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Class Lecture on Social Security Macroeconomics, EC 204

Class Lecture on Social Security Macroeconomics, EC 204. Social Security Has Been an Enormous Success. Long-term Funding Problem for Social Security. Introducing Private Investment Accounts Won’t Solve the Funding Problem and Will Worsen the Problem in the Short-Term.

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Class Lecture on Social Security Macroeconomics, EC 204

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  1. Class Lecture on Social Security Macroeconomics, EC 204

  2. Social Security Has Been an Enormous Success. Long-term Funding Problem for Social Security. Introducing Private Investment Accounts Won’t Solve the Funding Problem and Will Worsen the Problem in the Short-Term. Private Accounts Should be Evaluated Separately, On Their Own Merits.

  3. Social Security is a Social Insurance Program with 3 Components: • - Income to retirees • - Support for disabled workers • - Benefits to survivors • Social Security provides an average of 40% of income to people 65 and older. • 80% of income to those in the lower two-fifths. • Main reason why poverty has dropped among elderly over past 40 years. People 65 and over now have a poverty rate lower than the overall average compared with twice the average in 1960.

  4. What are the mechanics of Social Security? Workers pay a “dedicated” payroll tax Benefits are financed through this revenue The tax is 12.4%: 6.2% each for worker and employer Based on income up to a certain level ($90, 000 currently) Base rises each year as overall wages rise Starting level of benefits is indexed to wages Continuing level of benefits are indexed to CPI Exactly how large are benefits? It depends….

  5. Estimated Annual Scheduled Benefit Amounts for Retired Workers Based on Intermediate Assumptions Workers with Average Earnings: Note: Benefits are for Normal Retirement Age of 65.5 years for 2005 and 67 for other years shown.

  6. Estimated Annual Scheduled Benefit Amounts for Retired Workers Based on Intermediate Assumptions Workers with Steady Maximum Earnings: Note: Benefits are for Normal Retirement Age of 65.5 years for 2005 and 67 for other years shown.

  7. Social Security is a Pay-As-You-Go System: Established in 1935 by President Roosevelt Early years had many more workers paying in than beneficiaries receiving payments Social Security currently is taking in more than it pays out Benefits are about 3/4 of Revenue But Babyboomers (your parents!) soon will begin to retire and then benefits will rise faster than revenues

  8. Number of Covered Workers Per Social Security Beneficiary

  9. Estimated Social Security Income and Cost in Constant Dollars, Based on Intermediate Assumptions [billions]

  10. Social Security Income and Cost Rates Under Intermediate Assumptions [As a percentage of taxable payroll]

  11. Cumulative Social Security Income Less Cost [Present value as of January 1, 2005, in trillions]

  12. Social Security Cost and Scheduled Tax Revenue as a Percentage of GDP

  13. Didn’t the shortfall worsen between last year and this year by about $300 billion--rising to $4 trillion from $3.7 trillion? What’s going on? Main reason for this is that we are adding a “bad” year at the end of the 75-year horizon and removing a “good” year…

  14. Social Security Annual Balances: 2004 and 2005 Trustees Reports [As a percentage of taxable payroll under the intermediate assumptions]

  15. Reasons for Change in the 75-Year Outlook [As a percentage of taxable payroll under the intermediate assumptions]

  16. So how large is the problem? Deficit is $4 trillion in present value (2005 dollars) Represents a shortfall of 1.92% of taxable payroll Need to start redeeming treasury IOUs in 2017 Trust Fund exhausted in 2041 Can still pay about 70% of promised benefits after 2041 Could solve problem by: Raising tax revenue about 15 percent (1.92/12.4) Cutting benefits by about 13 percent (1.92/14.32)

  17. Possible Ways to Close the Financing Gap Raising revenue: Cover all state and local workers Increase the base on which tax is levied Tax a larger share of Social Security benefits Raise the tax rate Cutting benefits: Adjust cost-of-living indexing for known bias in CPI Raise retirement age

  18. Problem seems manageable: Similar problem was solved in 1983 by raising taxes and cutting benefits Changes in economy and demographics altered the outlook by the late 1980s But, what happens if you look beyond 75 years? Problem is appears much worse…

  19. Unfunded Social Security Obligations for 1935 Through the Infinite Horizon [Present values as of January 1, 2005; dollar amounts in trillions]

  20. Present Values of Social Security Cost Less Tax Revenue and Unfunded Obligations for Program Participants [Present values as of January 1, 2005; dollar amounts in trillions]

  21. On the other hand, could the forecasts be wrong? Sure could… Over last decade, projections generally have been too pessimistic (although last year was slightly too optimistic) Date when Trust Fund is exhausted is now 2041 versus 2029 in 1997 Likewise, the 75-year shortfall as a percent of taxable payroll is now just over 1.9 compared with 2.2 Let’s look at the assumptions behind the forecasts…

  22. Ultimate Values of Key Demographic and Economic Assumptions for the Long-Range (75-year) Projection Period Also assumes that Total Employment grows at 0.2 percent, so that Real GDP grows at 1.8 percent.

  23. Long-Range Social Security Trust Fund Ratios Under Alternative Assumptions [Assets as a percentage of annual cost]

  24. How would private accounts work? Would take revenue that otherwise would be use to pay Social Security benefits Would require additional borrowing ($ trillions) to cover the shortfall--the so-called “transition costs” Would thus worsen the financing shortfall--until well into the future Guaranteed benefits would be reduced Lots of questions need to be answered concerning types of investments, whether you must buy an annuity, whether your heirs will inherit your account, how to handle disability

  25. Potential benefits of private accounts: • Provide investment opportunities to lower income people who now don’t have this option • Potentially earn a better “return” than on Social Security • Provide “ownership” to participants • Give people more choice in managing their retirement • Would start to move Social Security to a pre-funded program

  26. Yet, private accounts would represent a very different type of program than Social Security: • Participants would take on greater risk • Participants would give up an inflation-adjusted, guaranteed asset

  27. But, doesn’t the stock market return 7% per year after inflation over long periods of time? Yes, it does. But participants wouldn’t be investing a lump sum at the start--which is what the long-term average returns imply. Instead, participants would be investing continually--so returns closer to retirement get weighted more heavily than returns early in one’s career.

  28. How risky is investment in the stock and bond markets? One way to assess this is to look at hypothetical investment scenarios using data on historical returns. The variability of investment performance is significantly greater when participants add continually to their account--as would be the case under nearly all proposed plans. This continues to be true even when a “mixed” portfolio of stocks, bonds, and cash is chosen.

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