Why Have Social Security?

• Consumption Smoothing and the Annuity Market– How Social Security works– Consumption smoothing

• Insurance (annuity and life insurance):- Risk of living too long, not having accumulated enough assets (Annuity)- Risk of dying too young leaving family without sufficient assets (life

insurance)

• Adverse Selection and the Annuity Market– Asymmetric information– Adverse selection and life expectancy– Death spiral => incomplete market

11-1

Other Justifications

• Lack of foresight and paternalism• Moral hazard• Economize on decision-making and

administrative costs• Income Redistribution

11-2

Fully Funded Plan (Problematic issue?)

Period 1 Period 2 Period 3 Period 4

contribute benefits

contribute benefits

contribute benefits

Generation 1

The Baby BoomGeneration

Generation X

Work Retire Dead

Unborn

Work

Work

Retire

StillDead

DeadChildhood

Childhood Retire

11-3

Each generation’s benefits based on deposits it made

during working life plus accumulated

interest

Period 1 Period 2 Period 3 Period 4

Generation 1

The Baby BoomGeneration

Generation X

Work Retire Dead

Unborn

Work

Work

Retire

StillDead

DeadChildhood

Childhood Retire

contribute

benefits

contribute

benefits

contribute

benefits

benefits

Pay As You Go (or Unfunded) System(problematic issues?)

11-4

Each generation’s

benefits come from tax

payments made by current

workers

Period 1 Period 2 Period 3 Period 4

Generation1

The Baby BoomGeneration

Generation X

Work Retire Dead

Unborn

Work

Work

Retire

StillDead

DeadChildhood

Childhood Retire

contribute

benefits

contribute

benefits

contribute

benefits

benefits

Today’s Partially Funded System(problematic issue?)

Baby Boomers and Gen X are also

contributing to their own retirement

11-5

Distributional Issues for a pay as you go system

• Retirement insurance programme• Actuarially fair return • Benefits equal the premium paid (average life span)

Intergenerational redistribution in a pure p-a-y-g– Total benefits = Nb * B

– Total taxes = t * Nw * w

– If total benefits = total taxes (in equilibrium):

– > Nb * B = t * Nw * w or B = t * (Nw/Nb) * w

11-6

Distributional Issues

Nb * B = t * Nw * w or B = t * (Nw/Nb) * w

What are the implications?Can B increase? Given t constant:Either Nw (relative Nb) or w must increaseIf both constant => B = w*t => Implications on the Implicit rate of return If w=1.5% population =1% => IRR = 2.5% (about)Or any combination of w and population growthNote: Population ageing and productivity

11-7

What if t increases?

• t higher => who gains (IRR)?

=> Sustainable increases of IRR only on w and PopAt the start of the system extraordinarily high returns!Ida May Fuller the first ss beneficiaryWork 3 ys retired 65 died 99Opposite case for ending system (or changing it)Graduality of reforms! HOMEWORK:How would it apply or not a selfish politician who wants to be re-elected

referring to the median voter model

Other Distributional Issues

• Redistribution within a generation– Differences by earnings– Differences by lifespan– Differences by living arrangements– Differences by number of earners in the family

• Normative evaluation

11-9

Social Security and Savings Behavior

• Life-cycle theory of savings• Wealth Substitution Effect• Retirement Effect• Bequest Effect

11-10

Budget Constraint for Present and Future Consumption

Present consumption (c0)

Futu

re c

onsu

mpti

on (c

1)

N

MI0

I1

D

I0 - S

I1 + (1+r) S

S

(1+r)S

I1 - (1+r) BF

B

(1+r)B

At endowment point (A)

consumer neither saves nor borrows

11-11

A

Utility-maximizing Choice of Present and Future Consumption

Present consumption (c0)

Futu

re c

onsu

mpti

on (c

1)

N

MI0

I1

E1c1*

A

c0*

Saving

11-12

Crowding out of private saving due to Social Security

Present consumption (c0)

Futu

re c

onsu

mpti

on (c

1)

N

M

I0

I1

E1c1*

A

c0*

R

T

I0T

(1+r)T

Saving before Social Security

Saving after Social

Security

11-13

Empirical Evidence: Does Social Security Reduce Saving?

• Time-series evidence– Martin Feldstein (1974, 1996) v. Leimer and

Lesnoy (1982)

• Cross-section evidence• Evidence from other countries

– Attanasio and Brugiavini (2003) and Italy

11-14

Other ways Social Security Affects Saving

• Retirement effect• Bequest effect• Empirical evidence

11-15

Retirement Decisions

• Social Security wealth and the retirement decision

• Empirical evidence– Diamond and Gruber [1999]– Gruber and Wise [2004]

11-16

Long-Term Stresses on Social Security

Source: Social Security Trustees [2012]

Projected revenues and projected costs of Social Security as share of Gross Domestic Product

11-17

Long-Term Stresses on Social Security

Since: B = t * (Nw/Nb) * w

Rearrange: t = (Nb/Nw) * (B/w)

Dependency RatioReplacement Ratio

11-18

Social Security Reform

• Time horizon for solvency– Sustainable solvency

11-19

Maintain the Current System

• Raise the payroll tax• Raise the Maximum Taxable Earnings Level• Raise the Retirement Age• Reducing the Cost-of-Living Adjustment• Change the Benefit Formula• Comparing the Options

11-20

Homework

• Exercise 3 page 249 and 6 page 250