Social Security • Social Security is an example of a social insurance program. • Social Security provides income for older individuals. • Income comes in form of an annuity, i.e. the individual receives income payments until he dies.
Annuities • An annuity is an insurance product. • Annuities are typically issued by the same companies that issue life insurance policies • The risks undertaken by the issuer are fundamentally the same for both products -- that is, the insurance company bets on the life expectancy of the customer. • The result is to transfer the effects of the uncertainty of an individual's lifespan from the individual to the insurer, which reduces its own uncertainty by pooling many clients.
Why have Social Insurance? • One important feature of life insurance markets is asymmetric information – individuals have better information predicting their longevity than insurance companies. • If a private firm offers insurance and cannot observe the high risks from the low risks, likely to get a group of buyers that is adverse to its interests. • Adverse selection – Individual who knows he is especially likely to collect benefits will have an especially high demand for insurance.
How can government intervention improve efficiency? • Social security is compulsory: the adverse selection problem is avoided because the low risks are forced to purchase the insurance policy as well. • In the private market, the low risks would be less likely than the high risks to purchase the insurance policy.
Other Justifications for Social Insurance • Lack of Foresight / Paternalism • For example, some individuals do a poor job of planning for their retirement. • Individuals do not understand financial markets and investment opportunities. • Income Redistribution • Old individuals used to have lower incomes than young individuals (1930’s and 1940’s).
The Economic Status of the Aged • Elderly used to be a relatively disadvantaged group • Elderly now have lower poverty rates than the average household • Life expectancy has increased by more than 10 years during the past three decades.
Basic Components • Pay-as-you-go Financing • Explicit transfers • Benefit structure • Age at which benefits are withdrawn • Recipient’s family status
Pay-as-you-go Financing • Benefits for current retirees come from payments made by current workers. • There are no savings and hence on capital accumulation in such a system (except when taxes exceed benefits). • Early recipients received very high returns on their contributions.
The Benefit Structure • Benefits are base on Average Indexed Monthly Earnings • Only highest 35 years of earnings count toward AIME. • Consider a person with a typical “age-earnings” profile, who starts work at age 22 and retires at 67, and therefore has 45 years of full-time work. • Likely that the Social Security taxes paid from ages 22-32 will not matter for AIME.
Primary Insurance Amount • To compute benefits, we need to convert AIME into Primary Insurance Amount (PIA). • This the basic benefit payable to a work who retires at the “normal retirement age.” • Benefit schedule is progressive, where lower-earners receive a higher proportion of previous earnings.
Redistribution to Low Income Earners • Typical low-earner who retired in 2003 received 64% of AIME. • Average earner received 48% • High earner received 40%.
Normal Retirement Age • The normal retirement age is the age at which an individual qualifies for full Social Security benefits. • Can retire as early as age 62, but benefits are scaled down. Benefits are scaled up for retirement after the normal age. • Normal retirement age is being ratcheted up from 65 to 67 for younger generations. • Implicitly a benefit cut.
Financing of Social Security • Payroll tax is a flat percentage of an employee’s annual gross wages up to a cap. • Currently, the Social Security part of the payroll tax is split equally between employer and employee, with each paying 6.2% of gross wages. • Likely that much of the employer tax is shifted to employees in the form of lower wages.
The Payroll Tax • Payroll tax and the cap have increased dramatically over time. • In addition to the cumulative Social Security payroll tax of 12.4%, there is also an uncapped Medicare tax of 2.9%, resulting in a cumulative tax of 15.3%.
Social Security by Generation • Simulate lifetime net benefits for different representative individuals • Social Security Wealth: Lifetime value of Social Security benefits, discounted to present • Lifetime costs of being in the system – payroll taxes. • See Table 9.3
Other Distributional Issues • Social Security redistributes in other ways as well, many of which may be unintended. • Life expectancy varies by: • Race, gender, smoking status • Social Security redistributes to groups with higher life expectancies
Preferences for Married Couples • Social Security also redistributes by living arrangements due to the 50% PIA adjustment. Consider benefits for three households: Married, 1 earner Single Individual Married, 2 earners
Retirement Savings • In addition to Social Security individuals can use private savings to accumulate wealth for retirement. • One of the largest fringe benefits provided by employers to employees is the pension plan whereby employers save to provide retirement income for their workers. • The contributions that an employer makes to the pension fund are not taxed as income to the employee.
