Chapter 13: Social Security

1. Chapter 13: Social Security • This lesson reviews institutional features of Social Security, and provides economic motivations for government intervention. • It then examines behavioral responses, such as crowding out of saving and encouraging early retirement. • Lastly, we examine potential reforms.

2. Introduction • Social Security is a federal program that taxes workers to provide income support for the elderly. • Over the next 75 years, the program has promised $3.7 trillion more in benefit payments than it plans to collect in taxes from workers. • Social Security is the largest social insurance program in the U.S. • By making payroll tax payments to Social Security, workers purchase insurance against earnings loss when they die or retire.

3. Program Details • SS is financed through the FICA tax, which totals 12.4% of gross earnings up to $87,900 in 2004 (6.2% on employees and 6.2% on employers). • An individual can collect Social Security as early as age 62, assuming he/she has paid into the system through the payroll tax for 10 years. • When eligible, the Social Security claimant receives an annuity payment, a payment that lasts until the recipient’s death. • The payment is a function of average indexed monthly earnings, or AIME. • Earnings are calculated from the 35 highest years of earnings. If the claimant worked less than 35 years, those years are treated as “0”. • They are indexed for wage growth; thus AIME roughly represents the worker’s lifetime earnings relative to the average wage.

4. Figure 1 For AIME above $5,892, no benefits are paid because this corresponds to the level where no payroll taxes are paid. For the next $2,203 in monthly earnings, benefits increase by just 15¢ for every dollar of earnings. The corresponding benefit for someone earning $5,892 (or more) per month is $1865.89. Thus, the total benefit from earning $3,689 per month is $1535.44, which equals 0.90*$612 + 0.32*$3,077. For the next $3,077 in monthly earnings beyond the initial $612, workers receive only 32¢ in benefits per dollar earnings. Social Security Benefits as a Function of Earnings 0¢/$ $1,865.89 15¢/$ $1,535.44 This is the relationship between earnings and benefits. Workers who have monthly earnings less than $612 receive 90¢ in benefits for every $1 of earnings. Thus, a worker earning exactly $612 per month would get 0.90*$612, or $550.80 in monthly benefits. Social Security Benefits (PIA) 32¢/$ The x-axis measures real monthly earnings, known as AIME. The y-axis measures Social Security benefits taken at the “normal” retirement age. $550.80 90¢/$ $0 $3,689 $5,892 $612 $0 $7,000 $8,000 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 Average Indexed Monthly Earnings (AIME)

5. Program Details • How are Social Security benefits paid out? • Individuals can receive their Primary Insurance Amount (PIA) starting at age 65, which is the Full Benefits Age (FBA). • One can collect benefits as early as 62, the Early Entitlement Age (EEA). • The FBA is rising to age 67; almost all college students would need to wait until 67 to collect the PIA. • If one collects benefits before their FBA, the benefits are actuarially reduced. The reduction accounts for differing years of collecting benefits and the time value of money. • There is a delayed retirement credit (DRC) for those who wait to collect Social Security after the FBA.

6. Program Details • The replacement rate is the ratio of benefits received to earnings prior to the entitling event. • For the average earner, the Social Security replacement rate is 40%. • For low earners, it is closer to 60%. • For high earners, it is closer to 20%. • For beneficiaries between 62 and 64, there is an earnings test of $11,640, meaning any $1 earnings beyond that point reduces Social Security benefits by 50¢. • This is not exactly a tax, however, because the benefits are returned later with interest.

7. Program Details • Spouses of claimants are also entitled to receive benefits. The family’s total benefit would be equal to: • Where SSBEN is the total benefit collected from Social Security, PIA is the primary insurance amount, and the subscripts H and W denote the husband and wife’s PIAs. • For example, a wife with a low level of earnings may have her benefit determined by her husband’s PIA.

8. How Does Social Security Work Over Time? • How does Social Security work over time? • In contrast to private pension plans, which are funded, Social Security has typically been unfunded. • This means that taxes collected from a current worker go directly to current retirees. • This is referred to as a “Pay-As-You-Go” system. • There is no guarantee with a pay-as-you-go system that future benefits will be paid out in the way one might expect: • The system could go bankrupt. • Future generations could refuse to pay to finance the system.

