers


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Modifiers’ proposals: Increase limit on covered earnings that are taxed

  • Proposal: Raise cap to historic 90% of earnings and use current benefit formula: resolves 40% of deficit.

  • 2005 earnings taxed up to $90,000

  • Percent of aggregate earnings taxed has fallen

    • to 86% of 2003 taxable earnings vs 92% in 1937;


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Modifiers: Deficit reduced by other tax and benefit changes that are taxed

Cover currently uncovered state and local: 10%

Speed rise in Full retirement age

to 67 and raise gradually to 68: 28%

to 67 and raise gradually to 70: 36%

Change COLA post-benefit adjustments

COLA – 1 percentage point: 79%

40 percent of Trust Funds into equities with

6.5% real return: 48%


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Reformers—diversion of FICA to private accounts that are taxed

  • Divert 4-6% of employee FICA;

  • Individual chooses among limited number of funds approved by some central authority

  • Retirement annuity based on account accumulation

    • Reduced when split with spouse or at divorce

    • Retiree must purchase inflation adjusted joint & survivor annuity; survivor benefits reduce worker annuity

    • Some share of diverted FICA used to fund disability


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Reformers: Who pays the cost of diversion to private accounts?

  • In long run system must be brought into balance by reductions in SS benefits such that can be funded by payroll tax less contributions diverted to Individual Accounts

  • In short run General Fund transfer required to cover SS benefits until all individual account system is mature.

  • At annuitization, some offset of “traditional” SS benefits by annuitized amount.

    • Long-run cost higher if SS + account has minimum guarantee to reduce market risk


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Competing claims in Individual Accounts—whose are they? accounts?

  • Who has property rights to accounts?

  • Are accounts individual or marital property?

  • What happens to accounts upon divorce?

  • Is a joint & survivor annuity mandated in all cases?

  • What about children’s claims on accounts?


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Retain Redistribution Component? Challenges of Individualized Accounts

  • What annuity structure and rules protect surviving spouse, divorced surviving spouse, adult disabled children, surviving young children?

  • If inflation-adjusted annuity required, what market instruments are available to allow this?

  • If accounts inherited, does that reduce traditional SS further for those who inherit accounts?

  • Inheritance removes insurance pooling advantages.


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Overview: There is a financing problem Individualized Accounts

Total shortfall estimated = $4.0 trillion, though predicted with uncertainty.

In long-term: tax and benefits must be sufficient to balance system

Diversion of FICA in Individual Accounts MUST increase shortfall in short run and must lead to smaller traditional benefits than currently payable because no pooling of risk.

Question for all reforms and modifications:

How important is the social insurance nature of Social Security?


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Reform is not simple and Individualized Accounts are not a simple modification

Accounts introduce the market risks inherent in any defined contribution pension plan.

Individuals will gain if individual accounts earn more than Treasury Bills. Will lose if accounts earn less.

Accounts will require federal property law and probably more federal insurance company oversight.

Social insurance features must be paid out of individual accounts, rather than being pooled.


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