Health, Wealth & Workforce Exit: Disability Insurance, Individual Accounts & Social Security Reform Jason Seligman

Social Security Reform in the United States To date the United States has held its public pension to be a defined benefit (DB) program However many have suggested moving from a (DB) to a defined contribution (DC) plan. Two questions: -1- Is a DC Disability Program viable in the same way a DC Retirement program might be? -2- What might the impact of a DC structure for retirement programs on an interrelated DB Disability Program? (two variants considered as will be shown)

Why Consider Disability in this Context? Disabled individuals exit the workforce ahead of retirement age and thus have less opportunity to save, The DI trust fund is in worse financial shape than the retirement trust fund By design the DI and OASI programs are very integrated. Thus changes to the Nation’s retirement program may affect it’s disability program. Changes may have possible implications for other federal and state benefit programs as well. (SSI, Medicare, Medicaid)

Even without a change in Social Security, the DI program can look attractive to an elderly worker, –Award is made for full Normal Retirement Age benefit, not discounted for early retirement –For recipients age 63 and younger, a DI award comes with expanded Medicare eligibility. –However- you cannot work and apply for DI… Thus DI application is likely most attractive to the long term unemployed, and those between the Early and Normal Retirement Age who wish to exit the labor force The Current DI Application Decision

Disability Insurance Application Over Time

The behavioral DI literature relies on -a- An initial stock of potential applicants who could successfully apply to the program, but who do not. -b- Some change in relative prices to foster new interest in application. Black, Daniel and Sanders (1998) is a nice example of this sort of thing using a population of coal miners. Generally there is some evidence Unemployment changes relative prices, application and awards increase DI Application Behavior

Considering Disability and IA Pensions IA retirement return simulation 74 cohorts retiring between 1929 – 2003 Returns if Disabled 11 yrs before retirement (I) Can an Individual Account (IA) finance disability & thus replace DI? (II) How might a Defined Contribution Pension (IA) and Defined Benefit Disability Insurance (DI) Interact? With Account Forfeiture Individuals forfeit IA balance for DI uptake with benefits through mortality Without Account Forfeiture “Serial Participation” SSA replaces IA contribution stream through retirement, at retirement individual receives DC account balance II a II b I a I b

Basic approach: Calculate DC returns from withholdings invested in the S&P 500, with dividend rollover and experience weighted lifetime wage profile. Consider likely DC account balances for the disabled –Can disability likely be financed by the Account? –If not, how will a disability program interact with Accounts? Consider implications of a behavioral model with discrete workforce exit and disability insurance uptake in the context of DC Pensions –If individuals forfeit their account for a lifetime benefit –If SSA contributes to DC pension accounts for the disabled, handing back the account for retirement Interacting Disability Insurance and DC Pensions

To calculate returns and account balances one needs: Earnings: -Manufacturing Wages Historical Statistics of the United States Age-Earnings Profile: -Census 2000 Supplementary Survey Historic Stock Returns: -S&P 500 returns A Price Deflator: -Robert Shiller’s constructed PPI which goes back to the 1870’s Assumptions: - People work 40 continuous years before retiring (age 22 – 61) - All dividend income is reinvested each year - SSA calculations assume all beneficiaries are single, with no survivors - Individual Account balance is drawn down over 20 years Calculating Individual Account Returns

Simple Comparisons of Accounts by Type

Survivorship and Disability in Later Working Years

Comparisons of Accounts Balances -- Retirement

Comparisons of Accounts Balances -- Disability

Let:  = Pr (eligible | health).  = life expectancy | age & health (health self assessed perhaps).  = discount rate.  = expected cost of obtaining medical evidence.  = expected value of 1 months Medicare coverage.  = (NRA – current age in months). age = age of individual considering exiting the labor force = NRA - . PV = present value as a function of , . PIA= the SSA primary insurance amount at Normal Retirement Age. w = monthly wage and benefits.  = the withholding rate assigned to employers – ½ total withholding. = disutility of working one additional month.  = market valuation of retirement account at end of period. Program Interaction Modeling the Application Decision

Value of DB Disability Benefit : 1.E(DI) =  PV[(PIA(  -5) + (max {0, (  -24)-age}  )] -  value of Medicare benefits Value of working an additional month with DC pension is: 2. E(W t ) = w (1+  ) - +  (E (  t+1 )/  (age) +  (E (DI))/  (age) Where: 3.  = 2  w t +  t-1 /  tDC account value 4.  (E(DI))/  (age) =  PV(-  ) if medicare insured, else 0 5.  (W t )/  (age) average real wage growth Workforce Participation vs DI Claim

Consider an unemployment shock which lowers the opportunity cost of application: This is akin to letting w=0 & =0 in formula 2. Value of an additional month is now: 6. E(W t | w=0, =0) =  (E (  t+1 )/  (age) +  (E (DI))/  (age) With required forefiture of the DC pension balance, in excange for lifetime receipt of the DB plan benefit, remaining in the labor force hinges on: 7.  (E (  t+1 )/  (age) >  (E(DI))/  (age) -- Assuming feasibility (suffuicent savings) Valuation of DI Claim with Account Forefiture

Notice again that the previous inequality: 7.  (E (  t+1 )/  (age) >  (E(DI))/  (age) Depends on expectations regarding finacial market prices through E (  t+1 ). Any short run correlation in labor and equity markets may motivate an increase in DI applications By comparison a Serial Participation option does not allow the disabled to trade a DC pension for a fixed DB benefit but does include a contribution to the workers DC account as part of a Disability Benefit DI Application Decision with Serial Participation

Behaviorally agents will value this program differently- 1.(+) DI benefit now includes contributions to DC pension 2.(+/-) Eligible can no longer substitute to a DB plan for life i.(+)Those with high balances will be relieved not to have to forfeit their accounts ii.(-) The risk adverse, and those with low account balances will see this as a negative However those with low account balances may be more likely to have low contingent savings as well, in which case they may have no option but to apply The DI Application Decision -- Serial Participation

Results suggest IA financed disability would increase demand for SSI. SSI is financed by general funds, as such the fiscal burden on federal and state governments would likely increase as a result. A DI program brings a new set of incentives in this context, application and acceptance would likely increase in either of the two interacted Defined Benefit programs described here. This would impact deamnds on the Medicare and Disability Trustfunds. Policy makers considering OASI reform should consider the DI program and these interactions in the design phase of any reform, to avoid unintended consequences Summary and Conclusions

Thank you Jason Seligman