The Intergenerational Wealth Effects of the Social. Security Notch. Preliminary Draft: Please do not cite or distribute. without authors permission

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1 The Intergenerational Wealth Effects of the Social Security Notch Preliminary Draft: Please do not cite or distribute without authors permission Kathryn Edwards Malcolm Kang Nishaad Rao Kegon Tan October 14, 2015 Abstract This paper investigates the role of parental retirement wealth in determining offspring wealth. We examine a prominent policy change to Social Security benefit determination, the Notch, in which a handful of birth cohorts received higher benefits relative to neighboring cohorts. Using multiple datasets, we find that the effect of the policy change on the wealth distribution of the children of affected retirees is significant. We further investigate two possible mechanisms at work intervivos gifts and bequests. Our estimates suggest that the change in retirement benefits led to parents increasing financial transfer amounts to children (intensive margin), rather than encouraging more parents to make transfers (extensive margin). Both intervivos gifts and bequests combined can account for some of retirement wealth effect on child wealth, but not all. Our findings are important given the notable effects that wealth has on a wide variety of outcomes, ranging from human capital investment to health. We thank Steven Durlauf, Jesse Gregory, John Karl Scholz, Ananth Seshadri, Chris Taber, and the UW-Madison Public Economics Group for helpful discussions and comments. Support from the Human Capital and Economic Opportunity Working Group is gratefully acknowledged by Kegon Tan. Dept. of Economics, UW-Madison, kaedwards@wisc.edu Dept. of Economics, UW-Madison, mkang62@wisc.edu Dept. of Economics, UW-Madison, nsrao2@wisc.edu Dept. of Economics, UW-Madison, ttan8@wisc.edu 1

2 1 Introduction Though it is widely acknowledged that wealth may contribute to many economic outcomes, the determinants of wealth levels among households how much wealth is due to inheritances, versus how much is self-made in each generation are not well understood. Nor is it clear what determines the distribution of wealth across households, despite acknowledgement that wealth inequality, or the disparity in the distribution of assets, has far reaching implications for multiple dimensions of social inequality. In this paper, we exploit a policy change to Social Security that affected retiree benefit levels to evaluate to what extent changes in Social Security generosity affect the distribution of wealth among the children of affected beneficiaries. The policy in question is referred to as the Notch, a mistake in the way inflation adjustments to Social Security benefits were calculated. The error, which was in place between , and its correction, phased in in between , led to unexpected lower payouts for cohorts born between (the Notch group), relative to cohorts born between (the Windfall group). Comparing the Windfall and Notch cohorts has been a successfully applied identification method in studies of health and co-residence patterns of the elderly. Here, we closely examine this small change to Social Security a key source of income among retired Americans to learn more about the relationship between parents income and child s wealth in general. Our analysis is two-fold. We first estimate the causal change in assets among the children of both groups due to the Notch. We demonstrate the effect on assets of being born a child of a Notch parent, relative to being born the child of a Windfall parent. We examine the asset differences of the two groups at the median, at various points of the asset distribution, and various points of the income distribution, to demonstrate the distributional consequences of higher or lower retiree income. In the second part of our analysis, we identify possible mechanisms that explain the difference in assets among the second generation. After documenting the magnitude of the policy change in terms of both annual and lifetime income, we relate the difference in parents income to direct wealth transfers, such as gifts or bequests. 2

