1. 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

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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

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

11. 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)

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

13. 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)

14. 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

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

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

17. 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

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

19. Social Security Reform
Time horizon for solvency
Sustainable solvency

20. 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

21. Homework
Exercise 3 page 249 and 6 page 250