SOCIAL SECURITY:How It Works and How to Fix It

Jon FormanAlfred P. Murrah Professor of LawSeptember 22, 2005

available at http://www.law.ou.edu/profs/forman.shtml

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Overview How Social Security Works

Financing Social Security How Benefits Are Determined

Financial Troubles How to Fix It

Raise Taxes Cut Benefits Increase Investment Returns

A two-tier System

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How Many People Get Social Security?

47.7 million people receive Social Security each month

1 in 6 Americans get Social Security benefits

Nearly 1 in 4 households get income from Social Security

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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Who Gets Social Security?

30.0 million retired workers 4.8 million widows and widowers 6.2 million disabled workers 0.8 million adults disabled since

childhood 3.1 million children

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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How Much Does Social Security Pay?

www.ssa.gov/OACT/COLA/colaeffect.html

Type of Beneficiary AverageMonthly Benefit

All Retired Workers $955

Aged widow(er), non-disabled $920

Disabled worker $895

Aged couple-both receiving $1,574

Widowed mother and two children $1,979

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Social Security and Poverty

2005 Poverty Levels Single individuals – $9,570 ($798/month) Married couples – $12,830 ($1,070/month)

With Social Security only 9% were poor in 2000

Without it, 48% would have been poor

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Financing Social Security Workers and their employers pay with

Social Security taxes Workers pay

6.2% of their earning for Social Security, and 1.45% of their earnings for Hospital Insurance

under Medicare (Part A) Employers pay an equal amount The total is 12.4% for Social Security and

2.9% for HI Social Security tax base is $90,000 in 2005

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Worker Benefits

Workers over 62 are eligible If they have worked 10 years

Benefits are based on a workers earnings history Career-average earnings Average Indexed Monthly Earnings (AIME)

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Average Indexed Monthly Earnings (AIME)

Determine how much the worker earned every year through age 60 Determine Benefit Computation Years And Earnings in those years

Index those Earnings for Wage Inflation Up to the year the worker turns 60

Subsequent Work Years Also Count Pick the Highest 35 Years

Drop the rest

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Average Indexed Monthly Earnings (AIME), continued

Add those highest 35 years of earnings up

Divide by 35; Divide by 12 Result is called Average Indexed

Monthly Earnings (AIME) AIME is then linked by formula to the

basic retirement benefit Result is called Primary Insurance Amount

(PIA) Paid at full retirement age

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Full Retirement Age

http://www.ssa.gov/retire2/retirechart.htm

Year of Birth Full Retirement Age

1937 or earlier 65

1938 - 1942 plus 2 months per year

1942 – 1954 66

1955 - 1959 plus 2 months per year

1960 and later 67

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Primary Insurance Amount (PIA)

For a worker turning 62 in 2005,PIA = 90% of first $627 of AIME

+ 32% of AIME from $627 to $3,779 (if any)+ 15% of AIME over $3,779 (if any)

$627 and $3,779 are called bend points PIA indexed by cost of living after 62 Provides higher benefits relative to earnings

for lower paid

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Primary Insurance Amount (PIA) formulafor persons turning age 62 in 2005

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

$0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000

Average Indexed Monthly Earnings

Pri

mar

y In

sura

nce

Am

ount

PIA

Second Bend Point$3,779

FirstBend Point$627

following American Academy of Actuaries (2004).

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How do benefits compare to earnings?

$19,600$22,500

$15,800

$35,300

$55,400

$90,000

$14,800

$9,000

57%

42%

35%25%

$0

$20,000

$40,000

$60,000

$80,000

"low" "medium" "high" "maximum"

Earnings Amount

Past Wages Benefits

Retired worker age 65, 2005

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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Worker Benefits:Increases and Decreases Indexed for inflation Actuarial decrease for early retirement

Example: average-wage worker, 62 in 2003 get $1,258 at full retirement age (65 and 2

months) or $964 per month at 62

Actuarial increase for late retirement 8 percent per year

Retirement Earnings Test In 2005, early retirees lose $1 of benefits for

each $2 of earnings over $11,000

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How many people rely on Social Security for most of their income?

90% of people 65 and older get Social Security

Nearly 2 in 3 (66%) get half or more of their income from Social Security

About 1 in 5 (22%) get all their income from Social Security

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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Most elderly don’t receive pensions

Percent with Employer-Sponsored Pensions

All age 65+ 41%Couples 51%Unmarried men 39%Unmarried women 32%

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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Family Benefits

Spouses, dependents, and survivors Husband or wife gets 50% of worker’s

PIA Together, couple gets 150%

Widow or widower gets 100% of worker’s PIA

A joint and two-thirds annuity Dual entitlement rule limits benefits

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Estimates for 2005 Finances

Trust Fund income = $690 billion (taxes)Trust Fund outgo = $527 billion (benefits)Surplus = $163 billion

By law, surpluses are invested in U.S. government securities and earn interest that goes to the trust funds.

