Chapter 13: Social Security
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

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.
Social Security Benefits (PIA)
Figure 1
$1,865.89
For AIME above $5,892,For
nothe
benefits
The
corresponding
next $2,203 benefit
in monthly
for
are paid because this someone
corresponds
to $5,892
earnings,
earning
benefits
increase
(orby
more)
just
the level where no payroll
are dollar
15¢taxes
per
for every
month
is $1865.89.
of earnings.
paid.
Thus,
For theoftotal
next
benefit
$3,077 from
in monthly
earning
Social Security Benefits as a Function
Earnings
$3,689
earnings
per month
beyondisthe
$1535.44,
initial $612,
which
workers
equals receive
0.90*$612
only
0.32*$3,077.
in benefits
0¢/$+ 32¢
per dollar earnings.
$1,535.44
This is the
Workers
Thus, a worker
who have
earning
monthly
exactly
earnings
$612
relationship
perless
month
thanwould
$612get
receive
0.90*$612,
90¢ in or
between earnings
benefits
$550.80
forinevery
monthly
$1 ofbenefits.
earnings.
and benefits.
The x-axis measures
The y-axis measures
real monthly earnings,
$550.80
Social Security benefits
known as AIME.
taken at the “normal”
retirement age.
$0
$3,689
$612
$0
$1,000
$2,000
$3,000
$4,000
$5,892
$5,000
$6,000
$7,000
Average Indexed Monthly Earnings (AIME)
$8,000
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.

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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:
SSBEN  maxPIAH  PIAW ,15
. PIAH ,15
. PIAW 


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.
How Does Social Security Work Over Time?

How does Social Security work over time?
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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.
Individuals live for two periods, and
When
The population
theyReal
areWhen
old,
wages
grows
the
they
are
collect
over
are
assumed
time,
young,
in tothey
risework
at
then
die. 1
They are young in the first
Table
this
Social
case5%
Security.
by
and
as
5%
pay
well,
pera period.
due
tax to
to support
increased
Social
period, and old in the second.
productivity.
Security.
They
In year
now
3, receive
the elderly
$2,310
are those
in benefits,
whoin a Two-Period
Social
Security
World
There
is
no
Social
Security
program in
were young
10% more
and than
paying
they
taxes
paidinin.
year 2.
Period
Number Earnings
Taxes
Total
Number Benefits
Taxes
Rate of
year
1.
The
young
do
not
have
to
pay
This
If
population
return
comes
and
wage
from
higher
growth
total
are
Recall they
paid
in
$2,100
each.
of
per
paid per Because
taxes
The paid
initial
The
Social
the
generation
taxes
of
elderly
old
Security
collected
did
to
(elderly
old
not
is started
are
paypaid
who
$220,500;
into
as
byan return
Social
Security
taxes.
high,
collections
theretirees
rate
of
due
return
towinner
tobenefits,
“middle
growth
young
young
young the
retirees
old
didtax
system,
unfunded
$2,100
not
pay)
per
yet
isprogram
they
the
person
big
collect
in
x wage
105
year
young
from
2,
withpeople.
a 10%
workers
worker
worker
retirees
generations”
and
population
can
be
large.
their
This
the
payroll
rate
isunfunded
divided
oftax
return
on
among
system.
the
is growth.
infinite.
current
the 100
young.
elderly.
1
100
$20,000
0
0
0
0
---
---
2
105
The elderly$2,100
in year $220,500
5 Now
(whoimagine
were 100
young
that in
in$2,205
year 5, the0young
$21,000
3
110
4
115
$23,153
$2,315
$266,225
110
$2,420
$2,205
10%
5
121
$24,310
0
0
115
0
$2,315
-∞
year 4) suffer as a consequence.
workers scrap
They
the system.
paid
They pay no ∞
into the system
got nothing 105
out of
taxes.
it.$2,310 $2,100
$22,050
$2,205 but$242,550
10%
How Does Social Security Work Over Time?

The example shows how Social Security
redistributes across generations:

The first generation received a large windfall.

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The middle generations got a rate of return determined
by wage and population growth.
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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 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?
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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.
Higher
Moving
Moving
Younger
earners
down
across
generations
the
have
rows
the
lower
columns
looks
have
at
examines
lower
higher
SSW.
SSW
earners.
successively
than older
Table
2
younger
generations.
generations.
Redistribution under Social Security for a Single
Male
Earnings Level
Retirees turn Retirees turn Retirees turn 65
65 in 1960
65 in 1995
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
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:

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
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.
France
Figure 6
There
60% ofisthose
an enormous
working when
spike they
in the
turn
hazard
60 retire
rate during
in France
the at
next
ageyear.
60,
which
both
the Early Entitlement
SSisEEA
& FBA
Age and FBA.
0.7
Retirement Hazard Rate
0.6
0.5
0.4
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
Age
65
70
Germany lowered its retirement age in early 70s
Figure 7
Within
Germany
7 years,
lowered
the average
the early
age at
which
retirement
individuals
age from
retire
65had
to 60
fallen
in
from1973.
63 to 58.
Mean Retirement Age
64
63
62
61
EEA Introduced
in 1973
60
59
58
1968
1972
1976
1980
Year
1984
1988
1992
Figure 8
They Other
also have
countries,
lower like
percentages
the
Netherlands,
of elderly
Belgium,
working.
France, and
Italy, have high taxes.
70
Belgium
R2 = 0.82
Nonworking Elderly
France
Italy
60
UK
Netherlands
These
In nations
countries
like the
also
United
haveStates,
higher
percentages
Sweden, andofespecially
elderly working.
Japan,
50
there is little implicit tax.
40
Germany
Spain
Canada
US
Sweden
30
The
For
And
It also
example,
horizontal
it accounts
takes the
into
axis
for
measure
account
measures
the facttakes
any
that
the
average
into
“implicit
upward
account
earnings
tax”
adjustments
the
to extra
working
tendpayroll
to at
be
benefit
older
higher
taxes
Japan
paidbybydelaying
forworking
delaying
ages.
retirement.
another
retirement.
year.
20 levels
-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.
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.
Figure 9
40
By 2025, there will be
a larger share of
Ratio of Elderly to Working Age Population
elderly in the U.S. than
there are in Florida
currently.
Number of elderly per 100 working age
people
35
30 number of elderly,
The
relative to workers,
25
has grown over time.
20
15
10
5
0
1950
1960
1970
1980
1990
2000
Year
2010
2020
2030
2040
2050
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.