Savings, Retirement, and Social Security

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Savings, Retirement, and Social Security
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Social Security

• Social Security is an example of a social
  insurance program.
• Social Security provides income for older
  individuals.
• Income comes in form of an annuity, i.e. the
  individual receives income payments until he dies.

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Annuities

• An annuity is an insurance product.
• Annuities are typically issued by the same
  companies that issue life insurance policies
• The risks undertaken by the issuer are
  fundamentally the same for both products -- that
  is, the insurance company bets on the life
  expectancy of the customer.
• The result is to transfer the effects of the
  uncertainty of an individual's lifespan from the
  individual to the insurer, which reduces its own
  uncertainty by pooling many clients.

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Why have Social Insurance?

• One important feature of life insurance markets
  is asymmetric information individuals have
  better information predicting their longevity
  than insurance companies.
• If a private firm offers insurance and cannot
  observe the high risks from the low risks, likely
  to get a group of buyers that is adverse to its
  interests.
• Adverse selection Individual who knows he is
  especially likely to collect benefits will have
  an especially high demand for insurance.

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How can government intervention improve
efficiency?

• Social security is compulsory the adverse
  selection problem is avoided because the low
  risks are forced to purchase the insurance policy
  as well.
• In the private market, the low risks would be
  less likely than the high risks to purchase the
  insurance policy.

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Other Justifications for Social Insurance

• Lack of Foresight / Paternalism
• For example, some individuals do a poor job of
  planning for their retirement.
• Individuals do not understand financial markets
  and investment opportunities.
• Income Redistribution
• Old individuals used to have lower incomes than
  young individuals (1930s and 1940s).

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The Economic Status of the Aged

• Elderly used to be a relatively disadvantaged
  group
• Elderly now have lower poverty rates than the
  average household
• Life expectancy has increased by more than 10
  years during the past three decades.

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Basic Components

• Pay-as-you-go Financing
• Explicit transfers
• Benefit structure
• Age at which benefits are withdrawn
• Recipients family status

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Pay-as-you-go Financing

• Benefits for current retirees come from payments
  made by current workers.
• There are no savings and hence on capital
  accumulation in such a system (except when taxes
  exceed benefits).
• Early recipients received very high returns on
  their contributions.

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The Benefit Structure

• Benefits are base on Average Indexed Monthly
  Earnings
• Only highest 35 years of earnings count toward
  AIME.
• Consider a person with a typical age-earnings
  profile, who starts work at age 22 and retires at
  67, and therefore has 45 years of full-time work.
• Likely that the Social Security taxes paid from
  ages 22-32 will not matter for AIME.

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Primary Insurance Amount

• To compute benefits, we need to convert AIME into
  Primary Insurance Amount (PIA).
• This the basic benefit payable to a work who
  retires at the normal retirement age.
• Benefit schedule is progressive, where
  lower-earners receive a higher proportion of
  previous earnings.

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Example of Benefit Calculation (using 2004 rules)
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Redistribution to Low Income Earners

• Typical low-earner who retired in 2003 received
  64 of AIME.
• Average earner received 48
• High earner received 40.

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Normal Retirement Age

• The normal retirement age is the age at which an
  individual qualifies for full Social Security
  benefits.
• Can retire as early as age 62, but benefits are
  scaled down. Benefits are scaled up for
  retirement after the normal age.
• Normal retirement age is being ratcheted up from
  65 to 67 for younger generations.
• Implicitly a benefit cut.

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Financing of Social Security

• Payroll tax is a flat percentage of an employees
  annual gross wages up to a cap.
• Currently, the Social Security part of the
  payroll tax is split equally between employer and
  employee, with each paying 6.2 of gross wages.
• Likely that much of the employer tax is shifted
  to employees in the form of lower wages.

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The Payroll Tax

• Payroll tax and the cap have increased
  dramatically over time.
• In addition to the cumulative Social Security
  payroll tax of 12.4, there is also an uncapped
  Medicare tax of 2.9, resulting in a cumulative
  tax of 15.3.

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Social Security Taxes are Capped
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Social Security by Generation

• Simulate lifetime net benefits for different
  representative individuals
• Social Security Wealth Lifetime value of Social
  Security benefits, discounted to present
• Lifetime costs of being in the system payroll
  taxes.
• See Table 9.3

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Table 9.3
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Other Distributional Issues

• Social Security redistributes in other ways as
  well, many of which may be unintended.
• Life expectancy varies by
• Race, gender, smoking status
• Social Security redistributes to groups with
  higher life expectancies

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Preferences for Married Couples

• Social Security also redistributes by living
  arrangements due to the 50 PIA adjustment.
  Consider benefits for three households

Married, 1 earner
Single Individual
Married, 2 earners
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Retirement Savings

• In addition to Social Security individuals can
  use private savings to accumulate wealth for
  retirement.
• One of the largest fringe benefits provided by
  employers to employees is the pension plan
  whereby employers save to provide retirement
  income for their workers.
• The contributions that an employer makes to the
  pension fund are not taxed as income to the
  employee.