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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How do actuaries estimate the future?

Review the past: birth rates, death rates, immigration, employment, wages, inflation, productivity, interest rates

Assumptions for the next 75 years Three scenarios: Low cost; High cost;

Intermediate (best estimate)

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

21Social Security Administration, 2005 Trustees’ Report

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The Long-Range Forecast(Best estimate)

In 2017, tax revenues into the trust funds forecasted to be less than benefits due that year. Interest on the reserves and the assets themselves will help pay for benefits until 2041.

In 2041, reserves are projected to be depleted. Income is forecast to cover 74% of benefits due then.

By 2079, assuming no change in taxes, benefits or forecasts, revenue would cover about 68% of benefits due then.

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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Social Security’s Financing Problem

2005 Trustees Report shows Expenses will exceed payroll tax income in 2017 Trust funds will be out of money in 2041

75-year deficit equals 1.92% of taxable payroll Immediate payroll tax increase of 1.92% needed to

restore actuarial balance Alternatively, immediate 12.8% across-the-board

benefit cut $4 trillion unfunded liability 0.6% as a share of the entire economy (GDP)

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Why is the deficit so much smaller as a share of GDP?

The answer is because Social Security taxable wages are only a relatively small part of GDP. Wages taxed for Social Security are 39

percent of GDP. The other 61 percent of national income

is not taxed to help pay for Social Security.

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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What is that non-taxable income?

Income not subject to Social Security taxes includes: earnings above the tax cap ($90,000 in

2005); tax exempt compensation (non-taxable

fringe benefits, tax-deferred accounts, etc); wages of about one in four state and local

workers who are not covered by Social Security;

income from property – stock dividends, interest, and rental income.

National Academy of Social Insurance,Social Security Finances: A Primer (2005)

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Only 3 Ways to Fix Social Security

Raise Taxes Cut Benefits Increase Investment Returns

Private investment Either government or individual

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Options: Raise Taxes

OPTION Increase tax rate by

2% total Tax all earnings Tax 90% of earnings Include new state &

local govt. workers Tax SS benefits like

pensions

% of Deficit Eliminated104%

93%40%10%

20%

National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

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Options: Cut Benefits

OPTION Raise retirement age

(to 67 faster & index) Reduce COLA by ½%

each year Cut benefits by 5% for

those starting to get benefits in 2005

Increase # years in wage avg. to 40

% of Deficit Eliminated28%

41%

32%

21%

National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

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Options: Increase Investment Returns

OPTION Investments in equities

% of Deficit Eliminated36% - 50%

National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

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Long-term Reform

Social Security should ensure that every elderly American has an adequate retirement income

We could redesign the system Two-tier system

First tier: poverty-level benefit Second tier: earnings-related benefit Earnings sharing

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First Tier: Basic Benefit

Government guarantee of poverty-level income

2005 Poverty Levels Single individuals – $9,570 ($798/month) Married couples – $12,830 ($1,070/month)

Would replace SSI and redistribution within the current SS system

Pay for with general revenues

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Second Tier: Earnings-related Benefit

Individual accounts Hypothetical (“cash balance”) accounts Invested by professionals

Pay for with reduced payroll taxes Pay out lifetime annuities

Inflation-adjusted annuities

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Earnings Sharing

Credit each spouse with one-half of couple’s combined earnings during marriage

At retirement, each spouse’s benefit would be based on her half of the couple’s earnings, plus her prior earnings

Would replace spousal benefits

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Conclusions

$4 Trillion Unfunded Liability Oldest baby-boomers are 59½ Social Security should provide

adequate incomes throughout retirement

Reform is needed

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Sources American Academy of Actuaries, Social Security Reform: Solutions

Inside the Box: Proposals Not Including Individual Accounts (2004), available at http://www.actuary.org/pdf/socialsecurity/briefing_041604.pdf.

Jon Forman, Reforming Social Security, 76 (9) Oklahoma Bar Journal 657-661 (March 12, 2005), available at http://jay.law.ou.edu/faculty/jforman/SS-OBJ-2005.pdf.

National Academy of Social Insurance, Social Security Finances: A Primer (April 2005), available at http://www.nasi.org/usr_doc/Financing_Social_Security.ppt.

National Academy of Social Insurance, Options to Balance Social Security Over the Next 25 Years (Social Security Brief No. 18, February 2005), available at http://www.nasi.org/usr_doc/SS_Brief_18.pdf.

Social Security and Medicare Boards of Trustees, 2005 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (2005), available at http://ssa.gov/OACT/TR/TR05/tr05.pdf.