1. Social Security
Today: From the origins of Social Security to today’s structure; Long-run problems due to the graying of America

2. Previously
We looked through the benefits that seniors receive from Medicare
Hospital insurance
Supplemental medical insurance
Physician and medical services outside the hospital
Prescription drug benefits

3. Today We analyze another benefit that most seniors receive Questions
Social Security (SS)
Questions
How did Social Security begin?
What is today’s structure?
How is the graying of America affecting SS?
How do we solve the long-run challenges to SS?
How do people change their behavior with the implementation of SS?

4. How did Social Security begin?
SS, which is officially Old Age, Survivors, and Disability Insurance, began in 1937
White male work categories initially were covered
Coverage grew to more people over the next 50 years or so
Justification for SS
What if I outlive my money?
Indirectly transfers money from those that die young to those that die old
(Directly, the transfer is from workers to retirees)

5. Fully funded?
Original idea involved having a large fund to pay benefits out of
Political pressure turned SS into a pay-as-you-go system
The current generation of workers pays for today’s retirees
There has been some money in reserve
Reserves projected to diminish starting in 2017

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

7. Pay As You Go (or Unfunded) System
See also Figure 11.6 for payments and tax revenues of SS from
Period 1
Period 2
Period 3
Period 4
contribute
benefits
Work
Retire
Each generation’s benefits come from tax payments made by current workers
Dead
Still Dead
The Greatest
Generation
contribute
benefits
Childhood
Work
Retire
Dead
The Baby Boom
Generation
contribute
benefits
Unborn
Childhood
Work
Retire
Generation X
benefits

8. SS and consumption smoothing
The purpose of SS is to prevent the problems of adverse selection in annuity markets
Who would buy an annuity that paid out for the rest of a person’s life?
People that expect to live a long time
Recall “death spiral” from Chapter 9

9. Some other reasons for SS
Lack of foresight
Some people may overestimate their true discount rate
Moral hazard problems
The government may support old people with no resources anyways
Lower administrative costs per person
Improved economic status for old people

10. How does SS work? Mostly pay-as-you-go, or unfunded, financing
Recall that some reserves exist
Financing
Current workers pay, retirees receive
Retirement age
“Normal” age is gradually increasing
Benefit structure
Based on average indexed monthly earnings
See Figure 11.1 for SS expenditures from

11. Financing In 2006, each of the first $94,200 was subject to SS taxes
12.4%, evenly split between employee and employer
Note that Medicare financing is separate from SS
Taxes create illusion of obligation to future generations
SS could be eliminated if the federal gov’t decided to do so
See Table 11.1, p. 235, for SS tax rates over time

12. The Social Security Trust Fund
Worker
Retiree
Trust
Fund
Money flow shown above
Workers pay into the trust fund
Retirees receive money from the trust fund

13. Retirement age
62 is minimum retirement age (with reduction in benefits)
Year of birth
Full retirement age
Months between age 62 and full retirement age
1937 or earlier 65 36
1938
65 and 2 months 38
1939
65 and 4 months 40
1940
65 and 6 months 42
1941
65 and 8 months 44
1942
65 and 10 months 46 66 48
1955
66 and 2 months 50
1956
66 and 4 months 52
1957
66 and 6 months 54
1958
66 and 8 months 56
1959
66 and 10 months 58
1960 or later 67 60

14. Benefit structure Based off average indexed monthly earnings (AIME)
Top 35 years of wages, factored for inflation
2006 benefit formula: Primary insurance amount (PIA)
90% of first $656 of AIME, plus
32% of AIME between $656 and $3,955
15% above $3,955
Cap on benefits based on maximum taxable earnings subject to SS payroll tax

15. Benefit structure
PIA
First Bend Point
Second Bend Point
AIME

16. Long-run problems with SS
Population growth in some countries is stagnating
Populations are getting older on average
Both problems are putting pressure to do at least one of the following
Decrease benefits
Increase the retirement age
Increase SS taxes

17. A simple model Assume three equal periods of life
Childhood
Working years
Retirement
Suppose that each generation is twice as big as the previous one
Twice as many workers as retirees
Workers pay less into SS than they receive when they retire

18. Stagnation in population growth
Population growth has stagnated in some developed countries
Example: Greece, 2007 estimates
Current population growth is 0.16% per year
People are dying at a faster rate than births
1.35 children born per woman’s childbearing years
Only positive net migration is keeping Greece’s population from falling
(Source:

19. Greek population
Source:
Thousands of people
Year

20. Graying of the population
America is currently “graying” in two ways
Americans are living longer
Life expectancy
: years
2004: years
Infant mortality
: 2.6%
2004: 0.68%
Baby boom generation is beginning to retire
Statistics from Center for Disease Control and Prevention website

21. Graying of the population
Baby boom generation (roughly)
This graph show the number of people aged 0-99 in 1999

22. Some possible solutions to SS problem
In order to have sustainable solvency of the SS system in the US, additional financing equivalent to a 3.5 percentage point increase in the payroll tax must be achieved
Some other possible solutions
Raise the maximum taxable earnings level
Raise the retirement age
Reduce the cost-of-living adjustment
Change the benefit formula
A combination of options

23. Warning Secondary effects must be taken into account with SS reform
Be careful about increasing taxes
In Chapter 15, we will see that tax increases can cause other problems in the economy
Increasing the retirement age could increase the supply of workers
Could lead to lower wages for all workers

24. Major reform proposal: Privatization
Many people have proposed privatization of the SS system
Solvency may or may not improve
Effect on saving depends on type of accounts that are allowed
Risk would increase
Even safe stocks could go down in value
Administration costs would likely increase
Reduces SS’s role of insurance

25. What will happen to SS?
Over the next decade, one of several things could occur to SS
Nothing: Let the next generation solve the problem
Waiting too long could lead to social unrest
Partly solve the problem
Current solvency: years
Some proposals would increase this to 75 years
Fully solve the problem (not likely)

26. How do people change behavior with SS?
With SS, people change their behavior in the working years
We will examine the life-cycle theory of savings
Wealth substitution effect
Retirement effect
Bequest effect

27. Life cycle theory of savings
People save and borrow based on planned lifetime consumption
See Figure 11.3, p. 242, for budget constraints on present and future consumption
Somebody with diminishing MU prefers smooth consumption over time
Without SS, a rational person will save during the working years and use this money for retirement

28. Wealth substitution effect
Along the budget constraint, suppose I am forced to have $1 less today and $(1 + r) more in future consumption
This will lead to $1 less in saving today
Crowds out private saving
Known as the wealth substitution effect
See Figure 11.4, p. 244, and Figure 11.5, p. 245, for more on crowding out private saving

29. Retirement effect
SS gives workers a financial incentive to retire early
Retirement effect states that people may save more in their working years in order to have their desired consumption during a longer retirement period

30. Bequest effect
Some people may feel guilty with the fact that their children are financing their retirement
Bequest effect states that people save more during their working years to finance a larger bequest to their children when they die

31. Summary SS is a big part of the US economy
About 4.25% of GDP
Private saving likely changes when SS is introduced
An idea of fully-funded SS system turned into a pay-as-you-go system
Reforms will need to be made in order to make SS solvent for your retirement