The United States Social Security System “Nuts and Bolts” October 11, 2006

By the end of today, you should be able to: Briefly explain motivations for Social Security program Explain the basic structure of the Social Security retirement program Who participates? How is the system paid for? How are benefits calculated? Next few classes: Economic effects (labor supply, savings) Long-run financing problem Solutions / reform

What is Social Security? Formal name: “Old Age, Survivors, and Disability Insurance” Program (OASDI) Provides income to: Retirees Disabled Workers Spouses of Beneficiaries Widows & Dependants of Beneficiaries

Why Should You Care? Of every $1000 you earn in your lifetime, you will pay at least $124 in taxes to support it Your parents / grandparents may be depending on it during retirement The federal government spent more on Social Security than on the following programs combined: Homeland security education, training, employment, social services energy, natural resources, environment international affairs general science, space, and technology

Motivations for Social Security

Who Participates? 90%+ of all workers in the United States pay into Social Security Some state/local workers are exempt (including U of I employees) Must work at least 40 quarters (10 years) to be eligible for benefits Spouses also eligible

How Is It Paid For? While working, you and your employer each pay 6.2% of wages (=12.4% total) to the government Only taxed on first $90,000 of earnings Look at your paycheck – FICA Federal Insurance Contribution Act Covers SS (12.4%) and Medicare (2.9%) 2/3 of US households pay more in FICA than in income tax!

What Benefits Does It Pay? If you pay into SS long enough (10 years), you can receive a benefit at retirement Can claim as early as 62 Monthly income is paid to you for as long as you live (i.e., as an annuity) Payments are increased annually with inflation Spouse can also receive benefit

By the Numbers … June 2006 Beneficiary Data Number (mil’s) Dollars (bil’s) Total48.9$540 Retired workers and family members 33.8$391 Survivors of deceased workers 6.6$68 Disabled workers and family members 8.4$81

Other facts Social Security represents approx. 2/5 of all income for the elderly About 2/3 of elderly Social Security beneficiaries received more than half of their income from OASDI It is the only source of income for approx. 1/5 of the elderly It is, by far, the primary source of disability insurance in the U.S.

Benefit Eligibility Eligible for benefits after 10 years of paying into system Technically, you need 40 quarters of coverage In 2006, a quarter of coverage is earned for each $970 of covered earnings Amount goes up each year with the wage index Can earn at most 4 quarters in one calendar year But can earn all 4 quarters for the year as soon as you earn 4*$970=$3,880

Calculating AIME Take all of your years of earnings, and index them to age 60 by growth in average wages (AWI) Average the 35 highest years Convert to a monthly value to get Average Indexed Monthly Earnings (AIME)

Calculating PIA Take AIME and feed it through a non- linear benefit formula to get “Primary Insurance Amount” (PIA) If retire at the Normal Retirement Age, your benefit = PIA Actuarial reduction if claim before NRA Delayed retirement credit for later claiming

The Benefit (PIA) Formula PIA AIME 1 st bendpoint 2 nd bendpoint $656 $3,995 $ $

The Normal Retirement Age “Normal retirement age” (NRA) used to be 65 years. Now 65 years + 8 months got those turning 65 this year. It is rising to age 67 for those born in 1960 or later. Note: There is nothing “normal” about this age, since 80% of workers are retired prior to this Also known as “Full Benefit Age” – age at which your benefit is equal to the PIA. The Politics of the NRA

Early Entitlement Age You can claim SS benefits as early as age 62, but there is an “actuarial reduction” in your benefits to reflect the fact that you will be receiving the benefits for more years When NRA is age 67 (those born after 1960) Roughly a 6% reduction per year of benefits Benefit at age 62 will be 70% of benefit at age 65 Adjustment is same for men and women, despite longevity differences

Delayed Retirement If you wait past the normal retirement age to claim benefits, you receive a “Delayed Retirement Credit” Increases your benefit for each year of additional work Those born after 1960 will get 8% increase per year of delay

Spousal Benefits If Joe is eligible for SS worker benefits, and Mary is not, then she can receive a spousal benefit that is 50% of his (couple gets 150% of Joe’s PIA) If Joe and Mary are both eligible for benefits, then they receive the higher of: (150% of Joe’s; 150% of Mary’s; Joe’s+Mary’s) Upon death, survivor benefit = 100% of PIA

Spousal Benefits - 2 Spouse of high income worker gets bigger spousal benefit than spouse of low income worker System transfers resources, on average, from single individuals and from two- earner couples to one earner couples One earner couples tend to be higher income

Does Social Security Redistribute? Replacement Rates (PIA / AIME) are higher for people with lower AIME It is “progressive” See chart on next page …

Replacement Rates = PIA/AIME Benefit at 65 for those turning 65 in 2006 $ BenefitReplacement Rate Low earner 45% of AWI 9, Medium earner 100% of AWI 15, High earner 160% of AWI 20, Max earner23,

SS and Redistribution What is the complication? Some low income individuals are part of high income households Spousal benefits are higher for individuals married to high earners Some individuals with high potential income choose to consume it via leisure or home production Individuals with higher lifetime earnings live longer, on average

Does Social Security Redistribute? Yes, between generations More on this next time! Yes, if compare today’s taxpayers to today’s elderly Yes, if we simply compare replacement rates across the income distribution at age 65 But on a lifetime, household basis, the extent of redistribution is much lower (and maybe non-existent)