3 The central contribution of this paper is to estimate the sensitivity of child s wealth to parents retirement income. We have two key findings. First, children of the rich are shielded from a benefit cut, or conversely, do not gain from a benefit raise. The distribution of assets among children of the top 20% of the wealth distribution was unchanged if their parents came from the top 20% of the Notch cohorts or the top 20% of the Windfall cohorts. Second, upwardly mobile children were the most rewarded from the benefit increase, or conversely, would lose the most from a benefit cut. Children whose income ranks were more than ten percentage points higher than their parents income rank saw the largest difference in median assets, comparing Notch children to Windfall children. The changes in the asset distribution of children were not spread evenly among the bottom 80%, surpluses/shortfalls in one generation s retirement wealth appear to reward/punish income-climbing children in the next generation. These findings add to our understanding of how wealth is transmitted and identifies possible channels of inequality. Importantly, it centers the question of wealth inequality at the median of the wealth distribution, rather than focusing on disparities at the top 10% or top 1% level. We also estimate the effect of the Notch on intergenerational transfers to understand whether direct transfers from parents to children can explain the changes in child net worth. We find that there were statistically significant differences in the amount transferred, but the magnitudes suggest that this may not be the sole mechanism. Other less direct channels, such as coresidence and reduced financial burdens on children, are also likely to play important roles in explaining the changes in child net worth. In addition to the implications on wealth, our findings also serve as a policy evaluation of Social Security. Social Security is an insurance program that protects against risk of poverty in old age by spreading it across generations. Younger workers, in effect, pay for the benefits of retirees, who in turn may filter benefits back to younger generations, either by reducing the need for financial assistance or through direct financial transfers. Although other analyses of the Notch have been used to understand Social Security s role in the beneficiary s life, this 3

4 analysis furthers our understanding of the effectiveness of spreading risks across generations. Indeed, our paper can be thought of as a previously unexplored test for the adequacy of Social Security benefits how cuts and windfalls are absorbed by children speaks to benefit levels and the incidence of benefits and speaks to the need of examining potential changes to Social Security benefits via the consequences for both beneficiaries and their children. 2 Data We use two datasets to corroborate our findings, each with different key features that enable our multigenerational analysis of the Notch. Our first source of data is a survey of the children of the Notch and Windfall cohorts the Wisconsin Longitudinal Study (WLS). The WLS follows a cohort of 10,317 high school seniors from 1957 to 2011 (respondents are surveyed in 1957, 1975, 1992, 2004, and 2011). We construct a subsample of respondents whose parents were born either in the Notch or Windfall cohorts. The WLS contains rich data on their assets in 2011, our main outcome of interest. It also contains data on their income in 1992, and their parental income ( ). Further, it contains information on transfer and bequests received from parents over the lifecycle of the respondents. The second source of data is a survey of the Notch and Windfall cohorts themselves the Health and Retirement Study (HRS). The HRS is a longitudinal survey that began in 1992, and followed about 12,000 individuals who were retired at the time. The initial cohort was born between 1931 and Later, it was merged with a parallel longitudinal survey, the Study of Asset and Health Dynamics of the Oldest Old (AHEAD), which began in 1993 and followed 8,000 individuals born before HRS interviews are conducted every two years; by 2010 we have ten waves of data for each individual. Within the HRS, there are two groups of people who are of interest to us. The first are those whose parents were born in either the Notch or the Windfall cohorts. These are the children whose wealth were affected by changes in parental retirement wealth. The 4

5 HRS contains information on net worth in each survey wave, our key outcome of interest. Unfortunately the HRS is less informative about the income of both the children and their parents but still records educational attainment. The second group of people in the HRS are members of the AHEAD survey, comprising parents who were born in the Notch and Windfall cohorts. The AHEAD data contains three important pieces of information that are useful for our purposes. First, it has records of Social Security payouts for parents affected by the Notch/Windfall. This allows us to evaluate the impact of the Notch on parental retirement wealth. Second, the HRS collects information on transfers made to offspring, similar to the WLS except that this is now parent-reported rather than child-reported. Third, it conducts detailed exit interviews for respondents who pass away between interview waves, capturing the amount of bequests to children. The AHEAD dataset constructed for this study is a combination of these exit interviews and HRS cross-wave data, which is built from a publicly available dataset provided by RAND. The exit interview (for obvious reasons) is conducted with a proxy interviewee, in most cases the respondent s surviving spouse. 3 The Social Security Notch The Social Security Act of 1935, which created the Old Age Insurance program typically referred to as Social Security, has been amended numerous since its initial passage to both modernize and expand the program. One such modernization was passed in the amendments of 1972, which automated the inflation adjustments of benefits for current retirees that had hitherto occurred on an ad hoc basis, and applied the formula to the calculation of benefits for new retirees. The formula went into effect in The high inflation at the time made clear that the formula for new retirees was overly generous and in effect double-counting inflation; the replacement rate of benefits were rapidly climbing and, left as they were, would pass 100%. In 1977, Congress passed a law to correct the mistake, which was phased in beginning 5

