Public Pension Systems andSocial Security in the US

Dr. Laura Dawson UllrichApril 1, 2014

Definition:◦ a regular payment made during a person's

retirement from an investment fund to which that person or their employer has contributed during their working life.

Two types:◦ Defined benefit plans (annuity plan)◦ Defined contribution plans (payout

depends on amount invested and return on investment)

What is a pension?

Defined Benefit◦ Employees and employer make regular

contributions during the employees’ working years◦ After retirement, employee receives monthly

payments that are calculated based on tenure at work and salary

Defined Contribution◦ Employees make contributions during their working

years (employers may as well)◦ Employee can choose how fund is invested◦ After retirement, employee can make withdrawals

from account

What is a pension?

Defined Benefit Example◦ Employee makes $100,000 a year during the last four

years of employment◦ Employee has 30 years of service at Company X◦ Company X contributes 9% of employee’s salary per

year into pension fund; employee does the same◦ The multiplier used by Company X is 2.07% per year of

service.◦ After retirement, pension is calculated as follows:

(30 * 0.0207) * $100,000 = 0.621 * $100,000 = $62,100This means that the employee will receive $5,175 per

month (before taxes) until death

What is a pension?

Defined Benefit Programs◦ Under a defined benefit program, the employee does

not bear the investment risk. ◦ The pension payment is the same regardless of the

success of the pension program investment.◦ Defined benefit programs have become less common

over time. 1985 – 89 of Fortune 100 companies 1998 – 67 of Fortune 100 companies 2004 – 38 of Fortune 100 companies 2010 – 17 of Fortune 100 companies 2013 – 7 of Fortune 100 companies

What is a pension?

Defined Benefit Programs◦Why have they become less common in the

private sector? Still common in government jobs Private companies are hesitant to bear risk Employees no longer expect/demand them Companies and employees are less loyal

than in previous generations

What is a pension?

Nearly all countries have some sort of social insurance (pension) program for the elderly.

Social insurance:◦ government provision for unemployed, injured, or aged

people; financed by contributions from employers and employees as well as by government revenue

These insurance programs for the elderly generally come in the form of a pension and healthcare

What about public pension programs?

Many citizens do not work in jobs that provide a pension after retirement.

Altruism: we are generally uncomfortable with the thought of the elderly living in extreme poverty.

To reward years of hard work. To guarantee some source of income in case of

poor investment outcomes in other accounts.

Why do governments provide the elderly with pensions?

The level of income replacement from the public pension varies greatly from country to country.

Pension replacement for median income earners:◦ United States: 41.0 percent◦ Netherlands: 91.4 percent◦ Denmark: 83.7 percent◦ South Africa: 11.8 percent◦ Saudi Arabia: 100.0 percent

World Comparisons

World Comparisons The amount replaced by governments may

is heavily dependent on other social services offered for the elderly.

OECD average: 57.9 percent

The public pension in the United States is known as Social Security

The Social Security Act of 1935 was a part of Franklin Delano Roosevelt’s “New Deal” during the Great Depression

Provided workers aged 65 and older monthly pension checks based on years worked and salary earned.

Social Security

Because of the financial situation in the US in 1935, the Social Security program was designed as “pay as you go”.◦ Current working-age citizens pay for current retirees’ benefits.

Employees and employers contribute 6.2% of wages (each) up to $117,000 in wages (wages above that are not taxed) – PAYROLL TAX

Employees must work at least 40 quarters to qualify for full Social Security benefits

Those who never work can qualify for spousal benefits after their spouse’s death.

Social Security

The first person to receive a check was Ida May Fullerin 1940.

By the time Ida May died at 100 years old she had

collected $22,888.92 in Social Security benefits (she only paid $24.75 into the system).

Social Security

Retirement age:◦ Early benefits can be received at age 62 (with

penalty for early withdrawal)◦ Full benefits are received at age 67 (for most

Americans, for some it is still 66)

Maximum monthly benefit: ◦ $2,642 per month

Social Security tax is only placed on the first $117,000 of wages◦ Self-employed must pay payroll taxes themselves

Social Security in 2014

Pay-as-you-go has become a big issue.◦ The number of workers per retiree has fallen

dramatically.◦ This will get worse during the Baby Boomers’

retirement.

From 1940 until now, payroll tax revenues have always exceeded Social Security payouts. That will no longer be the case after 2015 or 2016.

So, what is the problem?

Too many retirees are relying on Social Security as the sole source of income.

In 1935, life expectancy for a man was 59.9 years and for a woman was 63.9 years. Since Social Security benefits started at age 65, most people would never receive them.

Today, life expectancy for men is 76.2 years and 81.2 years for women. Since early retirement is at age 62, the average retiree would receive payments for greater than 15 years!

So, what is the problem?

Raise the retirement age◦ Raising it to 70 would fix the problem for the

foreseeable future. Increase the payroll tax rate Raise the payroll tax cap (or eliminate it

entirely) Reduce benefits Reduce or eliminate the cost of living

adjustment (COLA)

Surprise: None of these is politically popular.

What can be done?