SOCIAL SECURITY: How It Works and How to Fix It by Jon Forman Professor in Residence IRS Office of Chief Counsel, Room 3501 & Alfred P. Murrah Professor of Law University of Oklahoma Norman, Oklahoma

2 Overview  How Social Security Works Financing Social Security How Benefits Are Determined  Financial Troubles  How to Fix It Raise Taxes Cut Benefits Increase Investment Returns  A two-tier System

3 How Many People Get Social Security?  52 million people receive Social Security each month  1 in 6 Americans get Social Security benefits  Nearly 1 in 4 households get income from Social Security National Academy of Social Insurance, Social Security Finances: A Primer 4 (2008).

4 Who Gets Social Security? (June 2009 Beneficiary Data)  33 million retired workers  2.9 million dependents  7.6 million disabled workers  1.8 million dependents  6.4 million survivors Social Security Administration, Social Security Basic Facts (2009),

How Much Does Social Security Pay? (June 2009 Beneficiary Data)  Retired workers $1,159 average monthly benefit  Disabled workers $1,062 average monthly benefit  Survivors $1,118 average monthly benefit 5 Social Security Basic Facts.

6 Social Security and Poverty  2009 Poverty Levels Single individuals – $10,830 ($903/month) Married couples – $14,570 ($1,214/month)  With Social Security only 9% were poor (in 2000)  Without it, 48% would have been poor 2009 HHS Poverty Guidelines, Social Security Administration, Social Security Bulletin: Annual Statistical Supplement: 2001 (2002), at 9.

7 Financing Social Security  Social Security taxes  Workers pay 6.2% of their earnings for Social Security, and 1.45% of their earnings for Hospital Insurance under Medicare (Part A)  Employers pay an equal amount  The total is 12.4% for Social Security and 2.9% for HI  Tax base is $106,800 in 2009 Unchanged for 2010 Social Security Administration, Contribution and Benefit Base (2009),

8 Worker Benefits  Workers over 62 are eligible If they have worked 10 years  Benefits are based on a workers earnings history Career-average earnings Average Indexed Monthly Earnings (AIME)

9  Determine how much the worker earned every year through age 60 Determine Benefit Computation Years And Earnings in those years  Index those Earnings for Wage Inflation Up to the year the worker turns 60  Subsequent Work Years Also Count  Pick the Highest 35 Years Drop the rest Social Security Administration, Benefit Calculation Examples for Workers Retiring in 2010 (2009),

10 Average Indexed Monthly Earnings (AIME), continued  Add those highest 35 years of earnings up  Divide by 35; Divide by 12  Result is called Average Indexed Monthly Earnings (AIME)  AIME is then linked by formula to the basic retirement benefit The Primary Insurance Amount (PIA) Paid at full retirement age

11 Full Retirement Age Social Security Administration, Full Retirement Age, Year of BirthFull Retirement Age 1937 or earlier plus 2 months per year 1942 – plus 2 months per year 1960 and later67

12 Primary Insurance Amount (PIA)  For a worker turning 62 in 2010, PIA = 90% of first $761 of AIME + 32% of AIME from $761 to $4,586 (if any) + 15% of AIME over $4,586 (if any)  $761 and $4,586 are called bend points  PIA indexed by cost of living after 62  Provides higher benefits relative to earnings for lower paid Social Security Administration, Benefit Formula “Bend Points” (2009),

13

14 Social Security Basic Facts; Social Security Finances: A Primer, 7.

15 Worker Benefits: Increases and Decreases  Indexed for inflation  Actuarial decrease for early retirement  Actuarial increase for later retirement 8 percent per year Example: maximum-wage worker, 62 in 2010  Will have AIME of $7,949  Will get $1,820 per month at age 62  Or $2,191 per month at age 65  Or $3,119 per month at age 70 Social Security Administration, Workers with Maximum Taxable Earnings (2009),

Retirement Earnings Test  Applies only to people below normal retirement age (NRA), which ranges from age 65 to 67 depending on year of birth.  In 2010, early retirees lose $1 of benefits for each $2 of earnings over $14, Social Security Administration, Exempt Amounts Under the Earnings Test (2009),

17 How many people rely on Social Security for most of their income?  90% of people 65 and older get Social Security  Social Security represents 40% of the income of the elderly  Nearly 2 in 3 (66%) get half or more of their income from Social Security  About 1 in 5 (22%) get all their income from Social Security Social Security Basic Facts; Social Security Finances: A Primer, 8.

