1 Social Security Chapter 34

2 Social Security’s Origin The 1935 Social Security Act Part of the FDR “New Deal” Does more than just funding retirement, but that is all that I want to talk about Intended to be a “third leg” of a retirement tripod Social Security Individual Savings Company Pensions 2

3 Why Social Security is Needed It can be talked about in many ways but basically social security is forced savings We worry that (some) people left to their own devices won’t save enough, so the government does it for them Suppose the minimum that anyone should save for retirement is 5% of their income and the government enforced this For anyone who was saving 5% already, this is irrelevant as you were already doing it For people who were not saving enough, we may well be helping them Thus if it were this simple, it seems like a good thing to do-of course things are actually more complicated 3

4 How to Fund Social Security Every retirement system must be funded by using currently generated money to pay current retirees or use the balances of previously saved money to pay current retirees. – Pay-as-you-go : a system where current workers’ taxes are used to pay pensions to current retirees – Fully-Funded : system where for every benefit dollar it is required to pay in the future there is an off- setting amount currently invested that is sufficient to pay off that dollar When the population is growing, Pay-as-you-go is great-especially for the first cohort of retired people When the population is not growing-not so much 4

5 The Current Funding System Social Security was, until 1982, a pay-as-you-go system. The baby-boom ( ) created a problem for the system starting in Recognizing this, Congress created the Social Security Trust Fund in This makes Social Security a hybrid of a pay-as-you-go and fully funded system. 5

6 The Basics: Taxes Social Security is funded with a payroll tax (taxes owed on what workers earn from their work) Employers and employees both pay an equal amount. The amount for Social Security is 6.2% of payroll up to the Maximum Taxable Earnings (the maximum of taxable earnings subject to the payroll tax). Remember when we talked about tax incidence earlier-it shouldn’t matter whether tax is on the employer or the worker 6

7 The Basics: Benefits People who have reached the retirement age (the age at which retirees get full benefits) are eligible for a benefit check. You can start to get benefits at 62 The expected present value of benefits is roughly the same if you start receiving benefits anywhere from 62 to retirement age From retirement age until 70 you receive more by retiring later, but generally a lower expected present value At age 70, there is no earnings test-you can receive full benefits even if you work Before age 70 benefits are much lower if you work while receiving benefits 7

88 The amount of the benefit check is a factor (1 plus.5 times the number of dependents) times the Primary Insurance Amount (PIA, the amount single retirees receive in a monthly check if they retire at their retirement age). The PIA is a function of the Average Index of Monthly Earnings (AIME, the monthly average of the 35 highest earnings years adjusted for wage inflation) Benefits adjusted each year for wage inflation Primary insurance goes up with AIME, but at a decreasing rate As an example consider the current relationship

99 Relationship between PIA and AIME (both in $1000s) These guys paid double what these guys paid But they get less than double the benefits

10 Changes to Social Security Tax Rate %; % (6.2% excluding Medicare) Maximum Taxable Earnings 1935 $1000; 2011 $106,800 Retirement Age years of age; 2009 (Depends on the year of birth) 1938->65+2 months; 1939->65+4 months; 1940->65+6 months; 1941->65+8 months; 1942->65+10 months; >66; 1955->66+2 months; 1956->66+4 months; 1957->66+ 6 months; 1958->66+8 months; 1959->66+10 months; 1960 on 67 Coverage 1935 Old age; 2007 Old age + Medicare + Disability + Survivor 10

11 Social Security’s Impact on the Economy Work (lower) People retire earlier than they otherwise would have. People work less that they otherwise would have. Saving (in net lower) – Asset Substitution Effect: government is saving for you, you will save less for yourself – Induced Retirement Effect : because people need to save more if they are going to retire earlier than they would have without Social Security. – Bequest Effect: increases national savings because people save more so as to give larger gifts to their descendants 11

12 Who is the Program Good For People who retired before 1980 received, on average, more than they would have in private alternatives. People who retired between 1980 and 2000 received ______ than they would have in private alternatives More (if they were poor) Less (if they were wealthy) People who retire today will receive less than they would have in private alternatives. 12

13 Using Present Value To compute the value of Social Security to an individual, a person would Use a reasonable low-risk real rate of interest (3-5%) Compute the present value of expected Social Security taxes to be paid. Compute the present value of expected Social Security benefits to be received. Subtract the present value of costs from the present value of benefits to get the net present value. I am not going to work it out exactly, but a single worker beginning today can expect a negative net present value. 13

14 Will the System Be There for Me? The Social Security Trust Fund a fund set up in 1982 in order to hold government debt which will be sold as necessary when tax revenues are less than benefits The trust fund is not an asset but more accurately the ability for the government to reborrow money it had previously repaid. 14

15 Why is Social Security in Trouble The number of workers per retiree Was above 40 in 1940 Fell to around 5 in the 1980s and 1990s Will eventually fall to under 3. This demographic problem resulted from the baby- boom ( ). 15

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17 Estimates of Social Security’s Bankruptcy An organization is bankrupt if it has insufficient assets to pay off its obligations. Estimates suggest that Social Security will be “bankrupt” in the 2040s. “bankrupt” is not necessarily the correct term because the government could borrow to continue to pay benefits. 17

18 Options of Saving Social Security raising payroll taxes Raise the tax rate Eliminate the maximum taxable earnings raising the retirement age further cutting benefits with a Means Test those with high incomes or great wealth would get less of their PIA than those who depend on the monthly check reduce the adjustment for inflation to price inflation rather than wage inflation (perhaps only for upper income recipients) investing the trust fund in corporate stocks and bonds carving out some of the payroll tax for privatized individual accounts. 18

19 Private Accounts To motivate, there are two kinds of pensions Defined Benefit Defined Contribution In a defined contribution system you have control over where the money goes and how it is invested This on average has a higher return Also exposes people to more risk-if stock market crashes you lose a lot of money Might not want/probably not feasible for Social Security to be nothing but private accounts Also not obvious that there should be no private accounts 19