1. Copyright © 2010 Worth Publishers

2. Social Security 13.1 What Is Social Security and How Does It Work?
13.2 Consumption-Smoothing Benefits of Social Security
13.3 Social Security and Retirement
13.4 Social Security Reform
13.5 Conclusion
Social Security
P R E P A R E D B Y
FERNANDO QUIJANO AND SHELLY TEFFT

3. Social Security A federal program that taxes workers to provide income support to the elderly.

4. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
Program Details
How Is Social Security Financed?
Almost all workers in the United States pay the Federal Insurance Contributions Act (FICA) tax on their earnings.
Who Is Eligible to Receive Social Security?
A person must have worked and paid this payroll tax for 40 quarters (10 years) over their lifetime, and must be age 62 or older.

5. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
Program Details
How Are Social Security Benefits Calculated?
annuity payment A payment that lasts until the recipient’s death.
The amount of this annuity payment is a function of the recipient’s average earnings over the person’s 35 highest earning years where each month’s earnings are expressed in today’s dollars.
This 35-year average of real monthly earnings is called the Average Indexed Monthly Earnings, or AIME.

6.   What Is Social Security and How Does It Work? 13.1 APPLICATION
Why Choose 35 Years?
First, individuals should not be penalized for years of part-time work or particularly low earnings.
Second, if the averaging period is too short, it can have perverse incentives for behavior by older workers:
A 61-year-old subway driver for the Boston MBTA fell asleep at the wheel, causing a crash in which 18 people were injured.
An investigation revealed that this driver had been working 25 hours straight in an effort to maximize his overtime pay.
The pension that the driver would be able to claim was a function of his earnings during his last 5 years of work.
In the wake of this accident, the MBTA changed its pension plan to no longer reward such excessive work at the end of one’s career. 

7. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
Program Details
How Are Social Security Benefits Calculated?
replacement rate The ratio of benefits received to earnings prior to the entitling event.

8. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
Program Details
How Are Social Security Benefits Paid Out?
Full Benefits Age (FBA) The age at which a Social Security recipient receives full retirement benefits (Primary Insurance Amount).
Early Entitlement Age (EEA) The earliest age at which a Social Security recipient can receive reduced benefits.

9. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
Program Details
Can You Work and Receive Social Security?
The earnings test reduces the benefits of 62- to 64-year-olds by $0.50 for each dollar of earnings they have above $13,560. These benefits are returned later when the worker’s earnings fall below this threshold.
Are There Benefits for Family Members?
Spouses of claimants.
Children of deceased workers.
Spouses who survive a Social Security recipient.
AIME is Average Indexed Monthly Earnings
PIA is the Primary Insurance Amount
FBA is the Full Benefits Age (currently age 65, rising to 67)
EEA is the Early Entitlement Age (currently age 62)
DRC is the Delayed Retirement Credit amount (currently 6%, rising to 8%)

10. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
How Does Social Security Work Over Time?
funded Refers to retirement plans in which today’s savings are invested in various assets in order to pay future benefits.
unfunded Refers to retirement plans in which payments collected from today’s workers go directly to today’s retirees, instead of being invested in order to pay future benefits.

11. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
How Does Social Security Work Over Time?
How Social Security Redistributes Income
In this two-period model, workers in period 1 pay no taxes when young, but do receive benefits when old in period 2. In period 2, young workers pay $2,100 in taxes each, so each retiree receives $2,205 in benefits—an infinite rate of return. In periods 3 and 4, the retirees pay taxes when young, so they receive a 10% rate of return, which is determined by population and wage growth. In period 5, the last generation pays in when young, but gets nothing when old, so there is a rate of return of -100%.

12.   What Is Social Security and How Does It Work? 13.1 APPLICATION
Ida May Fuller
The very first beneficiary of Social Security was Ida May Fuller. May worked for only three years after the establishment of the Social Security system, and paid a total of $24.75 in Social Security taxes:
The first Social Security check in U.S. history was issued to her on January 31, 1940, for $22.54.
May went on to live for 35 more years, dying at age 100 in Over those 35 years, she collected a total of $22, in Social Security benefits.
Ida May is a striking example of the first generation of Social Security beneficiaries who were the big winners under this new social program. 

13. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
How Does Social Security Work Over Time?
Lessons Learned
legacy debt The debt incurred by the government because early generations of beneficiaries received much more in benefits than they paid in taxes.

14. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
How Does Social Security Redistribute in Practice?
Social Security Wealth (SSW) The expected present discounted value of a person’s future Social Security payments minus the expected present discounted value of a person’s payroll tax payments.
SSW is computed as follows:
Calculate the entire future stream of benefits that a person expects to receive before he or she dies.
Use a discount rate to calculate the present discounted value (PDV) of that stream of benefits.
Calculate the entire future stream of taxes that a person expects to pay before he or she dies.
Compute the PDV of that stream of taxes.
Take the difference between these two to get the SSW.

15. What Is Social Security and How Does It Work?
13.1
What Is Social Security and How Does It Work?
How Does Social Security Redistribute in Practice?
TABLE 13-2
Some examples of how SSW varies within groups that are the same ages include the following:
Females have more SSW than males because they live longer.
Married couples have more SSW than single people.
Single-earner couples have more SSW than two-earner couples.
The gains to the poor relative to the rich from Social Security are overstated because the length of life rises with income.

16. Consumption-Smoothing Benefits of Social Security
13.2
Consumption-Smoothing Benefits of Social Security
Rationales for Social Security
There are market failures in the annuities market:
The longer a person lives, the less money the insurer makes from an annuity contract.
This could lead to such a high price for annuities that most potential buyers would not want to buy them.
The true reason that most policy makers favor the program is paternalism:
They are concerned that people won’t save enough for their own retirement.
Most workers have very little savings other than Social Security (and private pensions) when they retire.

17. Consumption-Smoothing Benefits of Social Security
13.2
Consumption-Smoothing Benefits of Social Security
Does Social Security Smooth Consumption?
All that Social Security may be doing is crowding out the savings that individuals would otherwise set aside for their retirement.
Social Security and Private Savings
Social Security might crowd out private savings by allowing people to count on a government transfer to support their income in old age. The larger this crowd-out is, the less consumption smoothing Social Security provides for retired individuals.

18. Consumption-Smoothing Benefits of Social Security
13.2
Consumption-Smoothing Benefits of Social Security
Living Standards of the Elderly

19. Social Security and Retirement
13.3
Social Security and Retirement
Theory
If a 62-year-old worker works until 63, instead of retiring at 62 and claiming her Social Security benefits, four things happen through the Social Security system:
She pays an extra year of payroll taxes on her earnings.
She receives one year less of Social Security benefits.
She gets a higher Social Security benefit level through the actuarial adjustment.
Since earnings generally rise with age, she gets to replace a low- earnings year with a high-earnings year in the 35-year benefits average.

20. Social Security and Retirement
13.3
Social Security and Retirement
M P I R I C A L E V I D E N C E E
MEASURING THE CROWD-OUT EFFECT OF SOCIAL SECURITY ON SAVINGS
The effect of Social Security on private savings has been the subject of a large number of studies over the past 30 years.
To measure the impact of Social Security on savings, there must be a way to compare people with different levels of Social Security benefits who are otherwise identical.
In the United States, Social Security is a national program that applies to almost all workers; very similar people usually have very similar benefits. Recent studies have provided evidence on the impact of Social Security-like programs on private savings in Italy:
Reforms in 1992 substantially reduced the benefits, and thus future SSW, for younger workers in the public sector, while reducing much less the benefits of older workers and those in the private sector.
According to the authors’ estimate, 30–40% of the reduction in SSW was offset by higher private savings.

21. Social Security and Retirement
13.3
Social Security and Retirement
Evidence

22. Social Security and Retirement
13.3
Social Security and Retirement
Evidence
FIGURE 13-4
retirement hazard rate The percentage of workers retiring at a certain age.

23. Social Security and Retirement
13.3
Social Security and Retirement
Evidence
FIGURE 13-5

24. Social Security and Retirement
13.3
Social Security and Retirement
Evidence
FIGURE 13-6 24

25. Social Security and Retirement
13.3
Social Security and Retirement
Evidence
FIGURE 13-7

26.   Social Security and Retirement 13.3 APPLICATION
Implicit Social Security Taxes and Retirement Behavior
FIGURE 13-8 

27. Social Security and Retirement
13.3
Social Security and Retirement
Implications
Evidence suggests that it is potentially very costly to design Social Security systems that penalize additional work beyond the retirement age.
Adjusting systems to more fairly reward work at old ages can mitigate much of the moral hazard effect of Social Security.

