Social Security Today: From the origins of Social Security to today’s structure; Long-run problems due to the graying of America

Previously We looked through the benefits that seniors receive from Medicare Hospital insurance Supplemental medical insurance Physician and medical services outside the hospital Prescription drug benefits

Today We analyze another benefit that most seniors receive Questions Social Security (SS) Questions How did Social Security begin? What is today’s structure? How is the graying of America affecting SS? How do we solve the long-run challenges to SS? How do people change their behavior with the implementation of SS?

How did Social Security begin? SS, which is officially Old Age, Survivors, and Disability Insurance, began in 1937 White male work categories initially were covered Coverage grew to more people over the next 50 years or so Justification for SS What if I outlive my money? Indirectly transfers money from those that die young to those that die old (Directly, the transfer is from workers to retirees)

Fully funded? Original idea involved having a large fund to pay benefits out of Political pressure turned SS into a pay-as-you-go system The current generation of workers pays for today’s retirees There has been some money in reserve Reserves projected to diminish starting in 2017

Fully Funded Plan Period 1 Period 2 Period 3 Period 4 The Greatest Generation Work Retire Dead Still Dead Each generation’s benefits based on deposits it made during working life plus accumulated interest contribute benefits The Baby Boom Generation Retire Childhood Work Dead contribute benefits Unborn Childhood Work Retire Generation X contribute benefits

Pay As You Go (or Unfunded) System See also Figure 11.6 for payments and tax revenues of SS from 1990-2080 Period 1 Period 2 Period 3 Period 4 contribute benefits Work Retire Each generation’s benefits come from tax payments made by current workers Dead Still Dead The Greatest Generation contribute benefits Childhood Work Retire Dead The Baby Boom Generation contribute benefits Unborn Childhood Work Retire Generation X benefits

SS and consumption smoothing The purpose of SS is to prevent the problems of adverse selection in annuity markets Who would buy an annuity that paid out for the rest of a person’s life? People that expect to live a long time Recall “death spiral” from Chapter 9

Some other reasons for SS Lack of foresight Some people may overestimate their true discount rate Moral hazard problems The government may support old people with no resources anyways Lower administrative costs per person Improved economic status for old people

How does SS work? Mostly pay-as-you-go, or unfunded, financing Recall that some reserves exist Financing Current workers pay, retirees receive Retirement age “Normal” age is gradually increasing Benefit structure Based on average indexed monthly earnings See Figure 11.1 for SS expenditures from 1937-2005

Financing In 2006, each of the first $94,200 was subject to SS taxes 12.4%, evenly split between employee and employer Note that Medicare financing is separate from SS Taxes create illusion of obligation to future generations SS could be eliminated if the federal gov’t decided to do so See Table 11.1, p. 235, for SS tax rates over time

The Social Security Trust Fund Worker Retiree Trust Fund Money flow shown above Workers pay into the trust fund Retirees receive money from the trust fund

Retirement age 62 is minimum retirement age (with reduction in benefits) Year of birth Full retirement age Months between age 62 and full retirement age 1937 or earlier 65 36 1938 65 and 2 months 38 1939 65 and 4 months 40 1940 65 and 6 months 42 1941 65 and 8 months 44 1942 65 and 10 months 46 1943-1954 66 48 1955 66 and 2 months 50 1956 66 and 4 months 52 1957 66 and 6 months 54 1958 66 and 8 months 56 1959 66 and 10 months 58 1960 or later 67 60

Benefit structure Based off average indexed monthly earnings (AIME) Top 35 years of wages, factored for inflation 2006 benefit formula: Primary insurance amount (PIA) 90% of first $656 of AIME, plus 32% of AIME between $656 and $3,955 15% above $3,955 Cap on benefits based on maximum taxable earnings subject to SS payroll tax

Benefit structure PIA First Bend Point Second Bend Point AIME

Long-run problems with SS Population growth in some countries is stagnating Populations are getting older on average Both problems are putting pressure to do at least one of the following Decrease benefits Increase the retirement age Increase SS taxes

A simple model Assume three equal periods of life Childhood Working years Retirement Suppose that each generation is twice as big as the previous one Twice as many workers as retirees Workers pay less into SS than they receive when they retire

Stagnation in population growth Population growth has stagnated in some developed countries Example: Greece, 2007 estimates Current population growth is 0.16% per year People are dying at a faster rate than births 1.35 children born per woman’s childbearing years Only positive net migration is keeping Greece’s population from falling (Source: http://en.wikipedia.org/wiki/Demographics_of_Greece)

Greek population Source: http://en.wikipedia.org/wiki/Demographics_of_Greece Thousands of people Year

Graying of the population America is currently “graying” in two ways Americans are living longer Life expectancy 1959-1961: 69.9 years 2004: 77.8 years Infant mortality 1959-1961: 2.6% 2004: 0.68% Baby boom generation is beginning to retire Statistics from Center for Disease Control and Prevention website

Graying of the population Baby boom generation (roughly) This graph show the number of people aged 0-99 in 1999

Some possible solutions to SS problem In order to have sustainable solvency of the SS system in the US, additional financing equivalent to a 3.5 percentage point increase in the payroll tax must be achieved Some other possible solutions Raise the maximum taxable earnings level Raise the retirement age Reduce the cost-of-living adjustment Change the benefit formula A combination of options

Warning Secondary effects must be taken into account with SS reform Be careful about increasing taxes In Chapter 15, we will see that tax increases can cause other problems in the economy Increasing the retirement age could increase the supply of workers Could lead to lower wages for all workers

Major reform proposal: Privatization Many people have proposed privatization of the SS system Solvency may or may not improve Effect on saving depends on type of accounts that are allowed Risk would increase Even safe stocks could go down in value Administration costs would likely increase Reduces SS’s role of insurance

What will happen to SS? Over the next decade, one of several things could occur to SS Nothing: Let the next generation solve the problem Waiting too long could lead to social unrest Partly solve the problem Current solvency: 30-40 years Some proposals would increase this to 75 years Fully solve the problem (not likely)

How do people change behavior with SS? With SS, people change their behavior in the working years We will examine the life-cycle theory of savings Wealth substitution effect Retirement effect Bequest effect

Life cycle theory of savings People save and borrow based on planned lifetime consumption See Figure 11.3, p. 242, for budget constraints on present and future consumption Somebody with diminishing MU prefers smooth consumption over time Without SS, a rational person will save during the working years and use this money for retirement

Wealth substitution effect Along the budget constraint, suppose I am forced to have $1 less today and $(1 + r) more in future consumption This will lead to $1 less in saving today Crowds out private saving Known as the wealth substitution effect See Figure 11.4, p. 244, and Figure 11.5, p. 245, for more on crowding out private saving

Retirement effect SS gives workers a financial incentive to retire early Retirement effect states that people may save more in their working years in order to have their desired consumption during a longer retirement period

Bequest effect Some people may feel guilty with the fact that their children are financing their retirement Bequest effect states that people save more during their working years to finance a larger bequest to their children when they die

Summary SS is a big part of the US economy About 4.25% of GDP Private saving likely changes when SS is introduced An idea of fully-funded SS system turned into a pay-as-you-go system Reforms will need to be made in order to make SS solvent for your retirement