SOCIAL SECURITY: How It Works and How to Fix It Jonathan Barry Forman (“Jon”) Alfred P. Murrah Professor of Law April 2008

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?  Almost 50 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 Social Security Basic Facts, National Academy of Social Insurance, Social Security Finances: A Primer (2005)

4 Who Gets Social Security?  31.5 million retired workers  2.9 million dependents  7.1 million disabled workers  1.8 million dependents  6.5 million survivors Social Security Basic Facts,

5 How Much Does Social Security Pay? Type of BeneficiaryAverage Monthly Benefit All Retired Workers$1,079 Aged widow(er), non-disabled$1,041 Disabled worker$1,004 Aged couple-both receiving$1,761 Widowed mother and two children$2,243

6 Social Security and Poverty  2008 Poverty Levels Single individuals – $10,400 ($867/month) Married couples – $14,000 ($1,167/month)  With Social Security only 9% were poor (in 2000)  Without it, 48% would have been poor

7 Financing Social Security  Social Security taxes  Workers pay 6.2% of their earning 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  2008 tax base is $102,000 in

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

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 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 2008, PIA = 90% of first $711 of AIME + 32% of AIME from $711 to $4,228 (if any) + 15% of AIME over $4,228 (if any)  $711 and $4,228 are called bend points  PIA indexed by cost of living after 62  Provides higher benefits relative to earnings for lower paid

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14 How do benefits compare to earnings? Retired worker age 65, 2005

15 Worker Benefits: Increases and Decreases  Indexed for inflation  Actuarial decrease for early retirement Example: average-wage worker, 62 in 2008 Will get $1, per month at her full retirement age of 66 or $1,083 per month at 62  Actuarial increase for later retirement 8 percent per year  Retirement Earnings Test In 2008, early retirees lose $1 of benefits for each $2 of earnings over $13,

16 How many people rely on Social Security for most of their income?  90% of people 65 and older get Social Security  Social Security represents 39% 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, National Academy of Social Insurance, Social Security Finances: A Primer (2005);

17 Most elderly don’t receive pensions Percent with Employer-Sponsored Pensions All age 65+41% Couples51% Unmarried men39% Unmarried women32% National Academy of Social Insurance, Social Security Finances: A Primer (2005)

18 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

19 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.

20 Estimates for 2007 Finances Trust Fund income = $785 billion (taxes) Trust Fund outgo = $595 billion (benefits) Surplus = $190 billion By law, surpluses are invested in U.S. government securities and earn interest that goes to the trust funds. Social Security Administration 2008 Trustees’ Report

21 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)

22 Social Security Administration, 2008 Trustees’ Report

23 The Long-Range Forecast (Best estimate)  In 2017, 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 2041, reserves are projected to be depleted. Income is forecast to cover 78% of benefits due then.  By 2082, assuming no change in taxes, benefits or forecasts, revenue would cover 75% of benefits due then.

24 Social Security’s Financing Problem  2008 Trustees Report shows Expenses will exceed payroll tax income in 2017 Trust funds will be out of money in 2041  75-year deficit equals 1.70% of taxable payroll Immediate payroll tax increase of 1.70% needed to restore actuarial balance Alternatively, immediate 11.5% across-the-board benefit cut $4.3 trillion unfunded liability (over 75 years) About 0.6% as a share of the entire economy (GDP)

25 Unfunded Obligations (Present values as of January 1, 2008; trillions of dollars) Present value As a % of future payroll As a % of GDP Over the infinite horizon $ Over the next 75 years Social Security Administration, 2008 Trustees’ Report, Table IV.B6.

26 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. National Academy of Social Insurance, Social Security Finances: A Primer (2005)

27 What is that non-taxable income?  Income not subject to Social Security taxes includes: earnings above the tax cap ($102,000 in 2008) 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. National Academy of Social Insurance, Social Security Finances: A Primer (2005)

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

29 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.

30 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.

31 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).

32 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% National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2007); Center for Retirement Research at Boston College (2007).

33 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% National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2007).

34 Options: Increase Investment Returns OPTION  Investments in equities % of Deficit Eliminated 36% - 50% National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2007).

35 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

36 First Tier: Basic Benefit  Government guarantee of poverty-level income  2008 Poverty Levels Single individuals – $10,400 ($867/month) Married couples – $14,000 ($1,167/month)  Would replace SSI and redistribution within the current SS system  Pay for with general revenues

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

38 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

39 Conclusions  $4.3 Trillion Unfunded Liability  Oldest baby-boomers are 62  Social Security should provide adequate incomes throughout retirement  Reform is needed

40 Sources  American Academy of Actuaries, Social Security Reform Options (2007),  Jon Forman, Reforming Social Security, 76 (9) Oklahoma Bar Journal (March 12, 2005), pdf pdf  National Academy of Social Insurance, Social Security Finances: A Primer (2005),  National Academy of Social Insurance, Options to Balance Social Security Over the Next 25 Years (Social Security Brief No. 18, 2005),  Center for Retirement Research at Boston College, The Social Security Fix-It Book, it_book.html. it_book.html  Social Security Board of Trustees, 2008 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (2008),

41 About the Author  Jonathan Barry Forman (“Jon”) is the Alfred P. Murrah Professor of Law at the University of Oklahoma College of Law, where he teaches courses on tax, pension, and elder law.  Professor Forman is also Vice Chair of the Board of Trustees of the Oklahoma Public Employees Retirement System (OPERS) 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 he also has master’s degrees in economics and psychology.  Jon can be reached at or (405) His web page is