Examining Retirement Security Chief of Staff Retreat February 20 – 22, 2009 copies of this presentation can be found at 1

2 Defined Benefit vs. Defined Contribution Operative difference is one of risk.  Defined benefit plan puts risk on the plan provider.  Defined contribution plan puts risk on the worker.

3 Defined Benefit vs. Defined Contribution Since returns are commensurate with risk:  Defined benefit plan yields a lower return (generally).  Defined contribution plan yields a higher return (generally). * Warning: Defined benefit plans can hide risk. There are limits on PBGC and legal challenges are possible.

4 Since 1985, defined contribution plans have displaced defined benefit plans.

Aged unit = Husband and wife age 65 or older, or a single person age 65 or older. Asset income = income generated from savings, CDs, stocks and mutual funds, real estate. Pensions include both defined benefit and defined contribution plans. Asset Income Pensions Social Security Public Assistance Wage Earnings Proportion of “Aged Units” Receiving Each Income Type 5 90% of aged units obtain income from private retirement accounts.

Share of Aged Income by Source 6 Asset income = income generated from savings, CDs, stocks and mutual funds, real estate. Pensions include both defined benefit and defined contribution plans. Private retirement accounts generate 33% of the aged’s incomes.

Aged unit = Husband and wife age 65 or older, or a single person age 65 or older. White Non-married Married Couples Black Median Real Income of Aged Units 7

Share of Aged Income by Source and Income Level 8 Private retirement accounts generate 40% of income. Private retirement accounts generate 6% of income. Earnings account for a large share of income.

Who pays the Social Security tax? 9

10 Statutory Burden vs. Economic Burden The statutory burden is shared by the employer and the employee (6.2% each). What is relevant is the economic burden. Example If a gallon of gas sells for $1.75 when there is no tax, but $2.00 (including tax) when the government requires the seller to pay a $0.50 tax per gallon, then the statutory burden is on the seller, but the economic burden is shared equally by the buyer and seller.  In response to the tax, the seller lowered his price by $0.25.

11 Demand Supply $1.75 $1.50 $2.00 $0.50 tax Seller pays $0.25 per unit Buyer pays $0.25 per unit

12 Demand Supply No Tax Price Price Price plus Tax Worker pays this Employer pays this Workers supply labor. Employers demand labor. If the economic burden of the Social Security tax were the same as the statutory burden, the economic burden would look like this. Jobs

13 Demand Supply No Tax Price Price Price plus Tax Demand becomes more elastic (i.e., “buyers become more sensitive to price changes”) when there are more alternatives to buying this product. Jobs Worker pays more Employer pays less Intuitively: The more alternatives to hiring (e.g., spread the work load to other workers, automation, etc.) the employer has, the more able the employer is to pass on the tax to the worker in the form of lower wages.

14 Demand Supply No Tax Price Price Price plus Tax Workers supply labor. Employers demand labor. Jobs Worker pays this Employer pays this

15 Demand Supply No Tax Price Price Price plus Tax Supply becomes less elastic (i.e., “sellers become less sensitive to price changes”) when the seller has fewer alternatives to selling. Jobs Worker pays more Employer pays less Intuitively: The fewer alternatives to employment the worker has, the more able the employer is to pass on the tax to the worker in the form of lower wages.

16 Who Bears the Social Security Tax Burden The full economic burden (12.4%) of the Social Security Tax is more likely to fall on the worker when: 1.The employer has more alternatives to hiring the worker. 2.The worker has fewer alternatives to working for the employer.  Lesser skilled workers are more likely to bear the entire cost of the Social Security tax.  Studies suggest that almost all workers bear the entire cost of the Social Security tax.

What are Social Security retirement benefits worth? 17

18 Three ways to evaluate the benefit of an investment 1.Internal Rate of Return 2.Net Present Value 3.Breakeven Point * Technically, Social Security is neither a defined contribution plan because tax receipts are not earmarked for the individual, nor is it a defined benefit plan as Congress can unilaterally alter the terms at any time.

19 Internal Rate of Return The effective interest yield after accounting for monies paid in, monies received, and the timing of each. Example Pay $100 each year for 10 years and receive back $1,500 at the end of the 10 th year. IRR = 10%

20 Net Present Value The “cash in hand” equivalent value of a stream of future payments. Example Pay $100 today and receive back $200 at the end of the year (suppose you can earn 10% on your money elsewhere). NPV = $74  the deal is equivalent to someone giving you $74 right now.

21 Breakeven Time required for accumulated benefits to offset accumulated costs. Example Pay $100 today and receive back $10 at the end of each year. Breakeven = 10 years

What are Social Security retirement benefits worth? Internal Rate of Return 22

Expected Annual Cash Flows from Social Security (HS Education) Cash flows are in 2006 dollars and assuming median wages, median probability of employment for white males, and economic burden on the worker. 23 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census Effective real rate of return = –1.8% Decline in benefits is due to mortality. Upon death, an individual’s Social Security benefits cease.

Expected Annual Cash Flows from Social Security (College Education) 24 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census Effective real rate of return = –3.4% Cash flows are in 2006 dollars and assuming median wages, median probability of employment for white males, and economic burden on the worker. Decline in benefits is due to mortality. Upon death, an individual’s Social Security benefits cease.