Reliance on Social Security Benefits by Race  Percent of beneficiaries who receive half or more of their income from Social Security 65% of Whites 74% of Blacks 67% of Asians 78% of Hispanics  Percent of Beneficiaries who receive all of their income from Social Security 19% of Whites 40% of Blacks 28% of Asians 43% of Hispanics 18 Social Security Finances: A Primer, 9.

Most elderly don’t receive pensions Percent with Employer-Sponsored Pensions All age 65+41% Couples51% Unmarried men42% Unmarried women34% 19 Social Security Finances: A Primer, 10.

20 How are Benefits Projected to Change in the Future?  Benefits will grow faster than prices, but slower than wages.  The increase in the full benefit age from 65 to 67 over the next 20 years means that benefits will replace a smaller share of retirees’ past earnings. Social Security Finances: A Primer, 11.

21 Under Current Law Net Replacement Rates will Decline  An average earner at 65 today gets a benefit that replaces about 39% of earnings after deducting Medicare premiums.  A similar earner age 65 in 2030 will have a benefit that replaces about 32% of earnings Higher age for full benefits lowers wage replacement at 65 Medicare premiums will take a bigger bite Virginia P. Reno, Are Social Security Benefits Adequate? 4 (2009),

22 Family Benefits  Spouses, dependents, and survivors  Husband or wife gets 50% of worker’s PIA Together, couple gets 150%  Widow or widower gets 100% of worker’s PIA  A joint and two-thirds survivor annuity  Dual entitlement rule limits benefits

23 The Need for Reform  Social Security is in financial trouble and will not be able to meet its future benefit commitments.  Social Security redistributes payroll tax revenues in many ways that are quite simply unfair.

24 Estimates for 2009 Finances Trust Fund income = $819 billion (taxes) Trust Fund outgo = $682 billion (benefits) Surplus = $137 billion By law, surpluses are invested in U.S. government securities and earn interest that goes to the trust funds Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds 41 (2009),

25 How do actuaries estimate the future?  Review the past: birth rates, death rates, immigration, employment, wages, inflation, productivity, interest rates  Assumptions for the next 75 years  Three scenarios: Low cost; High cost; Intermediate (best estimate)

26 The Long-Range Forecast (Best estimate)  In 2016, tax revenues into the trust funds forecasted to be less than benefits due that year. Interest on the reserves and the assets themselves will help pay for benefits until  In 2037, reserves are projected to be depleted. Income is forecast to cover 76% of benefits due then.  By 2083, assuming no change in taxes, benefits or forecasts, revenue would cover 74% of benefits due then Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, 9.

2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, 10.

2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, 12.

2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, 13.

Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, 15.

31 Social Security’s Financing Problem  2009 Trustees Report shows Expenses will exceed payroll tax income in 2016 Trust funds will be out of money in 2037  75-year deficit equals around 2% of taxable payroll Immediate payroll tax increase of 2% needed to restore actuarial balance Alternatively, immediate ~13% across-the-board benefit cut $5.3 trillion unfunded liability (over 75 years) About 0.7% as a share of the entire economy (GDP) 2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, 2-3.

32 Unfunded Obligations (Present values as of January 1, 2009; trillions of dollars) Present value As a % of future payroll As a % of GDP Over the next 75 years Over the infinite horizon $ Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, 63 (table IV.B6).

33 Why is the deficit so much smaller as a share of GDP?  The answer is because Social Security taxable wages are only a relatively small part of GDP. Wages taxed for Social Security are 39 percent of GDP. The other 61 percent of national income is not taxed to help pay for Social Security. Social Security Finances: A Primer, 30.

34 What is that non-taxable income?  Income not subject to Social Security taxes includes: Earnings above the tax cap ($106,800 in 2009 & 2010) Tax exempt compensation (non-taxable fringe benefits, tax-deferred accounts, etc) Wages of about one in four state and local workers who are not covered by Social Security Income from property – stock dividends, interest, and rental income. Social Security Finances: A Primer, at 31.

Social Security Shortfall and Other Policy Changes  The Social Security shortfall over the next 75 years is smaller than the lost revenue from making permanent the tax cuts of 2001 and The Social Security shortfall is about one-third the size of the tax cuts over the next 75 years. Social Security deficit 0.56% of GDP Tax cuts made permanent1.95% of GDP 35 Social Security Finances: A Primer, at 32.

