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Chapter 8

Social Security and Social Insurance

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Social Security Act of 1935

Requirements at that time: Retirement Age: 65 Payroll Tax:

1% for employer and employee

Tax applied to the first $3000 of earned income

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Social Security in the United States

OASDI: Old Age Survivors Disability Insurance 

HI: Health Insurance (Medicare)  UI: Unemployment Insurance

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FICAFederal Insurance Contribution Act

Employers and employees each currently contribute 7.65% of wages in FICA tax.

15.3 % for the self-employed

Taxes applied on earned income up to $87,000 in 2003 (indexed).

 

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Fully Funded vs Pay-As-You-Go A Fully Funded

system: current fund has balances sufficient to pay the present value of all future obligations.

 

A Pay-As-You-Go system: current taxes pay for current benefits.

The current U.S.system is a modified pay-as-you-go system with a trust fund as backup.

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Social Security Trust Fund Since 1982, Social Security taxes collected

have greatly exceeded benefits paid out. The trust fund is an accounting mechanism

by which U.S. government debt is issued to the Social Security Administration in exchange for SS fund surpluses.

This debt will be sold to the public when taxes paid fall below what is needed to pay benefits.

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Retirement Age People born prior to 1935 can retire with full

benefits at 65.  People born between 1936 and 1942 can

retire with full benefits at age 65 + 2 months for every year after 1936 they were born. 

People born between 1943 and 1954 can retire with full benefits at age 66.

People born between 1955 and 1960 can retire with full benefits at age 66 + 2 months for every year after 1955 they were born. 

People born after 1960 can retire at full benefits at age 67.

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How Retirement Benefits are Computed

The AIME (Average Index of Monthly Earnings) calculates the highest 35 years of inflation-adjusted earnings, expressed in monthly terms.

The PIA (Primary Insurance Amount) is the amount to which a individual is entitled given their AIME. 

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The Gross Replacement Rate is the monthly retirement benefit divided by the monthly labor earnings in the year prior to retirement.

The Net Replacement Rate is the monthly after-tax benefit divided by the monthly after-tax labor earnings in the year prior to retirement .

Replacement Rates

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Worker Status Gross Replacement Rate

Low Earner 53.6%

Average Earner

39.9%

Maximum Earner

24.8%

Gross Replacement Rates by Income2002

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Figure 8.1 How Gross Replacement Rates for Social Security Pension Recipients Vary with

Pre-retirement Earnings

Gro

ss

Re

pla

ce

me

nt

Ra

te (

Pe

rce

nt)

Gross Monthly Earning in the Year Prior to Retirement (Dollars)

110 100 90 80 70 60 50 40 30 20 10

0 1,000 2,000 3,000 4,000

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Spousal and Dependent Benefits

.5 of PIA is added for a spouse over age 65 and for each dependent child

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Divorce and the Two-Income Family

A woman who worked while married to a high income-earning husband will get nothing or virtually nothing for the taxes she paid. She and her husband would get 1.5 times his PIA if she earned nothing and 1.5 time his PIA if she earned a modest income.

Divorced people are entitled to either their own PIA or a spouse/widow benefit (whichever is larger). This applies to multiple spouses as well. Thus, breadwinners can have multiple people receiving half or full pensions based on a single taxpayer’s earnings.

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Other Anomalies When one party in a marriage dies, the benefit to

the survivor depends on who made the money. If both earned equal amounts, then when one dies the

other receives their own amount. If one earned all the money and the breadwinner dies,

the survivor keeps the spouse’s pension (which is often quite a bit more).

Singles fair substantially worse than do married dependent partners with deceased breadwinning partners.

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The Importance of Social Security Income to the Elderly

2/3 get more than half of their income from Social Security. 

Private pensions only account for 20% of elderly income. 

For low-income persons, Social Security is 80% of their monthly income.

More than 50% of the elderly would be below the poverty line without Social Security.

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Cost-of-Living Adjustments Benefits are adjusted for inflation using

the CPI. 

