LECTURE: SOCIAL SECURITY HILARY HOYNES UC DAVIS EC230 OUTLINE OF LECTURE:

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1 LECTURE: SOCIAL SECURITY HILARY HOYNES UC DAVIS EC230 OUTLINE OF LECTURE: 1. Inroducion and definiions 2. Insiuional Deails in Social Securiy 3. Social Securiy and Redisribuion 4. Jusificaion for Governmen Involvemen

2 SOCIAL SECURITY Social Insurance Programs Feaures of social insurance programs (in conras o public assisance) -- Compulsory (yes) -- Conribuory (payroll axes) -- Provides benefis when condiion is me (old age) -- Benefis limied o hose who have paid in (work hisory) -- Mechanism for sociey o pool risk for evens ha have caasrophic consequences (loss of a job) or evens people do no plan adequaely for (reiremen) -- Benefis ied o previous labor marke experience Bigges of he social insurance programs. Differen from oher income securiy programs we have sudied so far in ha i is less designed o insure agains unanicipaed shocks; insead geing old. 2

3 Social Securiy Same issues of proecion and disorion are relevan here in he opimal design of SS. Proecion: Insurance o proec agains povery and reducions in sandard of living ha can occur when earnings sop Disorion: Benefis are condiional on employmen and are funded by axes while working. Deadweigh loss from he program s aleraion of people s behavior Imporan quesions in SS lieraure -- How does Social Securiy affec privae savings? -- How does Social Securiy affec reiremen? -- Wha are he disribuional implicaions for SS? -- Privaizaion of SS 3

4 Imporan conceps for undersanding pensions Defined Benefi (DB): Benefis in reiremen defined by rules (age, earnings, ec.) and benefi formulas. Rae of reurn on conribuions cerain a ime of conribuion Defined Conribuion (DC): Benefis in reiremen deermined by conribuions. Rules dicae conribuions by employer and employee. Funds placed in accoun-- worker ges gross reurn. Rae of reurn on conribuions uncerain a ime of conribuion. Funded: Asses are in he bank o pay obligaions (ousanding benefis) Unfunded: No asses are accumulaed curren workers conribuions fund curren reiree s benefis. Pure unfunded programs are ofen referred o as Pay as you go [PAYG] Acuarily Fair Defined for an individual worker PDV (axes or conribuions) = PDV (benefis) 4

5 Examples: Funded DB Privae pensions (older larger firms, radiional privae pension vehicle) S&L Gov pensions Univ of CA DC IRA / 401(K) programs Privae pensions (newer, smaller firms, mos common form) Newly adoped SS programs ouside US (Chili, Mexico, Argenina, Ausralia) Unfunded US Social Securiy Less common Sweden? 5

6 US Social Securiy Program OASDHI: OASI: Old age Survivors DI: Disabiliy Insurance HI: Hospial Insurance SMI: Supplemenal Medical Insurance Timeline: 1935: Social Securiy Ac (iniiaed Social Securiy) 1960: DI added 1961: Reiremen allowed a age : HI, SMI (Medicare) added 6

7 Funding Hisorically, SS is PAYG sysem; now some accumulaion Recall definiion of pay as you go Curren axes = Curren benefis : No surplus, pure pay as you go Tax raes low since he raio of workers o reirees is high 1985: Huge surplus Tax raes increased (1977, 1983) o build up he fund so ha as he raio of workers o reirees decreases (baby boom generaion) he sysem does no go bankrup Trus fund now $1 rillion; liabiliies of $9 rillion Financing: Paid ou of payroll ax on earnings. Tax raes Social Securiy: 6.2% (employee) + 6.2% (employer); fla ax up o maximum earnings 15.3% for self employed Medicare: 1.45% (no maximum) 7

8 Benefi Formula Benefis are a funcion of: age a reiremen, average earnings, growh in real wages, and family srucure. Definion: AIME (Average Indexed Monhly Earnings) Average monhly earnings in covered employmen Indexed o changes in real wages Based on 35 years of highes earnings Definion: PIA (Primary Insurance Amoun) Se a reiremen Used as base for all fuure benefis In 2003: PIA = 0.90*(1 s $606 of AIME) *(of $606-$3,653 of AIME) *(AIME>$3653 Redisribuion in formula: higher replacemen rae for lower AIME workers 8

9 Benefi in year : CPI B = ~ PIA* CPI reiremen Reiremen Dae 62 year old early reiremen benefis based on 80% PIA 65 year old normal reiremen benefis based on 100% PIA (Exising legislaion gradually increasing normal reiremen age o 67) Adjusmen from % from is acuarially fair adjusmen for average recipien Earnings Tes In 1992: Earnings < $7440 per year penaly free Earnings >$7440 per year axed a 50% rae Adjusmens o PIA -- Married: choose beer of eiher (a) 150% of higher PIA or (b) sum of PIAs -- Surviving spouse earns 100% of deceased spouse s PIA -- Deah benefis o children 9

