Chapter 8

Social Security and Social Insurance


Social Security Act of 1935
Requirements at that time:  Retirement Age: 65  Payroll Tax: 1% for employer and employee Tax applied to the first $3000 of earned income


Other Nations and Social Insurance
  

Germany 1889 U.K. 1908 France 1910

Now more than 170 nations have some form of social security system.


Social Security in the United States

  

Old Age Survivors Disability Insurance

 

HI: Health Insurance (Medicare) UI: Unemployment Insurance


Social Security Throughout the World
  

Most systems throughout the world are similar to the U.S. Social Security System. Some make fixed payments not related to preretirement earnings. The problem of supporting more retirees with fewer workers is greater in Japan and Western Europe. Chile, Argentina, Peru, Sweden, and Mexico have partially or fully privatized elements.

Federal Insurance Contribution Act

Employers and employees each currently contribute 7.65% of wages in FICA tax. 15.3 % for the self-employed Taxes applied on earned income up to $87,000 in 2003 (indexed).


Fully Funded vs Pay-As-You-Go

A Fully Funded system: current fund has balances sufficient to pay the present value of all future obligations.

A Pay-As-You-Go system: current taxes pay for current benefits.

The current U.S.system is a modified pay-as-yougo system with a trust fund as backup.

Social Security Trust Fund
 

Since 1982, Social Security taxes collected have greatly exceeded benefits paid out. The trust fund is an accounting mechanism by which U.S. government debt is issued to the Social Security Administration in exchange for SS fund surpluses. This debt will be sold to the public when taxes paid fall below what is needed to pay benefits.


Retirement Age
 

People born prior to 1935 can retire with full benefits at 65. People born between 1936 and 1942 can retire with full benefits at age 65 + 2 months for every year after 1936 they were born. People born between 1943 and 1954 can retire with full benefits at age 66. People born between 1955 and 1960 can retire with full benefits at age 66 + 2 months for every year after 1955 they were born. People born after 1960 can retire at full benefits at age 67.

How Retirement Benefits are Computed

The AIME (Average Index of Monthly Earnings) calculates the highest 35 years of inflationadjusted earnings, expressed in monthly terms. The PIA (Primary Insurance Amount) is the amount to which a individual is entitled given their AIME.


Replacement Rates

The Gross Replacement Rate is the monthly retirement benefit divided by the monthly labor earnings in the year prior to retirement. The Net Replacement Rate is the monthly aftertax benefit divided by the monthly after-tax labor earnings in the year prior to retirement .


Gross Replacement Rates by Income
Worker Status
Gross Replacement Rate

Low Earner Average Earner Maximum Earner

53.6% 39.9% 24.8%

Figure 8.1 How Gross Replacement Rates for Social Security Pension Recipients Vary with Pre-retirement Earnings
110 100 90 80 70 60 50 40 30 20 10 0

Gross Replacement Rate (Percent)

1,000 2,000 3,000 4,000 Gross Monthly Earning in the Year Prior to Retirement (Dollars) 13

Spousal and Dependent Benefits
.5 of PIA is added for a spouse over age 65 and for each dependent child


Divorce and the Two-Income Family

The structure of the benefit formula is such that a woman who worked while married to a high income-earning husband will get nothing or virtually nothing for the taxes she paid. She and her husband would get 1.5 times his PIA if she earned nothing and 1.5 time his PIA if she earned a modest income. Divorced people are entitled to either their own PIA or half the amount that they would have received as a couple had they not divorced. This applies to multiple spouses as well. Thus, breadwinners can have multiple people receiving half or full pensions based on a single taxpayer’s earnings.


Other Anomalies

When one party in a marriage dies, the benefit to the survivor depends on who made the money.
 

If both earned equal amounts, then when one dies the other receives their own amount. If one earned all the money and the breadwinner dies, the survivor keeps the spouse’s pension (which is often quite a bit more).

Singles fair substantially worse than do married dependent partners with deceased breadwinning partners.

The Importance of Social Security Income to the Elderly

2/3 get more than half of their income from Social Security. Private pensions only account for 20% of elderly income. For low-income persons, Social Security is 80% of their monthly income. More than 50% of the elderly would be below the poverty line without Social Security.

Cost-of-Living Adjustments

Benefits are adjusted for inflation using the CPI. Because the CPI overstates inflation (by estimates in the neighborhood of 1.1 percentage points), Social Security benefits increase in real terms each year.