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Defined Benefit Pension Plans

• Traditionally employer provided pension plans
  were defined benefit plans.
• In these plans workers accrued pension rights
  during their tenure at the firm.
• When workers retired the firm paid them a benefit
  that was a function of the workers tenure at the
  firm and their earnings.

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Defined Contribution Plans

• Over time employer provided pension plans have
  shifted to defined contribution plans in which
  employers set aside a certain proportion of the a
  workers earning (such as 5) in an investment
  account.
• The worker receives these savings and any
  accumulated investment earnings when she retires.

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401(k) Accounts

• The most rapidly growing form of retirement
  account is the 401 (k) account, an individually
  controlled savings program offered through the
  workplace.
• These accounts allow individuals to save on a
  tax-deferred basis with employers often matching
  workers contributions.
• In 401 (k) plans, the contributions are not
  counted as taxable income and the investment
  accrues at the before tax rate of return.
• Moreover contributions to 401(k) are vested,
  i.e. the investments belong immediatetly to the
  workers.

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Other Types of Saving Accounts

• IRAs (Individual Retirement Accounts)
• Roth IRAs
• 403(b) for not-profit, 457(b) for government
• Self-employment Retirement Plans
• Education Savings Account

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Excludable Forms of IncomeSome types of Saving
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Problems with 401(k)s

• Not all individuals have access to 401(k) plans.
• In 2003 only 49 of workers in the private
  sector participate in an employer-provided
  pension plan.
• Individuals sometimes make bad investment
  choices.
• A lot of workers heavily invest into the stock of
  their company. That works sometimes well
  (Microsoft) and sometimes is does not (ENRON).
  62 of ENRONs 401(k) assets were invested in
  ENRON stock.

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Long-Term Stresses on Social Security

• Given its current pay-as-you-go structure, Social
  Security is financially unstable.
• In stable system, benefits received equals
  payments collected.
• We can decompose these two parts.

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Long-Term Stresses on Social Security

• Benefits received

• Payments collected

• Where Nbnumber of retirees, Baverage benefit
  per retiree, ttax rate, Nwnumber of workers,
  and waverage wage per worker

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Long-Term Stresses on Social Security

• For solvency, we must have

• Or rearranging

• The first term on the right hand side is the
  dependency ratio, and the second term is the
  replacement ratio.

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Population Growth and Social Security

• Dependency ratio has been going down because of
  an aging population.
• Currently 3 workers per retiree
• By 2030, 2 workers per retiree
• Only way to keep system stable would be to
  increase taxes or lower benefits.

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Incremental Social Security Reform

• Thus far, the US as primarily relied on
  incremental reforms to keep the Social Security
  System solvent.
• One can tweak the current system by
• raising payroll tax,
• Increasing retirement age
• reducing the benefits for retirees

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Fundamental Reform

• In addition, advocates of Social Security often
  favor the introduction of personal retirement
  accounts.
• The accounts work similar as 401(k) plans.
• These accounts would allow workers to invest a
  fraction of their payroll taxes into a funded
  retirement account.

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Personal Retirement Accounts

• While the adoption of personal accounts are often
  linked to demographic concerns (retirement of the
  baby boom generation in the US), the actual
  evidence does not seem to support this motive.
• The largest reforms occurred in less developed
  countries where future demographic problems are
  least severe, including Chile (1981) and Mexico
  (1997).

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An International Perspective

• More modest reforms have been implemented in
  high-income countries where demographic problems
  are more severe including the UK (1986), Sweden
  (1998), and Poland (1999).
• Some countries with the most severe demographic
  problems including Germany, Italy, and Japan have
  only implemented minor reforms.

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Some Lessons

• Traditional Pay-as-you-go systems require a
  significant amount of trust between workers of
  different generations the so called social
  contract.
• If the median voters loses under a
  pay-as-you-system he may not be willing to
  support the system.
• In developing countries, where reform have been
  the largest, there is a distrust in government
  policies due to previous misuse of retirement
  funds.
• Funded defined-contribution accounts give workers
  independence from the government.
• In developing countries such as the US the
  creation of personal accounts is driven by
  demographic problems.

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The Trust Fund

• When pay-roll revenues exceed payments to
  beneficiaries, the difference is used to buy
  government bonds which are deposited in the
  trust fund.
• According to the 2005 Trustees Report, the US
  Social Security System faces a shortfall equal to
  about 11.1 trillion, which is equal to the
  present value of the benefits minus the present
  value of all future payroll taxes after
  subtracting the value of the trust fund.

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The Solvency of the US System

• The shortfall in the Medicare program is seven
  times as large.
• Absent benefit cuts, placing Social Security and
  Medicare on a permanently sustainable course
  would require increasing the payroll taxes from
  15.3 to 36.1 --- immediately and forever.
• Personal accounts do not improve or worsen the
  financial outlook since they reduce future taxes
  and benefits by an equal amount in present value.