Why Have Social Security? Consumption Smoothing and the Annuity Market How Social Security works Consumption smoothing Insurance (annuity and life insurance): - Risk of living too long, not having accumulated enough assets (Annuity) Risk of dying too young leaving family without sufficient assets (life insurance) Adverse Selection and the Annuity Market Asymmetric information Adverse selection and life expectancy Death spiral => incomplete market

Other Justifications Lack of foresight and paternalism Moral hazard Economize on decision-making and administrative costs Income Redistribution

Fully Funded Plan (Problematic issue?) Period 1 Period 2 Period 3 Period 4 Generation 1 Work Retire Dead Still Dead contribute benefits Each generation’s benefits based on deposits it made during working life plus accumulated interest The Baby Boom Generation Retire Childhood Work Dead contribute benefits Unborn Childhood Work Retire Generation X contribute benefits

Pay As You Go (or Unfunded) System (problematic issues?) Period 1 Period 2 Period 3 Period 4 Each generation’s benefits come from tax payments made by current workers contribute benefits Generation 1 Work Retire Dead Still Dead contribute benefits The Baby Boom Generation Work Retire Childhood Dead contribute benefits Unborn Childhood Work Retire Generation X benefits

Today’s Partially Funded System (problematic issue?) Period 1 Period 2 Period 3 Period 4 contribute benefits Baby Boomers and Gen X are also contributing to their own retirement Generation1 Work Retire Dead Still Dead contribute benefits The Baby Boom Generation Work Retire Childhood Dead contribute benefits Unborn Childhood Work Retire Generation X benefits

Distributional Issues for a pay as you go system Retirement insurance programme Actuarially fair return Benefits equal the premium paid (average life span) Intergenerational redistribution in a pure p-a-y-g Total benefits = Nb * B Total taxes = t * Nw * w If total benefits = total taxes (in equilibrium): > Nb * B = t * Nw * w or B = t * (Nw/Nb) * w

Distributional Issues Nb * B = t * Nw * w or B = t * (Nw/Nb) * w What are the implications? Can B increase? Given t constant: Either Nw (relative Nb) or w must increase If both constant => B = w*t => Implications on the Implicit rate of return If w=1.5% population =1% => IRR = 2.5% (about) Or any combination of w and population growth Note: Population ageing and productivity 11-7 7

What if t increases? t higher => who gains (IRR)? => Sustainable increases of IRR only on w and Pop At the start of the system extraordinarily high returns! Ida May Fuller the first ss beneficiary Work 3 ys retired 65 died 99 Opposite case for ending system (or changing it) Graduality of reforms! HOMEWORK: How would it apply or not a selfish politician who wants to be re-elected referring to the median voter model

Other Distributional Issues Redistribution within a generation Differences by earnings Differences by lifespan Differences by living arrangements Differences by number of earners in the family Normative evaluation

Social Security and Savings Behavior Life-cycle theory of savings Wealth Substitution Effect Retirement Effect Bequest Effect

Budget Constraint for Present and Future Consumption At endowment point (A) consumer neither saves nor borrows Future consumption (c1) D I1 + (1+r) S (1+r)S B A I1 (1+r)B S F I1 - (1+r) B M I0 - S I0 Present consumption (c0)

Utility-maximizing Choice of Present and Future Consumption Future consumption (c1) E1 c1* A I1 Saving M c0* I0 Present consumption (c0)

Crowding out of private saving due to Social Security Future consumption (c1) E1 c1* R A I1 (1+r)T Saving after Social Security T Saving before Social Security M c0* I0T I0 Present consumption (c0)

Empirical Evidence: Does Social Security Reduce Saving? Time-series evidence Martin Feldstein (1974, 1996) v. Leimer and Lesnoy (1982) Cross-section evidence Evidence from other countries Attanasio and Brugiavini (2003) and Italy

Other ways Social Security Affects Saving Retirement effect Bequest effect Empirical evidence

Retirement Decisions Social Security wealth and the retirement decision Empirical evidence Diamond and Gruber [1999] Gruber and Wise [2004]

Long-Term Stresses on Social Security Projected revenues and projected costs of Social Security as share of Gross Domestic Product Source: Social Security Trustees [2012] 11-17

Long-Term Stresses on Social Security Since: B = t * (Nw/Nb) * w Rearrange: t = (Nb/Nw) * (B/w) Dependency Ratio Replacement Ratio

Social Security Reform Time horizon for solvency Sustainable solvency

Maintain the Current System Raise the payroll tax Raise the Maximum Taxable Earnings Level Raise the Retirement Age Reducing the Cost-of-Living Adjustment Change the Benefit Formula Comparing the Options

Homework Exercise 3 page 249 and 6 page 250