6 in 1979, affecting new retirees in To avoid any selection in when individuals chose to claim benefits, we divide our sample based on year of birth. The Windfall cohorts are those who benefited from the double counting, reaching full retirement age between 1975 and The Notch cohorts are those who reached full retirement age during the phase out, Their years of birth are and , respectively. Below, we show a figure of average monthly Social Security payout by birth cohort from the Congressional Budget Office (Kollmann, 2003) to illustrate the change in monthly payouts due to the Notch. Table 1: Comparing Notch and Windfall Monthly Social Security Payouts Figure is taken from the Congressional Budget Office. The unanticipated change in retirement wealth helps us identify the effect of parental retirement wealth on child net worth. A key assumption is that parents born in the Notch versus the Windfall are comparable in terms of characteristics that could influence the net worth of offspring through channels other than retirement wealth. For example, if parents 6

7 born in the Notch were less educated than those born in the Windfall, then differences in their offsprings net worth values may be due in part to the education gap rather than the difference in retirement wealth generated by the Notch. We perform a series of balancing tests using both the WLS and the HRS to check this assumption for parental traits including education attainment, fertility, and income. We regress each trait on an indicator for the Notch as well as Table?? reports the results of these tests and shows that mean levels of the traits are not different across the Notch and Windfall cohorts. Table 2: Comparing Notch and Windfall Parents variables coef. s.e. p val. Parental Income (0.618) Father's Education (0.389) Number of Siblings (0.340) Child's Education (0.319) Balancing tests are performed using the WLS. 4 The Effect of the Notch on Child Wealth We use both the WLS and the HRS to construct distributions of net worth for children whose parents were affected by the Notch or Windfall. Figure 1 shows that there is a meaningful shift in the distribution of offspring net worth and this is similar across both datasets that we use. These distributional figures are supplemented with quantile regressions specified as follows: Child snetw orth i = β (p) 0 + β (p) 1 Notch i + ɛ (p) i (1) where p refers to the pth quantile. The coefficient for the Notch would therefore refer to the 7

8 Figure 1: The Effect of SS Payouts on Offspring Assets (a) WLS Children Density Child Net Worth (in thousands) Notch Parent Windfall Parent (b) HRS Children Density Child Net Worth (in thousands) Notch Parent Windfall Parent Vertical lines indicate respective medians. Net worth is measured when children are age 70, conditional on parents being deceased. 8

9 effect of the Notch on the pth quantile of the child net worth distribution (as opposed to the mean in the standard linear regression). We report the results for the median, which are better suited for analyzing assets due to the high degree of skew. 1 Table 3: The Median Effect of SS Payouts on Offspring Assets Unconditional Conditional WLS HRS WLS HRS coeff s.e. (22.868) (74.882) (22.451) (79.225) p val obs mean Net worth is measured when children are age 70, conditional on parents being deceased. Net worth measured in thousands of 2011 dollars. The results are consistent across the two datasets, although the standard errors are much larger for the HRS, likely due to a smaller sample. 4.1 Effect Heterogeneity We investigate the overall effect further by showing the net worth distributions for children who had high income parents (top 20%) versus less well off parents (lower 80%). We find that the effect is strong among the bottom 80% of parental income, while the median effect is tiny for children with high income parents (see Figure 2). From this we draw the inference that high income parents are likely to insulate their children from retirement wealth shocks, whereas other parents transmit such shocks to their children. 1 Additional results are in an appendix. The bulk of the effect comes through the middle quantiles of the net worth distribution. 9