What are Social Security retirement benefits worth? Net Present Value 25

Net Present Value of Social Security by Race, Gender, and Education NPV is at age 20 and assumes retirement at age 66, economic burden on the worker, median wages, median probability of employment, 2% real rate of return, and 1% real discount rate. 26 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census NPV is more negative for blacks than for whites due to differences in mortality. NPV is more negative for college graduates than for high school graduates.

What are Social Security retirement benefits worth? Is NPV positive for anyone? 27

Net Present Value of Social Security at Age 18 Wage (shared burden) NPV assumes retirement at age 66, median wages, median probability of employment, 2% real rate of return, and 1% discount rate. 28 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census Assuming that the employer and worker equally share the tax burden, Social Security has a positive net present value only for workers with starting incomes under $25,000.

Net Present Value of Social Security at Age 18 Wage (burden on worker) NPV assumes retirement at age 66, median wages, median probability of employment, 2% real rate of return, and 1% discount rate. 29 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census Assuming that the worker bears the entire tax burden, Social Security has a positive net present value only for workers with starting incomes under $6,000.

What are Social Security retirement benefits worth? Breakeven Point 30

Cumulative SS Benefits Less Payments (shared burden) Assumes retirement at age 66, median wages, median probability of employment for white males, economic burden on the worker. 31 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census The median white male with a high school education breaks even at age 83.

Breakeven Point for Social Security Benefits Assumes retirement at age 66, median wages, median probability of employment, economic burden on the worker. 32 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census

How does a 401(k) compare? (it depends) 33

Expected Annual Cash Flows from Social Security and 401(k) (HS Education) Cash flows are in 2006 dollars and assuming median wages and median probability of employment for white males, and a 2% real rate of return on the 401(k). 34 Average withdrawal from privatized account is 4 times the average Social Security payment. (1.7 times ignoring mortality) Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census Expected withdrawals if 12.4% of the employee’s wages had been invested in a private retirement account. Expected Social Security benefits.

Expected Annual Cash Flows from Social Security and 401(k) (College Educ.) Cash flows are in 2006 dollars and assuming median wages and median probability of employment for white males, and a 2% real rate of return on the 401(k). 35 Average withdrawal from privatized account is 6 times the average Social Security payment. (2.7 times ignoring mortality) Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census

Net Present Value of 401(k) by Race, Gender, and Education NPV is at age 20 and assumes retirement at age 66, median wages, median probability of employment, 2% real rate of return, and 1% real discount rate. 36 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census

Breakeven Point for 401(k) Returns Assumes retirement at age 66, median wages, median probability of employment, 2% real rate of return. 37 Compiled from data published in 2006 Statistical Abstract of the United States, U.S. Bureau of the Census

38 “There’s just no guarantee that when you’re ready to retire you’re going to have the money.” –A 35 year old project manager in response to the 44% drop in her 401(k) since last year. “This is the biggest test that the 401(k) plan has seen…and it has failed.” –A retirement consultant commenting on the 50% loss incurred by some workers close to retirement. Wall Street Journal, 1/8/09

Source: 3-Month Treasury Bill Rate 39

Source: 6-Month CD Rate 40

Source: 41 DJIA Growth Rate

42 In your dreams. Social Security (exaggerated) (it’s worse than this)

43 The Wrong Discussion The discussion on Social Security versus private retirement is typically about safety. This is the wrong discussion on two counts: 1.Where investments are concerned, it’s never about safety; it’s always about the tradeoff of safety versus return. 2.Social Security is not only not safe, it is arguably more risky than equities.

Average Nominal Rates of Return 1953 to 2003 Compiled from data published in 2003 Statistical Abstract of the United States, U.S. Bureau of the Census, and provided by the Social Security Administration 44 Treasury Bills are safer than Social Security retirement benefits, yet the effective rate of return on SS benefits is less than half the rate of return of Treasury Bills.

45 The sooner we take action, the less pronounced the action need be.

46 Possible Solutions: Tweaks (Diamond and Orszag) Raise the earnings cap.  Risks reducing work incentive for entrepreneurs. Increase the retirement age.  Life expectancies have increased by 5 years since Reduce benefits.  Benefits have been growing faster than inflation.

47 Possible Solutions: Delayed Opt Out Allow workers to opt-out of Social Security after having paid in for some number of years. Workers forego all retirement benefits in exchange for diverting the remaining 12.4% tax to private retirement accounts.  A college educated white male is equally well off opting out of Social Security as late as age 55.  A high school educated white male is equally well off opting out as late as age 50.

Examining Retirement Security Chief of Staff Retreat February 20 – 22, 2009 copies of this presentation can be found at 48

Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table 668. % of Households in Each Income Bracket (2006$) 49

From 1980 to 1990, the number of households with purchasing power of at least $75,000 grew while the number with purchasing power less than $75,000 declined. % of Households in Each Income Bracket (2006$) Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table

From 1990 to 2006, the number of households with purchasing power of at least $75,000 grew while the number with purchasing power less than $75,000 declined. % of Households in Each Income Bracket (2006$) Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table

In which world would each person rather live? (prices are the same in the two worlds) In world #1, Person 10 earns 10% of all income. In world #2, Person 10 earns 15% of all income.