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.

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.

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.

Figure 1

$5,892$3,689

$1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000

$0

Soc

ial S

ecur

ity B

enef

its (

PIA

)

$0

Average Indexed Monthly Earnings (AIME)

Social Security Benefits as a Function of Earnings90

¢/$

32¢/$

15¢/$

0¢/$$1,865.89

$1,535.44

$550.80

$612

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.The x-axis measures real monthly earnings,

known as AIME.The y-axis measures

Social Security benefits taken at the “normal”

retirement age.

This is the relationship

between earnings and benefits.

For the next $3,077 in monthly earnings beyond the initial $612,

workers receive only 32¢ in benefits per dollar earnings.

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 $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.

For AIME above $5,892, no benefits are paid because this corresponds to the level where no payroll taxes are

paid.

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.

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.

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.

SSBEN PIA PIA PIA PIAH W H W m ax , . , .1 5 1 5

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.

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.

Table 1

Social Security in a Two-Period WorldPeriod Numbe

r of young worker

s

Earnings per

young worker

Taxes paid per

young worker

Total taxes paid

Number of old retiree

s

Benefits to old retirees

Taxes paid

by old retiree

s

Rate of return

1 100 $20,000 0 0 0 0 --- ---

2 105 $21,000 $2,100 $220,500

100 $2,205 0 ∞

3 110 $22,050 $2,205 $242,550

105 $2,310 $2,100 10%

4 115 $23,153 $2,315 $266,225

110 $2,420 $2,205 10%

5 121 $24,310 0 0 115 0 $2,315 -∞

Individuals live for two periods, and then die. They are young in the first

period, and old in the second.

When they are young, they work and pay a tax to support Social

Security.

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.There is no Social Security program in year 1. The young do not have to pay

Social Security taxes.Social Security is started as an

unfunded program in year 2, with a 10% payroll tax on the current young.

The taxes collected are $220,500; $2,100 per person x 105 young people. This is divided among the 100 elderly.

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.

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.

This return comes from higher total tax collections due to wage growth

and population growth.

If population and wage growth are high, the rate of return to “middle

generations” can be large.

Now imagine that in year 5, the young workers scrap the system. They pay no

taxes.

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.

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.

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.

Table 2

Redistribution under Social Security for a Single Male

Earnings Level Retirees turn 65 in

1960

Retirees turn 65 in

1995

Retirees turn 65 in 2030

Low earner $26,100 $12,500 -$4,100

Average earner $36,500 -$5,100 -$56,200

High earner $36,800 -$37,100 -$248,500

Moving across the columns examines successively younger generations.

Younger generations have lower SSW than older

generations.

Moving down the rows looks at higher earners.

Higher earners have lower SSW.

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.

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.

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.

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.

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.

50 55 60 65 70

0

0.1

Ret

irem

ent

Haz

ard

Rat

e

Age

-0.1

0.2

0.3

0.4

0.5

0.6

0.7 SS EEA & FBA

There is an enormous spike in the hazard rate in France at age 60,

which is both the Early Entitlement Age and FBA.

60% of those working when they turn 60 retire during the next year.

Moreover, when the “age 60” retirement age was not an option in France, the hazard rate was 10%.

Figure 6France

58

59

60

61

62

63

64

1968 1972 1976 1980 1984 1988 1992

EEA Introduced in 1973

Year

Mea

n R

etire

men

t A

geGermany lowered the early

retirement age from 65 to 60 in 1973.

Within 7 years, the average age at which individuals retire had fallen

from 63 to 58.

Figure 7Germany lowered its retirement age in early 70s

Figure 8

20

-0.5 0 0.5 1.0 1.5 2.0 2.5

30

40

50

60

70

Disincentive to work

Non

wor

king

Eld

erly

R2 = 0.82

Japan

US

Canada

Sweden

Spain

UK

France

Germany

Belgium

Italy

NetherlandsIn nations like the United States, Sweden, and especially Japan,

there is little implicit tax.

These countries also have higher percentages of elderly working.

Other countries, like the Netherlands, Belgium, France, and

Italy, have high taxes.

They also have lower percentages of elderly working.

The horizontal axis measures the “implicit tax” to working at older

ages.

For example, the measure takes into account the extra payroll taxes

paid by working another year.

It also takes into account any upward adjustments to benefit levels for delaying retirement.

And it accounts for the fact that average earnings tend to be higher

by delaying retirement.

Natural log of the sum of implicit taxes on work at older ages.

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.

Ratio of Elderly to Working Age Population

0

5

10

15

20

25

30

35

40

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Year

Nu

mb

er o

f el

der

ly p

er 1

00 w

ork

ing

ag

e p

eop

le

The number of elderly, relative to workers,

has grown over time.

By 2025, there will be a larger share of

elderly in the U.S. than there are in Florida

currently.

Figure 9

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.

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.

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.

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.