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Savings, Retirement, and Social Security


Social Security provides income for older individuals. ... Likely that the Social Security taxes paid from ages 22-32 will not matter for AIME. ... – PowerPoint PPT presentation

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Title: Savings, Retirement, and Social Security

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

  • 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.

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
  • Adverse selection Individual who knows he is
    especially likely to collect benefits will have
    an especially high demand for insurance.

How can government intervention improve
  • 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.

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).

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

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  • Age at which benefits are withdrawn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

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.

The Benefit Structure
  • Benefits are base on Average Indexed Monthly
  • Only highest 35 years of earnings count toward
  • 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.

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.

Example of Benefit Calculation (using 2004 rules)
Redistribution to Low Income Earners
  • Typical low-earner who retired in 2003 received
    64 of AIME.
  • Average earner received 48
  • High earner received 40.

Normal Retirement Age
  • The normal retirement age is the age at which an
    individual qualifies for full Social Security
  • 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.

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.

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.

Social Security Taxes are Capped
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
  • See Table 9.3

Table 9.3
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

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
Retirement Savings
  • In addition to Social Security individuals can
    use private savings to accumulate wealth for
  • 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

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.

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
  • The worker receives these savings and any
    accumulated investment earnings when she retires.

401(k) Accounts
  • The most rapidly growing form of retirement
    account is the 401 (k) account, an individually
    controlled savings program offered through the
  • 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

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

Excludable Forms of IncomeSome types of Saving
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
  • 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.

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.

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

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.

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.

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

Fundamental Reform
  • In addition, advocates of Social Security often
    favor the introduction of personal retirement
  • 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.

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

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.

Some Lessons
  • Traditional Pay-as-you-go systems require a
    significant amount of trust between workers of
    different generations the so called social
  • 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
  • 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.

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.

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.