SOCIAL SECURITY:How It Works and How to Fix It

Jonathan Barry Forman (“Jon”)Alfred P. Murrah Professor of LawApril 2008

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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?

Almost 50 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

Social Security Basic Facts, http://ssa.gov/pressoffice/basicfact.htm; National Academy of Social Insurance, Social Security Finances: A Primer (2005)

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Who Gets Social Security?

31.5 million retired workers 2.9 million dependents 7.1 million disabled workers 1.8 million dependents 6.5 million survivors

Social Security Basic Facts,http://ssa.gov/pressoffice/basicfact.htm

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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 $1,079

Aged widow(er), non-disabled $1,041

Disabled worker $1,004

Aged couple-both receiving $1,761

Widowed mother and two children $2,243

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Social Security and Poverty

2008 Poverty Levels Single individuals – $10,400 ($867/month) Married couples – $14,000 ($1,167/month)

With Social Security only 9% were poor (in 2000)

Without it, 48% would have been poor

http://aspe.hhs.gov/poverty/08poverty.shtml

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Financing Social Security 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 2008 tax base is $102,000 in 2008

http://www.socialsecurity.gov/OACT/COLA/cbb.html

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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

http://www.socialsecurity.gov/OACT/ProgData/retirebenefit1.html

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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 The 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 2008,PIA = 90% of first $711 of AIME

+ 32% of AIME from $711 to $4,228 (if any)+ 15% of AIME over $4,228 (if any)

$711 and $4,228 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 2008

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

$2,200

$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

$4,228

First

Bend Point

$711

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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

$0

$20,000

$40,000

$60,000

$80,000

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

Earnings Amount

Past Wages Benefits

Retired worker age 65, 2005

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

Example: average-wage worker, 62 in 2008 Will get $1,444.30 per month at her full

retirement age of 66 or $1,083 per month at 62

Actuarial increase for later retirement 8 percent per year

Retirement Earnings Test In 2008, early retirees lose $1 of benefits for

each $2 of earnings over $13,560

http://www.socialsecurity.gov/OACT/ProgData/retirebenefit2.html; http://www.ssa.gov/OACT/COLA/rtea.html

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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

Social Security represents 39% of the income of the elderly

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

Social Security Basic Facts, http://ssa.gov/pressoffice/basicfact.htm; 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 survivor annuity Dual entitlement rule limits benefits

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The Need for Reform

Social Security is in financial trouble and will not be able to meet its future benefit commitments.

Social Security redistributes payroll tax revenues in many ways that are quite simply unfair.

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Estimates for 2007 Finances

Trust Fund income = $785 billion (taxes)Trust Fund outgo = $595 billion (benefits)Surplus = $190 billion

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

Social Security Administration 2008 Trustees’ Report

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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)

22Social Security Administration, 2008 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 78% of benefits due then.

By 2082, assuming no change in taxes, benefits or forecasts, revenue would cover 75% of benefits due then.

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Social Security’s Financing Problem

2008 Trustees Report shows Expenses will exceed payroll tax income in 2017 Trust funds will be out of money in 2041

75-year deficit equals 1.70% of taxable payroll Immediate payroll tax increase of 1.70% needed to

restore actuarial balance Alternatively, immediate 11.5% across-the-board

benefit cut $4.3 trillion unfunded liability (over 75 years) About 0.6% as a share of the entire economy (GDP)

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Unfunded Obligations(Present values as of January 1, 2008; trillions of dollars)

Present value

As a % of future payroll

As a % of GDP

Over the infinite horizon

$13.6 3.2 1.1

Over the next 75 years

4.3 1.6 .6

Social Security Administration, 2008 Trustees’ Report, Table IV.B6.

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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 ($102,000 in

2008) 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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Second problem: Social Security Redistributes Economic Resources Evaluate the program’s impact over

the course of a worker’s lifetime. Compare Social Security taxes paid

by a worker and expected benefits. Linkage between the Social Security

taxes and benefits is loose. Can vary dramatically depending on

such factors as family status, income, and age.

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Social Security favors Early generations of retirees over later

generations, Workers with low career-average earnings

over workers with high career-average earnings,

Married couples over singles individuals, One-earner couples over two-earner couples, Larger families over smaller families, and Elderly retirees over elderly workers.

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Social Security's Transfer of Wealth Among Generations by Each Cohort's Year of Birth (Billions of 2003 dollars)

Congressional Budget Office, How Pension Financing Affects Returns to Different Generations (2004).

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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 (2007); Center for Retirement Research at Boston College (2007).

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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 (2007).

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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 (2007).

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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

2008 Poverty Levels Single individuals – $10,400 ($867/month) Married couples – $14,000 ($1,167/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

$4.3 Trillion Unfunded Liability Oldest baby-boomers are 62 Social Security should provide

adequate incomes throughout retirement

Reform is needed

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Sources American Academy of Actuaries, Social Security Reform Options (2007),

http://www.actuary.org/pdf/socialsecurity/reform_07.pdf. Jon Forman, Reforming Social Security, 76 (9) Oklahoma Bar Journal 657-661

(March 12, 2005), http://jay.law.ou.edu/faculty/jforman/SS-OBJ-2005.pdf. National Academy of Social Insurance, Social Security Finances: A Primer

(2005), 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, 2005), http://www.nasi.org/usr_doc/SS_Brief_18.pdf.

Center for Retirement Research at Boston College, The Social Security Fix-It Book, http://crr.bc.edu/special_projects/the_social_security_fix-it_book.html.

Social Security Board of Trustees, 2008 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (2008), http://www.socialsecurity.gov/OACT/TR/TR08/tr08.pdf.

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About the Author Jonathan Barry Forman (“Jon”) is the Alfred P.

Murrah Professor of Law at the University of Oklahoma College of Law, where he teaches courses on tax, pension, and elder law.

Professor Forman is also Vice Chair of the Board of Trustees of the Oklahoma Public Employees Retirement System (OPERS) and the author of Making America Work (Washington, DC: Urban Institute Press, 2006).

Prior to entering academia, Professor Forman served in all three branches of the federal government. He has a law degree from the University of Michigan, and he also has master’s degrees in economics and psychology.

Jon can be reached at jforman@ou.edu or (405) 325-4779. His web page is www.law.ou.edu/faculty/forman.shtml.