Chapter 5: Social Security Chapter 5 Social Security Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter 5: Social Security Introduction Four ways to prepare for retirement The U.S. Social Security system Reforming Social Security

Chapter 5: Social Security Four Ways to Prepare for Retirement IndividuallyCollectively Workers Support RetireesHistoricalU.S. Social Security Each Generation is Self-Sufficient RecentPossible Table 5.1

Chapter 5: Social Security Four Ways to Prepare for Retirement Workers support retirees Historical Compact between generations Individually Collectively Advantages and disadvantages U.S. Social Security Advantages and disadvantages

Chapter 5: Social Security Four Ways to Prepare for Retirement Each generation is self-sufficient Recent Individual savings or home ownership Individually Collectively Possible Government taxes all workers and saves the revenue to be dispersed upon retirement

Chapter 5: Social Security The Rate of Return There are two stages of life of equal length WORK RETIREMENT r * = (B 2 – T 1 ) T 1 = B2T1B2T1 T1 is the sacrifice made in the work stage and B2 is the benefit received in the retirement stage.

Chapter 5: Social Security B = benefit per retiree R = number of retirees t = payroll tax rate W = wage of workers L = number of workers BR = tWL What determines the benefit you receive? Faster growth in the labor force Faster growth in the wage per worker The Rate of Return when Workers Support Retirees

Chapter 5: Social Security The Rate of Return when Workers Support Retirees PeriodWorkersWageTaxRevenueRetireesBenefitr 1100$10,000$2,000$200, $10,000$2,000$250,000100$2,50025% 1100$10,000$2,000$200, $12,000$2,400$200,000100$2,40020% 1100$10,000$2,000$240, $12,000$2,400$300,000100$3,00050% Table 5.2 r * = g L + g W + g L g W If the payroll tax rate, the growth rate of labor, and the growth rate of the wage remain constant over time then:

Chapter 5: Social Security The Rate of Return when Each Generation is Self-Sufficient Individuals save at banks or by buying stocks and bonds. Upon retirement, you receive principle plus interest Marginal product of capital (mpk) Is mpk greater than, less than, or equal to r *? Individual versus collective saving

Chapter 5: Social Security The Impact on the Economy No real capital accumulates in the workers support retirees economy. The self-sufficiency economy operates with permanent capital stock. There are advantages and disadvantages to each system. Imagine two economies being born One is self-sufficient and one is a workers support retirees economy. Results

Chapter 5: Social Security Breaking Out is Hard to Do To transition from a workers-support-retirees to a self-sufficient economy is difficult. 2. The current retirees are ditched 1. The current workers must double-save Three transition options 3. The sacrifice is spread out over several generations of workers and retirees Defined benefit versus defined contribution

Chapter 5: Social Security Table 5.3 Collective Workers Support Retirees Each Individual is Self-Sufficient Average rate of returnr* = g L +g W +g L g W = 3%mpk = 6% K and output of economyLowerHigher Individual ownership and control NoYes Benefit depends on Wage history, defined benefit Investment Income, defined contribution Risk of variation of r*LowHigh Benefit is an annuityYesNo Benefit is inflation protectedYesNo Redistribution from high to low wage workers YesNo Defined Benefit versus Defined Contribution

Chapter 5: Social Security The U.S. Social Security System “New Deal” 1935 Pay-as-you-go (PAYGO) Use current payroll taxes to pay current benefits. BR = tWL Background Key PAYGO Equation B = benefit per retiree R = number of retirees t = payroll tax rate W = wage of workers L = number of workers

Chapter 5: Social Security The Ratio of Workers to Retirees Workers per beneficiary Source: 2007 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, Table IV.B2. Historical Estimated Figure 5.1 Over the next 25 years, the ratio of workers to retirees is projected to fall from 3 to 2.

Chapter 5: Social Security Description of the Current U.S. Social Security System Table 5.4 Payroll tax rate has increased over time Year Employee Tax Rate Taxable Ceiling Maximum Employee Tax Combined Tax Rate Maximum Combined Tax %$35,700$1, %$3, %$37,800$2, %$4, %$51,300$3, %$6, %$97,500$6, %$12, %$102,000$6, %$12,648 Payroll tax ceiling

Chapter 5: Social Security Description of the Current U.S. Social Security System A person must pay payroll taxes for at least 40 quarters to be eligible. Earliest Eligible Age (EEA) is 62. The retiree’s monthly benefit is called the Primary Insurance Amount (PIA). The PIA depends on the person’s wage history, their Average Indexed Monthly Earning (AIME). The retiree receives the full PIA if they wait until the Full Benefits Age (FBA).

Chapter 5: Social Security PIA AIME Figure 5.2 $640 $711 90% $1,785 $4,288 32% 15% Description of the Current U.S. Social Security System A progressive benefit formula favors low-earners more than high- earners.

Chapter 5: Social Security Description of the Current U.S. Social Security System Source: Fast Facts & Figures about Social Security 2007, p.34 Figure 5.3 Sources and uses of Social Security revenues in 2006 ($744.9 billion)

Chapter 5: Social Security Description of the Current U.S. Social Security System The impact on work The impact on saving, investment, and capital accumulation. The impact on retirement. Present value of Social Security wealth “Normal” retirement age Spousal benefit

Chapter 5: Social Security Reforming Social Security Figure 5.4 If benefits remain constant, the trust fund will run out in U.S. Bonds in SS Trust Fund Benefits and Taxes Taxes Benefits T F G B Current taxes and benefits and the amount in the trust fund Slowing benefit growth and increasing taxes would grow the trust fund

Chapter 5: Social Security Reforming Social Security Ways to raise tax growth: Ways to slow benefit growth: Wage indexing compared to price indexing Progressive indexing Increase the payroll tax rate Increase the FBA Reduction in the replacement rate for high earners Payroll above the ceiling can be taxed Payroll tax ceiling can be increased Treating the 2040 problem

Chapter 5: Social Security Reforming Social Security Making each generation self-sufficient Collective self-sufficiency Combinations and compromises Combine measures from each solution: Treating the 2040 problem, collective self-sufficiency, and individual self-sufficiency Individual self-sufficiency individual investment accounts

Chapter 5: Social Security Summary Four ways to prepare for retirement The U.S. Social Security system Reforming Social Security

Chapter 5: Social Security Preview of Chapter 6: Health Insurance Principles of health insurance Features of the health sector The role of government