9. How Does Social Security Work Over Time? • Unlike private pension plans, which are backed by the actual assets of the plan, the promises of Social Security are backed by the policies of the government. • Because of the large fiscal imbalance in Social Security, nearly ¾ of young people today believe that the system will not provide them with significant income in retirement. • In fact, Social Security is not a completely unfunded system; some of today’s payroll contributions go into the Social Security Trust Fund to help pay for future retirees. • Yet, the trust fund is projected to run out of money by 2042, at which point Social Security becomes a completely unfunded system.

10. Table 1 Individuals live for two periods, and then die. They are young in the first period, and old in the second. When they are old, the collect Social Security. The population grows over time, in this case by 5% per period. Real wages are assumed to rise at 5% as well, due to increased productivity. When they are young, they work and pay a tax to support Social Security. In year 3, the elderly are those who were young and paying taxes in year 2. Recall they paid in $2,100 each. They now receive $2,310 in benefits, 10% more than they paid in. There is no Social Security program in year 1. The young do not have to pay Social Security taxes. If population and wage growth are high, the rate of return to “middle generations” can be large. This return comes from higher total tax collections due to wage growth and population growth. Because the elderly did not pay into the system, yet they collect benefits, their rate of return is infinite. The initial generation (elderly who did not pay) is the big winner from the unfunded system. The taxes collected are $220,500; $2,100 per person x 105 young people. This is divided among the 100 elderly. Social Security is started as an unfunded program in year 2, with a 10% payroll tax on the current young. The elderly in year 5 (who were young in year 4) suffer as a consequence. They paid into the system but got nothing out of it. Now imagine that in year 5, the young workers scrap the system. They pay no taxes.

11. How Does Social Security Work Over Time? • The example shows how Social Security redistributes across generations: • The first generation received a large windfall. • Unfunded Social Security carries with it a legacy debt, the debt incurred by the government because early generations received much more in benefits than they paid in taxes. • The middle generations got a rate of return determined by wage and population growth. • The return to “middle generations” depends on the rates of population and wage growth. • The final generation was the big loser.

12. How Does Social Security Redistribute in Practice? • How does Social Security redistribute in practice? • We compute Social Security Wealth (SSW), the expected PDV of Social Security benefits over a person’s lifetime, minus the PDV of payroll taxes. • This involves several steps: • Calculate the entire future stream of benefits that the person expects to receive before he or she dies, accounting for mortality. Use a discount rate to compute PDV of benefits. • Calculate the entire future stream of payroll taxes. Compute the PDV of taxes. • Take the difference between the two to get SSW.

13. Higher earners have lower SSW. Moving down the rows looks at higher earners. Moving across the columns examines successively younger generations. Younger generations have lower SSW than older generations. Table 2

14. How Does Social Security Redistribute in Practice? • Social Security redistributes in other ways. • It pays an annuity until death; therefore groups with shorter life expectancies (men, the poor, minorities, smokers) tend to lose under such a system. • It provides survivorship benefits; this redistributes toward married couples relative to single individuals. • It adjusts the benefit level by 50% for married households with a single earner; this redistributes toward single-earner married households. • It generally redistributes from the rich to the poor, even with adjustments for life expectancy.

15. Rationales for Social Security • First, there may be market failures in the annuities market that Social Security solves. • This market is subject to adverse selection, where the “high risks” are the ones who live a long time. • Second, paternalism comes into play: policymakers believe that individuals won’t save enough for their own retirement. • In 1991, for example, the median American aged 51-61 had $107,000 in future Social Security wealth, but only $16,000 in private pension wealth and $3,000 in other personal retirement assets.

16. Does Social Security Affect Saving? • Social security provides a benefit in retirement. • Individuals needs to save less for retirement. • But because of the pay-as-you-go nature of SS, there is no corresponding increase in Government saving. • SS may encourage people to retire earlier, so saving might increase to support a longer retirement period. • Existing research suggests that each $1 of Social Security wealth crowds out 30¢ to 40¢ of private savings. • This is important, but not full crowd-out.

17. SOCIAL SECURITY AND RETIREMENT: Theory • Social Security may encourage early retirement through: • Implicit taxation, acting as a “substitution effect.” • Redistribution, acting as an “income effect.” • The “implicit tax” takes account of the fact that a worker at the early entitlement age can choose to work another year. • Working another year alters social security wealth because: • One more year of payroll taxes is paid. • One year of Social Security benefits is given up. • The benefit level goes up because of actuarial adjustment. • The year of work usually replaces a low earnings year with a high earnings year. • Higher implicit taxes should lead to earlier retirement. • The redistributive effects were discussed early, and act as an income effect.