10 Redisribuion in Social Securiy Program Several papers have used represenaive samples of reirees o consruc he pdv of lifeime SS axes and projeced SS benefis. This can be used o consruc an inernal rae of reurn on he invesmen: MaxAge ( Ba Ta) Definiion: i such ha = 0 a= 0 (1 + i)^ a This can be used o compare he inernal rae of reurn (IRR) wihin and across cohors. The research shows ha here is redisribuion: Across generaions: Par of early jusificaion of he program was o ransfer $ from younger, richer cohors o older cohors. IRR clearly falling over ime. (See Table 1 in Feldsein and Liebman) Wihin generaions by income. Higher IRR for lower income earnings. PIA formula. Offses progressive ax srucure Wihin generaions by family srucure. Higher IRR for single earning married couples. Wihin generaions from unhealhy o healhy. Lower life expecancy means lower PDV of benefis. 10

11 How does Social Securiy differ from a simple annuiy? [Definiion of simple annuiy: Take ax conribuions and purchase bond a age 65 ha yields cerain reurn forever.] 1. Redisribuion (wihin cohor)-- see PIA formula 2. No acuarially fair (across cohors) 3. Surviving spouse/child 4. Earnings es 5. Indexed o wages, prices 6. Canno be sold 11

12 Raionale for Social Securiy: 1. Marke failure (adverse selecion) Social securiy is a real annuiy (e.g. COLA adjusmen in US SS) Unil recenly no such securiies available (US Treasury now offers hese) Annuiy companies face adverse selecion (only healh sign up) 2. Paernalism People are myopic and undersave Why? Lack of informaion; high discoun rae? Wha is enough? How o measure? 3. Samarian s dilemma Wihou SS (forced savings), hen some people will end up poor and old. A ha poin you wan o help hem. So you migh as well force hem o save o begin wih. 4. Redisribuion based on lifeime earnings Oher sources of redisribuion well documened. 12

13 Basic Economics of Pay as you go Social Securiy Oulined in Samulson s seminal paper JPE 1958 paper. Generalizaion of Samuelson s model in 2 period Overlapping Generaions Model (Feldsein and Liebman, Handbook of Public Economics) Assumpions: Idenical Individuals Each agen lives for 2 periods Work a fixed amoun in period 1, reire in period 2 Populaion growh rae = n No capial, no money Can no save for old age (good is perfecly perishable) Noaion: L = # of workers in period W = wage rae B = SS benefi T = SS axes θ = SS ax rae 13

14 Implicaions: L + 1 = (1 + n) L labor growh (populaion=workers) T B = θl w aggregae ax revenue = T = θl w PAYG benefis=axes in year Rae of Reurn for person in cohor : Taxes paid as worker: T = θl w Benefis received as reired: B + 1 = θ L + 1w = θ (1 + n) L w 14

15 Taking raios generaes he inernal rae of reurn (IRR): B + 1 = = 1 + T θ (1 + n) L w θl w n= Inernal rae of reurn Samuelson called n he biological rae of ineres. Even an unfunded SS program pays ineres! Also, noe he windfall received by he 1 s generaion: B1 = = T 0 0 Connecing back o raionale for SS: SS is desirable since i permis individuals o reire and consume despie all perishable goods. Key resul of Samuelson: In a world wihou a capial good, SS leads o pareo improvemen by making iner-generaional rade feasible. 15

16 Adding echnological progress (wage growh) w ) + 1 = (1 + g w Inernal Rae of Reurn= B + 1 θ (1 + n) L (1 + g) w = = (1 + g)(1 + n) T θl w 16

17 Despie simpliciies, he model demonsraes realiies of PAYG SS sysem: -- High g and/or high n will yield a high rae of reurn (pareo improvemen) -- In he Unied Saes currenly boh g and n falling over ime, yielding falling reurns : Real wage bill grown by 2.8% (real wage growh 1%, labor force growh 1.8%) Wages/beneficiary: 3.27 in 1995, 2.04 in 2030 Reason for increasing wages and building up rus fund is o no have o raise ax raes by so much laer. 17

18 Adding Capial Sock Wih a non-perishable good, hen consumers can save from one period o he oher. Evaluaing impacs of SS are differen in ha model. Feldsein and Liebman presen his in heir chaper. Tax-Benefi Linkage? Noe: There is a deadweigh loss on pre-reiremen earnings due o payroll ax AS LONG AS ax is viewed as a ax and no a benefi. Back o balancing disorion and proecion Opimal SS sysem has o balance hese wo pars: (1) Proecion: Providing basic consumpion for hose who are oo myopic o save for hemselves (2) Disorion: Providing a lower rae of reurn for hose who ARE NOT myopic and herefore would have saved adequaely for heir reiremen. Crowding ou oher saving Disors reiremen and labor supply Feldsein and Liebman presen SS opimal ax in chaper. 18