36 Only 3 Ways to Fix Social Security  Raise Taxes  Cut Benefits  Increase Investment Returns Private investment Either government or individual

37 Second problem: Social Security Redistributes Economic Resources  Evaluate the program’s impact over the course of a worker’s lifetime.  Compare Social Security taxes paid by a worker and expected benefits.  Linkage between the Social Security taxes and benefits is loose.  Can vary dramatically depending on such factors as family status, income, and age.

38 Social Security favors  Early generations of retirees over later generations,  Workers with low career-average earnings over workers with high career-average earnings,  Married couples over singles individuals,  One-earner couples over two-earner couples,  Larger families over smaller families, and  Elderly retirees over elderly workers.

39 Social Security's Transfer of Wealth Among Generations by Each Cohort's Year of Birth (Billions of 2003 dollars) Congressional Budget Office, How Pension Financing Affects Returns to Different Generations (2004).

OPTIONS  Raise Taxes  Cut Benefits  Increase Investment Returns  Sources: National Academy of Social Insurance, Fixing Social Security: Adequate Benefits, Adequate Financing (2009), Craig Copeland, Social Security Reform: How Different Options Might Affect Future Funding, 30(9) ebri.org Notes 13 (2009). American Academy of Actuaries, Social Security Reform Options (2007), Center for Retirement Research at Boston College, The Social Security Fix-It Book (2007), it_book.html. it_book.html National Academy of Social Insurance, Options to Balance Social Security Over the Next 25 Years (2005),

41 Options: Raise Taxes OPTION  Increase tax rate by 2% total  Tax all earnings  Tax 90% of earnings  Include new state & local govt. workers  Tax SS benefits like pensions % of Deficit Eliminated 104% 93% 40% 10% 20%

42 Options: Cut Benefits OPTION  Raise retirement age (to 67 faster & index)  Reduce COLA by ½% each year  Cut benefits by 5% for those starting to get benefits in 2005  Increase # years in wage avg. to 40 % of Deficit Eliminated 28% 41% 32% 21%

43 Options: Increase Investment Returns OPTION  Investments in equities % of Deficit Eliminated 36% - 50%

44 Long-term Reform  Social Security should ensure that every elderly American has an adequate retirement income  We could redesign the system  Two-tier system First tier: poverty-level benefit Second tier: earnings-related benefit Earnings sharing

45 First Tier: Basic Benefit  Government guarantee of poverty-level income  2009 Poverty Levels Single individuals – $10,830 ($903/month) Married couples – $14,570 ($1,214/month)  Would replace SSI and redistribution within the current SS system  Pay for with general revenues

46 Second Tier: Earnings-related Benefit  Individual accounts Hypothetical (“cash balance”) accounts Invested by professionals  Pay for with payroll taxes  Pay out lifetime annuities Inflation-adjusted annuities

10% Individual Accounts  Workers work every year between ages 22 and 65  Each worker contributes 10% of payroll up to Social Security taxable maximum  3% annual real return (6% nominal; 3% inflation  Money must remain in the account until age 65 and then must be annuitized  In the long run, these accounts would replace around 45% of final wages Jonathan Barry Forman, Should We Replace the Current Pension System with a Universal Pension System, 16(2) Journal of Pension Benefits (Winter 2009)

48 Earnings Sharing  Credit each spouse with one-half of couple’s combined earnings during marriage  At retirement, each spouse’s benefit would be based on her half of the couple’s earnings, plus her prior earnings  Would replace spousal benefits

49 Conclusions  $5.3 Trillion Unfunded Liability  Oldest baby-boomers are 62  Social Security should provide adequate incomes throughout retirement  Reform is needed

About the Author  Jonathan Barry Forman (“Jon”) is the Professor in Residence at the Internal Revenue Service Office of Chief Counsel, Washington, DC, for the academic year; the Alfred P. Murrah Professor of Law at the University of Oklahoma College of Law, teaching tax and pension law; and the author of Making America Work (Washington, DC: Urban Institute Press, 2006).  Prior to entering academia, Professor Forman served in all three branches of the federal government. He has a law degree from the University of Michigan and master’s degrees in both economics and psychology.  Jon can be reached at  Slides, etc. at 50