18. Evidence on Labor Supply • Perhaps most compelling evidence that public pensions (like SS) affect retirement, is to make international comparisons. • This approach looks at the incentives for retirement at different dates and the likelihood that people actually retire then. • Look at evidence from France, Germany, and the OECD.

19. Figure 6 France 60% of those working when they turn 60 retire during the next year. There is an enormous spike in the hazard rate in France at age 60, which is both the Early Entitlement Age and FBA. 0.7 SS EEA & FBA 0.6 0.5 0.4 Retirement Hazard Rate Moreover, when the “age 60” retirement age was not an option in France, the hazard rate was 10%. 0.3 0.2 0.1 0 -0.1 50 55 60 65 70 Age

20. Figure 7 Germany lowered its retirement age in early 70s Within 7 years, the average age at which individuals retire had fallen from 63 to 58. Germany lowered the early retirement age from 65 to 60 in 1973. 64 63 62 EEA Introduced in 1973 Mean Retirement Age 61 60 59 58 1972 1976 1980 1984 1988 1992 1968 Year

21. Figure 8 They also have lower percentages of elderly working. Other countries, like the Netherlands, Belgium, France, and Italy, have high taxes. 70 Belgium R2 = 0.82 France Italy 60 UK Netherlands In nations like the United States, Sweden, and especially Japan, there is little implicit tax. These countries also have higher percentages of elderly working. Germany 50 Spain Canada Nonworking Elderly 40 US Sweden 30 It also takes into account any upward adjustments to benefit levels for delaying retirement. For example, the measure takes into account the extra payroll taxes paid by working another year. The horizontal axis measures the “implicit tax” to working at older ages. And it accounts for the fact that average earnings tend to be higher by delaying retirement. Japan 20 -0.5 0 0.5 1.0 1.5 2.0 2.5 Disincentive to work Natural log of the sum of implicit taxes on work at older ages.

22. SOCIAL SECURITY REFORM • Over the next 75 years, the PDV of the program’s obligations exceed the PDV of the taxes it will collect by $3.7 trillion. • Three factors contribute to this imbalance: • Improvements in life expectancy • A reduction in birth rates • The growth in wages has slowed dramatically.

23. Figure 9 By 2025, there will be a larger share of elderly in the U.S. than there are in Florida currently. The number of elderly, relative to workers, has grown over time.

24. Incremental Reforms • There are a number of incremental reform approaches: • Raise payroll taxes further: An increase from 12.4% to 14.3% solves financing problems for the next 75 years; raising it to 15.9% solves it forever. • Extend the base of taxable wages: Some workers are not covered by Social Security, and would represent a net gain in the financial position of the program. • Raise the retirement age: The FBA has not moved up in lock-step with life expectancy. • Lower benefits: Lower rates at which the AIME is translated into the PIA. Alternatively, the government could adjust the indexation rate. • Means-test the program: Another possibility would be to tax benefits for higher income households.

25. Fundamental Reforms • Investing the trust fund in stocks–100% of the assets of the Social Security Trust Fund are held in bonds. • A slow investment of the trust fund in the stock market could lead to a higher rate of return and cover half of the projected 75-year deficit. • This runs into the problem that politicians may simply take these higher returns and use them for government spending. • Also, there is concern the government might abuse its position to manipulate capital markets for its own good.

26. Fundamental Reforms • A more radical alternative is privatization–allowing individuals to invest their payroll taxes in various assets through individually controlled accounts. • The capital would then truly be “off-budget” to politicians, unlike the Social Security Trust Fund. • It would also respect consumer sovereignty with respect to investment decisions. • The transition to such a system is the most difficult problem–how do we let individuals save money for their own retirement, while at the same time supporting the existing generation of retirees? • Once the need to pay back this legacy debt is accounted for, a privatized Social Security system would not provide a higher rate of return.

27. Fundamental Reforms • Such a privatized system could also have higher administrative costs; the current system’s costs are only 0.19% of the program’s asset balances. • For example, the administrative costs of the U.K. and Chile, two countries with privatized systems, are more than 100 basis points higher, which over the course of many years substantially lowers wealth levels. • A final issue with privatization is that policy makers may not want to respect consumer sovereignty with respect to retirement savings. • In private 401(k) accounts, for example, company stock makes up 1/6th of aggregate assets. This option almost never makes sense.