Defined Benefit Pension Plans • Traditionally employer provided pension plans were defined benefit plans. • In these plans workers accrued pension rights during their tenure at the firm. • When workers retired the firm paid them a benefit that was a function of the worker’s tenure at the firm and their earnings.
Defined Contribution Plans • Over time employer provided pension plans have shifted to defined contribution plans in which employers set aside a certain proportion of the a worker’s earning (such as 5%) in an investment account. • The worker receives these savings and any accumulated investment earnings when she retires.
401(k) Accounts • The most rapidly growing form of retirement account is the 401 (k) account, an individually controlled savings program offered through the workplace. • These accounts allow individuals to save on a tax-deferred basis with employers often matching workers contributions. • In 401 (k) plans, the contributions are not counted as taxable income and the investment accrues at the before tax rate of return. • Moreover contributions to 401(k) are vested, i.e. the investments belong immediatetly to the workers.
Other Types of Saving Accounts • IRAs (Individual Retirement Accounts) • Roth IRAs • 403(b) for not-profit, 457(b) for government • Self-employment Retirement Plans • Education Savings Account
Problems with 401(k)’s • Not all individuals have access to 401(k) plans. • In 2003 only 49 % of workers in the private sector participate in an employer-provided pension plan. • Individuals sometimes make bad investment choices. • A lot of workers heavily invest into the stock of their company. That works sometimes well (Microsoft) and sometimes is does not (ENRON). 62% of ENRON’s 401(k) assets were invested in ENRON stock.
Long-Term Stresses on Social Security • Given its current pay-as-you-go structure, Social Security is financially unstable. • In stable system, benefits received equals payments collected. • We can decompose these two parts.
Long-Term Stresses on Social Security • Benefits received: • Payments collected: • Where Nb=number of retirees, B=average benefit per retiree, t=tax rate, Nw=number of workers, and w=average wage per worker
Long-Term Stresses on Social Security • For solvency, we must have: • Or rearranging: • The first term on the right hand side is the dependency ratio, and the second term is the replacement ratio.
Population Growth and Social Security • Dependency ratio has been going down because of an aging population. • Currently 3 workers per retiree • By 2030, 2 workers per retiree • Only way to keep system stable would be to increase taxes or lower benefits.
Incremental Social Security Reform • Thus far, the US as primarily relied on incremental reforms to keep the Social Security System solvent. • One can tweak the current system by • raising payroll tax, • Increasing retirement age • reducing the benefits for retirees
Fundamental Reform • In addition, advocates of Social Security often favor the introduction of personal retirement accounts. • The accounts work similar as 401(k) plans. • These accounts would allow workers to invest a fraction of their payroll taxes into a funded retirement account.
Personal Retirement Accounts • While the adoption of personal accounts are often linked to demographic concerns (retirement of the baby boom generation in the US), the actual evidence does not seem to support this motive. • The largest reforms occurred in less developed countries where future demographic problems are least severe, including Chile (1981) and Mexico (1997).
An International Perspective • More modest reforms have been implemented in high-income countries where demographic problems are more severe including the UK (1986), Sweden (1998), and Poland (1999). • Some countries with the most severe demographic problems including Germany, Italy, and Japan have only implemented minor reforms.
Some Lessons • Traditional Pay-as-you-go systems require a significant amount of trust between workers of different generations – the so called social contract. • If the median voters loses under a pay-as-you-system he may not be willing to support the system. • In developing countries, where reform have been the largest, there is a distrust in government policies due to previous misuse of retirement funds. • Funded defined-contribution accounts give workers independence from the government. • In developing countries such as the US the creation of personal accounts is driven by demographic problems.
The Trust Fund • When pay-roll revenues exceed payments to beneficiaries, the difference is used to buy government bonds which are “deposited” in the trust fund. • According to the 2005 Trustee’s Report, the US Social Security System faces a shortfall equal to about $11.1 trillion, which is equal to the present value of the benefits minus the present value of all future payroll taxes after subtracting the value of the trust fund.
The Solvency of the US System • The shortfall in the Medicare program is seven times as large. • Absent benefit cuts, placing Social Security and Medicare on a permanently sustainable course would require increasing the payroll taxes from 15.3% to 36.1% --- immediately and forever. • Personal accounts do not improve or worsen the financial outlook since they reduce future taxes and benefits by an equal amount in present value.