SOCIAL SECURITY:

How It Works and How to Fix It

Jonathan Barry Forman (Jon) Alfred P. Murrah Professor of Law September 2007

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

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)

How Much Does Social Security Pay?

Type of Beneficiary Average Monthly Benefit $1,044 $1,008 $979 $1,713 $2,167
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All Retired Workers Aged widow(er), non-disabled Disabled worker Aged couple-both receiving Widowed mother and two children

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

Social Security and Poverty

2007 Poverty Levels

Single individuals $10,210 ($851/month) Married couples $13,690 ($1,141/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 $97,500 in 2007
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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)

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 Up to the year the worker turns 60

Index those Earnings for Wage Inflation

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

Year of Birth 1937 or earlier 1938 - 1942 1942 1954 1955 - 1959 1960 and later
http://www.ssa.gov/retire2/retirechart.htm

Full Retirement Age 65 plus 2 months per year 66 plus 2 months per year 67
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Primary Insurance Amount (PIA)

For a worker turning 62 in 2007, PIA = 90% of first $680 of AIME + 32% of AIME from $680 to $4,110 (if any) + 15% of AIME over $4,110 (if any) $680 and $4,110 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) formula for persons turning age 62 in 2007
$ 2,200

Primary Insurance Amount

$ 2,000 $1 ,800 $1 ,600 $1 ,400 $1 ,200 $1 ,000 $800 $600 $400 $200 $0 $0 $1 ,000 $2,000 First Bend Point $680

Second Bend Point $4,1 0 1

PIA

$3,000

$4,000

$5,000

$6,000

Average Indexed Monthly Earnings

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How do benefits compare to earnings?

Retired worker age 65, 2005
$90,000

$80,000 Past Wages Benefits

$60,000
$55,400

$40,000
$35,300

35% $20,000
$15,800
$9,000

25%
$22,500

42% 57%
$19,600 $14,800

$0 "low" "medium" Earnings Amount "high" "maximum"

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Worker Benefits: Increases and Decreases

Indexed for inflation Actuarial decrease for early retirement

Example: average-wage worker, 62 in 2006 Will get $1,332.80 per month at her full retirement age of 66 or $999 per month at 62 8 percent per year In 2007, early retirees lose $1 of benefits for each $2 of earnings over $12,960
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Actuarial increase for later retirement

Retirement Earnings Test

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

Most elderly dont receive pensions

Percent with Employer-Sponsored Pensions All age 65+ Couples Unmarried men Unmarried women 41% 51% 39% 32%
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National Academy of Social Insurance, Social Security Finances: A Primer (2005)

Family Benefits

Spouses, dependents, and survivors Husband or wife gets 50% of workers PIA

Together, couple gets 150%

Widow or widower gets 100% of workers PIA A joint and two-thirds annuity Dual entitlement rule limits benefits
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Estimates for 2006 Finances

Trust Fund income = $745 billion (taxes) Trust Fund outgo = $555 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 2007 Trustees Report 19

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)

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Social Security Administration, 2007 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 75% of benefits due then. By 2081, assuming no change in taxes, benefits or forecasts, revenue would cover 70% of benefits due then.
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Social Securitys Financing Problem

2007 Trustees Report shows

Expenses will exceed payroll tax income in 2017 Trust funds will be out of money in 2041 Immediate payroll tax increase of 1.95% needed to restore actuarial balance Alternatively, immediate ~12.8% across-the-board benefit cut $4.7 trillion unfunded liability About 0.7% as a share of the entire economy (GDP)
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75-year deficit equals 1.95% of taxable payroll

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 ($97,500 in 2007); 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.
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National Academy of Social Insurance, Social Security Finances: A Primer (2005)

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 Eliminated 104% 93% 40% 10% 20%
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National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

Options: Cut Benefits

OPTION Raise retirement age (to 67 faster & index) Reduce COLA by % each year Cut benefits by 5% for those starting to get benefits in 2005 Increase # years in wage avg. to 40 % of Deficit Eliminated 28% 41% 32% 21%
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National Academy of Social Insurance, Social Security Brief No. 18 (2005); American Academy of Actuaries (2004).

Options: Increase Investment Returns

OPTION % of Deficit Eliminated Investments in equities 36% - 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 2007 Poverty Levels

Single individuals $10,210 ($851/month) Married couples $13,690 ($1,141/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 couples combined earnings during marriage At retirement, each spouses benefit would be based on her half of the couples earnings, plus her prior earnings Would replace spousal benefits
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Conclusions

$4.7 Trillion Unfunded Liability Oldest baby-boomers are 60 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 657661 (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, 2007 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (2007), available at http://ssa.gov/OACT/TR/TR07/tr07.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 masters degrees in economics and psychology. Jon can be reached at jforman@ou.edu or (405) 3254779. His web page is www.law.ou.edu/faculty/forman.shtml.

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