10 Figure 2: Parents in the Bottom 80% versus the Top 20% Density Child Net Worth (in thousands) Notch, Par. Inc. Bottom 80% Notch, Par. Inc. Top 20% Windfall, Par. Inc. Bottom 80% Windfall, Par. Inc. Top 20% Vertical lines indicate respective medians. Net worth is measured when children are age 70, conditional on parents being deceased. Estimates are based on the WLS. Given that it is parents in the bottom 80% of income that transmit the retirement wealth shock to children, we then seek to understand what type of child receives the retirement wealth shock. We examine whether children who were upwardly mobile (i.e. relatively better off than their parents) were affected by the Notch. Figure 3 verifies that upwardly mobile children indeed saw a much larger change to their net worth than non-upwardly mobile children. 10

11 Figure 3: Upwardly Mobile versus Non-mobile Children Density Child Net Worth (in thousands) Notch, Child not mobile Windfall, Child not mobile Notch, Child upward mobile Windfall, Child upward mobile Upward mobile refers to children who had an income percentile rank in 1992 that was at least 10 points higher than their parents rank in Vertical lines indicate respective medians. The distributional shift in child net worth due to differences in parental retirement wealth was largest for upwardly mobile children. For these cohorts of parents and children, there was substantial intergenerational mobility. Roughly 37% of children were upwardly mobile, i.e., had income percentile ranks at least 10 points higher than their parents. This pattern holds in the quantile regression setting, even conditional on parental income. This implies that parents were more willing to transmit retirement wealth shocks to children who did relatively well. 5 Intergenerational Transfers We turn our attention to understanding why retirement wealth would affect net worth in the next generation. Two obvious channels spring to mind: intervivos transfers from parent to child, and bequests. In this section we examine whether the Notch had an effect on either 11

12 Table 4: The Effect of the Social Security Windfall on Transfers (Child Report) Any Transfer Amount Transferred Nonzero Transfer Bequests coef s.e. (0.032) (3.609) (10.604) p val obs mean Intervivos Gifts coef s.e. (0.030) (1.515) (6.383) p val obs mean Total coef s.e. (0.035) (3.940) (8.341) p val obs mean Transfers more than a million are trimmed. Outcomes measured in thousands of 2011 dollars. Estimates are based on the WLS. intervivos transfers or bequests (or both). Our statistical model is as follows: T ransfer i = γ 0 + γ 1 Notch i + γ 2 X i + ν i (2) where T ransfer i is the transfer received by child i, Notch i indicates if the father of child i was born between 1917 and Our X s control for father s education, income, and fertility. Our dependent variables include: (a) indicator for positive transfer, (b) continuous measure of transfer amount (including zeros), and (c) non-zero transfer amounts. We perform this analysis for bequests, gifts, and total transfers (bequests + gifts). 12

13 The first column of Table 4 shows that the probability of receiving a transfer is not different between the Notch and Windfall groups (no effect on the extensive margin). The second shows that children with fathers born in the Notch period receive on average $7,761 less in bequests, $2,585 less in intervivos gifts, and $9,059 (WLS) less overall than their Windfall counterparts. The third column shows that conditional on a non-zero transfer (roughly half the sample), the Notch children receives a smaller amount than the Windfall children. This suggests that the effect of the increase in SS earnings on transfers is driven mainly by the intensive margin rather than the extensive margin. Overall, children whose fathers were born in the Notch years received $22,277 less than those whose fathers were born in the Windfall years. We supplement this analysis by estimating a similar set of regressions but using data from parents in the HRS AHEAD data. The model is as follows: T ransfer j = γ 0 + γ 1 Notch j + γ 2 X j + ν j (3) where T ransfer j is the transfer given by parent j, Notch j indicates if father j was born between 1917 and Our X s control for father s education, income, fertility, and race. The set of dependent variables are similar to that for child-reported transfers, but omits total transfers. The reason is because computing total transfers requires non-missing bequests and intervivos gifts, but bequest information in the HRS AHEAD data is rife with missings. Our results from Table 5 are broadly consistent with the child-reported results. Note that the magnitudes of the effects estimated are larger since they cover all children rather than a single child as in the child-reported results. One difference is that there is an extensive margin effect for bequests: fathers born in the Notch are 8.5 percentage points less likely to leave a bequest. 13