Because the CPI overstates inflation (by estimates in the neighborhood of 1.1 percentage points), Social Security benefits increase in real terms each year.

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Demographic Changes

Birthrates have fallen such that the number of workers supporting each retiree has fallen from more than 30 in the 1950s to below 5 beginning in 1990. Projections show that fewer than 3 workers will support each retiree by 2030; shortly thereafter, fewer than 2 workers will support each retiree.

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Algebraic Look at the Result of Demographic Changes Under a Pay-as-You-Go system

t = (B × R)/(W × L)

Where:

t is total benefits paid

B is the average benefit

R is the number of recipients

W is taxable wages

L is the number of workers

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Algebraic rearranging

t = B/W × R/L = the average replacement rate × the dependency ratio 

The dependency ratio was below .1; it is currently above .3 and is steadily increasing, and will be at .5 in 2030.

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Year Basic OASDHI

Tax Rate

Combined Employer-

Employee Tax Rate

Maximum Taxable

Wages per Worker

Maximum Tax Based on Combined

Rate

1937 1.00 2.00 $3,000 $60.00

1957 2.25 4.50 $4,200 $189.00

1967 4.40 8.80 $6,600 $528.00

1977 5.85 12.10 $16,500 $1,930.50

1987 7.15 14.30 $43,800 $6,263.40

1997 7.65 15.30 $65,000 $10,006.20

2003 7.65 15.30 $87,000 $13,615.50

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Proposals to Reform Social Security Maintain benefits

Increase taxability of benefits Invest Trust Fund in Corporate Securities Eventually increase payroll tax rate by 1.6 percentage

points Individual Accounts

Raise retirement age Reduce replacement rates for upper income people Allow 1.6 percent of payroll to be placed in special

retirement accounts Personal Security Accounts

Allow half of payroll taxes to be placed in individually managed accounts

Reduce guaranteed benefit

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Figure 8.2 Social Security Pensions and the Work-Leisure Choice

A

B

G

A

B

0

B

24

Inc

om

e p

er

Da

y

Leisure Hours per Day

24

A

0 4 9 19 14

U2

H

L2

E'

U2

L1

E

U1

$30

F

C

G $30

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Working While Eligible for Social Security Benefits

People may work and receive Social Security benefits.

If they receive benefits with the reduced benefits option at age 62, they lose $1 in benefits for every $2 they earn over approximately $10,000.

Those older than 65 may earn any amount and keep their benefits.

If they choose not to receive benefits, they receive a greater Social Security benefit when they decide to begin receiving them.

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Savings Incentives of Social Security Asset Substitution Effect: People save less than they

would if Social Security did not exist, because they are substituting government promises of a benefit for private savings. Stated simply, people save less because government is “saving” for them. 

Induced Retirement Effect: People save more than they would if Social Security did not exist because they would not have retired or would not have retired as early had Social Security not been there. Given that it does exist, people choose to ultimately retire or retire earlier and save in order to do so. 

Bequest Effect: People save more than they would have if Social Security did not exist in order to bequeath more to their children and grandchildren.

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Figure 8.3 The Asset Substitution Effect

A

B

Co

ns

um

pti

on

per

Ye

ar

aft

er

Re

tire

me

nt

Consumption per Year Prior to Retirement

0

A B

0

S

A

B

GF

TS' C

Social Security Pension

R

D

U1

E

U1

D

G2

T

Social Security Pension

F

SC

R2

U2

E

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The Net Effect of Social Security on Savings

Feldstein: Social Security leads to a substantial reduction in savings

Munnell: The net effect of the ASE, BE, and IRE is nearly zero 

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MedicareThe program provides substantially subsidized

health insurance to those 65 and older. It is financed with premiums, a 2.9% payroll tax (1.45% each for employers and employees) and general government revenue. Part A:

Mandatory Covers hospitalization Financed with payroll tax and premiums

Part B: Voluntary Covers doctor’s visits Financed from general federal revenue and premiums

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Unemployment Insurance

Covers nearly all full-time workers

Financed with a payroll tax on employers up to $7000 of earnings

Gross Replacement Rate: 33%