28. Social Security Reform
13.4
Social Security Reform 28

29. Social Security Reform
13.4
Social Security Reform
Reform Round I: The Greenspan Commission
The commission’s primary recommendation was that the Social Security system should move away from an unfunded system to some extent, and that the government should accumulate savings in the Social Security trust fund so that when the baby boomers retire, there would be enough money to pay their benefits. 29

30.   Social Security Reform 13.4 APPLICATION
The Social Security Trust Fund and National Savings
In theory, one benefit of the partial funding of Social Security through the build-up of the trust fund is an increase in national savings.
However, this trust fund is, by law, “off budget,” meaning that the government is supposed to consider its other revenue and spending obligations distinct from the trust fund.
When the government reports its budget deficit or surplus for each year, it typically reports the “unified budget,” which incorporates off-budget categories.
For 2008, the true deficit is about 40% more than that popularly reported.
When the baby boomers start to retire, the trust fund will get drawn down, and suddenly the unified budget will plunge sharply into deficit.
Thus, if policy makers only pay attention to the unified budget, then the trust fund is not new savings—it just displaces other government savings.  30

31. Social Security Reform
13.4
Social Security Reform
Incremental Reforms
Raise Taxes Further
Increasing the payroll tax by 1.7 percentage points is projected to solve the financing problem for the next 75 years, and raising it by 3.2 percentage points is projected to solve the financing problem forever.
Extend the Base of Taxable Wages
Try to increase the number of young who pay into the system.
Increase the maximum income on which the payroll tax that finances Social Security is paid. 31

32. Social Security Reform
13.4
Social Security Reform
Incremental Reforms
Raise the Retirement Age
Relative to life expectancy, the Social Security Full Benefits Age has been falling.
Lower Benefits
Benefits can just be cut or the government could reduce the indexation rate of Social Security benefits.
Reduce Benefits for Higher Income Groups
Over one-third of benefits are paid to those in families with incomes of over $50,000 per year, so that some reduction in their benefits would be unlikely to impose great hardship. 32

33. Social Security Reform
13.4
Social Security Reform
Fundamental Reforms
Invest the Trust Fund in Stocks
One problem with the Greenspan Commission’s solution was that the trust fund is very inefficiently invested.
Privatization
privatization A proposal to reform Social Security by allowing individuals to invest their payroll taxes in various assets through individually controlled accounts. 33

34.   Social Security Reform 13.4 APPLICATION
Company Stock in 401(k) Plans
One option in many company 401(k) plans is to invest money in company stock.
There are two major sources of financial uncertainty in a worker’s life:
Their job security.
The performance of their savings.
Investing in company stock binds these sources of uncertainty together. If the company does badly, the worker is both out of a job and out of savings:
When Enron went bankrupt, over 4,000 workers lost their jobs in a single day, and more had their retirement savings wiped out.
Sixty-two percent of Enron’s 401(k) assets had been invested in its own stock, which lost over 99% of its value over the course of the year surrounding its bankruptcy.  34

35. Social Security Reform
13.4
Social Security Reform
Fundamental Reforms
The Trade-Offs between Fundamental Reforms
One potential middle ground is government regulated accounts. Under such a plan, each person would get an account, but the government would limit investment choices and force annuitization.
Partly due to the dramatic decline in the stock market in , Social Security reform has taken a backseat to other issues. Over the long run, an efficient retirement portfolio should contain some stock investments. 35

36.   Social Security Reform 13.4 APPLICATION
Mixed Proposals for Social Security Reform
In 2001, President Bush appointed a commission to propose solutions to Social Security’s long-term fiscal problem. Each proposal reflected a hybrid between the current structure and a privatized structure. A more recent mixed proposal comes from Leibman et al. (2005):
Cut Social Security benefits by:
(a) Reducing the values of the rate at which the PIA is converted to the AIME.
(b) Raising the Full Benefits Age to 68 and the Early Entitlement Age to 65.
Raise new revenue through:
(a) A mandatory contribution into personal retirement accounts.
(b) An increase in the maximum earnings that can be taxed.
Establish individual retirement accounts with the following rules:
A 3%-of-earnings contribution rate.
Investment options restricted to five broad options provided by no more than 15 companies.
Mandatory annuitization.  36

37. 13.5
Conclusion
Social Security is the largest social insurance program in the United States, and the largest single expenditure item of the federal government.
Social Security faces a long-run financing problem to which there are no easy solutions.
The question of how to resolve this problem will be one of the most contentious sources of political debate for at least the first part of the twenty- first century. 37