How do Rates of Return Compare to Private Pensions

Between 1950 and 1975, the rate of return for Social Security was around 10%. The predicted real rate of return will be around 2% in the future. Private pensions have historically yielded from 5 to 10% over a similar period of time.


Intergenerational Transfers

Not only does Social Security transfer income from those who are young to those who are old, it transfers income from the generation born after 1945 to the generation born before 1925. On average, those born between 1925 and 1945 will see approximately the same return they would have received in a similarly safe asset.


Demographic Changes
Birthrates have fallen such that the number of workers supporting each retiree has fallen from more than 30 in the 1950s to below 5 beginning in 1990. Projections show that fewer than 3 workers will support each retiree by 2030; shortly thereafter, fewer than 2 workers will support each retiree.

Algebraic Look at the Result of Demographic Changes Under a Pay-as-You-Go system

t = (B × R)/(W × L)

    

t is total benefits paid B is the average benefit R is the number of recipients W is taxable wages L is the number of workers


Algebraic rearranging

t = B/W × R/L = the average replacement
rate × the dependency ratio

The dependency ratio was below .1; it is currently above .3 and is steadily increasing, and will be at .5 in 2030.



Basic OASDHI Tax Rate

Combined EmployerEmployee Tax Rate

Maximum Taxable Wages per Worker

Maximum Tax Based on Combined Rate

1937 1957 1967 1977 1987 1997 2003

1.00 2.25 4.40 5.85 7.15 7.65 7.65

2.00 4.50 8.80 12.10 14.30 15.30 15.30

$3,000 $4,200 $6,600 $16,500 $43,800 $65,000 $87,000

$60.00 $189.00 $528.00 $1,930.50 $6,263.40 $10,006.20 $13,615.50 24

Proposals to Reform Social Security

Maintain benefits  Increase taxability of benefits  Invest Trust Fund in Corporate Securities  Eventually increase payroll tax rate by 1.6 percentage points Individual Accounts  Raise retirement age  Reduce replacement rates for upper income people  Allow 1.6 percent of payroll to be placed in special retirement accounts Personal Security Accounts  Allow half of payroll taxes to be placed in individually managed accounts  Reduce guaranteed benefit


Impact of Social Security on Savings and Work Incentives Income and Substitution Effects

The Substitution Effect leads to decreased saving and work. The Income Effect may lead to an increase or decrease in savings and work. Most economists believe the income effect will decrease savings and work.

Figure 8.2 Social Security Pensions and the Work-Leisure Choice

Income per Day


U2 H G B


U2 U1 E' E G B 0 L1 L2 24








Leisure Hours per Day

Working While Eligible for Social Security Benefits
 

People may work and receive Social Security benefits. If they receive benefits with the reduced benefits option at age 62, they lose $1 in benefits for every $2 they earn over approximately $10,000. Those older than 65 may earn any amount and keep their benefits. If they choose not to receive benefits, they receive a greater Social Security benefit when they decide to begin receiving them.


Savings Incentives of Social Security

Asset Substitution Effect: People save less than they would if Social Security did not exist, because they are substituting government promises of a benefit for private savings. Stated simply, people save less because government is “saving” for them. Induced Retirement Effect: People save more than they would if Social Security did not exist because they would not have retired or would not have retired as early had Social Security not been there. Given that it does exist, people choose to ultimately retire or retire earlier and save in order to do so. Bequest Effect: People save more than they would have if Social Security did not exist in order to bequeath more to their children and grandchildren.


Figure 8.3 The Asset Substitution Effect
Consumption per Year after Retirement


Social Security Pension

E F U1
Social Security Pension

G2 R2

F E U1 U2 B











S T Consumption per Year Prior to Retirement


The Net Effect of Social Security on Savings

Feldstein: Social Security leads to a substantial reduction in savings Munnell: The net effect of the ASE, BE, and IRE is nearly zero


The program provides substantially subsidized health insurance to those 65 and older. It is financed with premiums, a 2.9% payroll tax (1.45% each for employers and employees) and general government revenue.

Part A:
  

Mandatory Covers hospitalization Financed with payroll tax and premiums Voluntary Covers doctor’s visits Financed from general federal revenue and premiums

Part B:
  


Unemployment Insurance

Covers nearly all full-time workers Financed with a payroll tax on employers up to $7000 of earnings Gross Replacement Rate: 33%

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