Chapter 5: Social Security

Chapter 5 Social Security

McGraw-Hill/Irwin 5 - 1.
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved
 Chapter 5: Social Security

Introduction

Four ways to prepare for retirement

The U.S. Social Security system
Reforming Social Security

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 Chapter 5: Social Security

Four Ways to Prepare for Retirement

Table 5.1

Individually Collectively
Workers Support Retirees Historical U.S. Social Security
Each Generation is
Recent Possible
Self-Sufficient

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 Chapter 5: Social Security

Four Ways to Prepare for Retirement

Workers support retirees
Individually
• Historical
• Compact between generations
• Advantages and disadvantages

Collectively
• U.S. Social Security
• Advantages and disadvantages

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 Chapter 5: Social Security

Four Ways to Prepare for Retirement

Each generation is self-sufficient

Individually
• Recent
• Individual savings or home ownership

Collectively
• Possible
• Government taxes all workers and saves
the revenue to be dispersed upon retirement

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 Chapter 5: Social Security

The Rate of Return

There are two stages of life of equal length

WORK RETIREMENT

r* = (B2 – T1) = B2 -1
T1 T1

T1 is the sacrifice made in the work stage and

B2 is the benefit received in the retirement stage.

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 Chapter 5: Social Security

The Rate of Return when Workers Support Retirees

BR = tWL • B = benefit per retiree

• R = number of retirees
• t = payroll tax rate
• W = wage of workers
• L = number of workers

What determines the benefit you receive?

• Faster growth in the labor force
• Faster growth in the wage per worker

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 Chapter 5: Social Security

The Rate of Return when Workers Support Retirees

Table 5.2

Period Workers Wage Tax Revenue Retirees Benefit r

1 100 $10,000 $2,000 $200,000 --- ---
2 125 $10,000 $2,000 $250,000 100 $2,500 25%
1 100 $10,000 $2,000 $200,000 --- ---
2 100 $12,000 $2,400 $200,000 100 $2,400 20%
1 100 $10,000 $2,000 $240,000 --- ---
2 125 $12,000 $2,400 $300,000 100 $3,000 50%

If the payroll tax rate, the growth rate of labor, and the growth
rate of the wage remain constant over time then:

r* = gL + gW + gLgW
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 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

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 Chapter 5: Social Security

The Impact on the Economy

Imagine two economies being born
One is self-sufficient and one is a
workers support retirees economy.

Results • 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.

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 Chapter 5: Social Security

Breaking Out is Hard to Do

To transition from a workers-support-retirees
to a self-sufficient economy is difficult.
Three transition options
1. The current workers must double-save
2. The current retirees are ditched
3. The sacrifice is spread out over several
generations of workers and retirees

Defined benefit versus defined contribution

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 Chapter 5: Social Security

Defined Benefit versus Defined Contribution

Table 5.3

Collective Workers Each Individual is

Support Retirees Self-Sufficient
Average rate of return r* = gL+gW+gLgW = 3% mpk = 6%
K and output of economy Lower Higher
Individual ownership and
No Yes
control
Wage history, Investment Income,
Benefit depends on
defined benefit defined contribution
Risk of variation of r* Low High
Benefit is an annuity Yes No

Benefit is inflation protected Yes No

Redistribution from high to
Yes No
low wage workers

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 Chapter 5: Social Security

The U.S. Social Security System

Background
• “New Deal” 1935
• Pay-as-you-go (PAYGO)
• Use current payroll taxes to pay current benefits.

Key PAYGO Equation

• B = benefit per retiree
BR = tWL • R = number of retirees
• t = payroll tax rate
• W = wage of workers
• L = number of workers

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 Chapter 5: Social Security

The Ratio of Workers to Retirees

Workers per beneficiary Figure 5.1

Historical Estimated
Over the next
25 years, the
ratio of workers
to retirees is
projected to fall
from 3 to 2.

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.

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 Chapter 5: Social Security

Description of the Current U.S. Social Security System

• Payroll tax rate has increased over time
• Payroll tax ceiling
Table 5.4

Employee Taxable Maximum Combined Maximum

Year
Tax Rate Ceiling Employee Tax Tax Rate Combined Tax
1983 5.4% $35,700 $1,928 10.8% $3,856
1984 5.7% $37,800 $2,155 11.4% $4,309
1990 6.2% $51,300 $3,181 12.4% $6,361
2007 6.2% $97,500 $6,045 12.4% $12,090
2008 6.2% $102,000 $6,324 12.4% $12,648

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 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).

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 Chapter 5: Social Security

Description of the Current U.S. Social Security System

Figure 5.2
PIA
A progressive
benefit formula
favors low-earners
15% more than high-
$1,785 earners.
32%

$640
0%
9
AIME
$711 $4,288

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 Chapter 5: Social Security

Description of the Current

U.S. Social Security System
Sources and uses of Social Security revenues in 2006 ($744.9 billion)

Figure 5.3

Source: Fast Facts & Figures about Social Security 2007, p.34

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 Chapter 5: Social Security

Description of the Current

U.S. Social Security System
The impact on work
• Spousal benefit

The impact on saving, investment, and

capital accumulation.
• Present value of Social Security wealth

The impact on retirement.

• “Normal” retirement age

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 Chapter 5: Social Security

Reforming Social Security

Figure 5.4
Benefits and Taxes
F • Current taxes and
benefits and the amount
G in the trust fund
T
T ax es • If benefits remain
e f its B constant, the trust fund will
Ben run out in 2040
U.S. Bonds in • Slowing benefit growth
SS Trust Fund
and increasing taxes
would grow the trust fund

2000 2010 2020 2030 2040

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 Chapter 5: Social Security

Reforming Social Security

Treating the 2040 problem
Ways to raise tax growth:
• Increase the payroll tax rate
• Payroll tax ceiling can be increased
• Payroll above the ceiling can be taxed

Ways to slow benefit growth:

• Increase the FBA
• Reduction in the replacement rate for high earners
• Wage indexing compared to price indexing
• Progressive indexing

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 Chapter 5: Social Security

Reforming Social Security

Making each generation self-sufficient

• Collective self-sufficiency
• Individual self-sufficiency
• individual investment accounts

Combinations and compromises

• Combine measures from each solution: Treating the
2040 problem, collective self-sufficiency, and individual
self-sufficiency

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 Chapter 5: Social Security

Summary

Four ways to prepare for retirement

The U.S. Social Security system

Reforming Social Security

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 Chapter 5: Social Security

Preview of Chapter 6:
Health Insurance

Principles of health insurance

Features of the health sector

The role of government

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