14 Table 5: The Effect of the Social Security Windfall on Transfers (Parent Report) Any Transfer Amount Transferred Nonzero Transfer Bequests coef s.e. (0.043) (23.654) (57.820) p val obs mean Intervivos Gifts coef s.e. (0.028) (6.610) (9.375) p val obs mean Transfers more than 2 million are trimmed. Outcomes measured in thousands of 2011 dollars. Estimates are based on the HRS. 6 Policy Implications Our main results show that unanticipated changes in retirement wealth due to the Notch can have large intergenerational effects on offsprings net worth. Further, these effects were different across types of families. In particular, children of high income parents were less affected. Also, the net worth of children who did better than their parents (upwardly mobile) were more responsive. We note that our results can be interpreted in two ways. The first point of view would see the Notch as an unanticipated reduction in retirement wealth, and this is the view commonly held in the literature. The second would see the Windfall cohorts as receiving an unanticipated increase in retirement wealth. While most of the language used in the text so far follows the first point of view, it is worthwhile to consider the second as well. In this case, we would report that children of high income parents did not see large changes 14

15 in median net worth. The earlier explanation of the protective role that high parental income would not work here. Instead, we may think that the change in retirement wealth induced by the calculation error in determining SS payouts was small relative to the overall wealth of these high income parents, and hence did not affect the distribution of offspring net worth. With regard to upwardly mobile children being more responsive, we may think that the type of parent who could nurture successful children may be more likely to pass on positive wealth shocks to the next generation (i.e., more altruistic). This is in contrast to the explanation above, which postulates that parents were more willing to pass on their negative shocks to children who were well off relative to themselves. Regardless, these effects suggest that retirement wealth shocks meaningfully impact both wealth levels and wealth inequality in the next generation. An increase in retirement wealth reduces wealth inequality in the next generation since our results suggest that it is the children of the bottom 80% of parental income who benefit, and vice versa. In addition, they suggest that intergenerational wealth mobility is increased with positive shocks to retirement wealth, and vice versa, since the wealth of upwardly mobile children is magnified (dampened) by positive (negative) shocks to parental retirement wealth. Our attempt to explain our findings through transfers were met with limited success. While we do find statistically significant responses in intervivos gifts and bequests, the effects do not seem large enough to explain the difference in net worth. These estimates are still meaningful for understanding parental motivations for intergenerational transfers. In particular, our estimates show that changes in retirement wealth arising from the Notch do not have a significant extensive margin effect - it is insufficient to influence parents who were unlikely to make intergenerational transfers at all. The changes in transfers come mainly through the intensive margin, where parents who were likely to make intergenerational transfers ended up making larger transfers. 15

16 7 Conclusion Recent debates over cuts to Social Security benefits often overlook the potential consequences on the next generation s wealth arising from these intergenerational transfers. Our paper investigates the potential intergenerational effects. We find that reductions in retirement wealth have potentially far reaching effects on the wealth distribution of the subsequent generation. The richest parents shielded their offspring from the negative consequences of reduced retirement wealth. The bottom 80% of income earners transmitted them to the next generation. Among the children who had lower values of net worth due to the Notch, it was those who were well-off relative to their parents and their peers that experienced the largest effects. This feature is likely due to the high rates of intergenerational mobility for the group of children in the study 37% of all children had income percentile ranks that were over 10 points higher than their parents. Overall, these wealth shifts that were induced by changes in Social Security benefits led to an increase in wealth inequality in the younger generation. With an aging population and a smaller number of children for each parent, these intergenerational effects could be more severe for more recent cohorts. 16

17 References Kollmann, G. (2003). Social Security Notch Issue: A Summary. Technical report, Domestic Social Policy Division, Congressional Research Service. 17