The United States Social Security System

“Nuts and Bolts”October 11, 2006

By the end of today, you should be able to:

Briefly explain motivations for Social Security programExplain the basic structure of the Social Security retirement program

Who participates?How is the system paid for?How are benefits calculated?

Next few classes:Economic effects (labor supply, savings)Long-run financing problemSolutions / reform

What is Social Security?

Formal name: “Old Age, Survivors, and Disability Insurance” Program (OASDI)Provides income to:

Retirees Disabled WorkersSpouses of BeneficiariesWidows & Dependants of Beneficiaries

Why Should You Care?Of every $1000 you earn in your lifetime, you will pay at least $124 in taxes to support itYour parents / grandparents may be depending on it during retirementThe federal government spent more on Social Security than on the following programs combined:

• Homeland security• education, training, employment, social services• energy, natural resources, environment • international affairs • general science, space, and technology

Motivations for Social Security

Who Participates?

90%+ of all workers in the United States pay into Social SecuritySome state/local workers are exempt (including U of I employees)Must work at least 40 quarters (10 years) to be eligible for benefitsSpouses also eligible

How Is It Paid For?

While working, you and your employer each pay 6.2% of wages (=12.4% total) to the governmentOnly taxed on first $90,000 of earningsLook at your paycheck – FICA

Federal Insurance Contribution ActCovers SS (12.4%) and Medicare (2.9%)2/3 of US households pay more in FICA than in income tax!

What Benefits Does It Pay?

If you pay into SS long enough (10 years), you can receive a benefit at retirement Can claim as early as 62Monthly income is paid to you for as long as you live (i.e., as an annuity)Payments are increased annually with inflationSpouse can also receive benefit

By the Numbers … June 2006 Beneficiary Data

Number (mil’s)

Dollars (bil’s)

Total 48.9 $540

Retired workers and family members

33.8 $391

Survivors of deceased workers

6.6 $68

Disabled workers and family members

8.4 $81

Other facts

Social Security represents approx. 2/5 of all income for the elderlyAbout 2/3 of elderly Social Security beneficiaries received more than half of their income from OASDIIt is the only source of income for approx. 1/5 of the elderlyIt is, by far, the primary source of disability insurance in the U.S.

Benefit Eligibility

Eligible for benefits after 10 years of paying into system

Technically, you need 40 quarters of coverageIn 2006, a quarter of coverage is earned for each $970 of covered earnings

• Amount goes up each year with the wage index

Can earn at most 4 quarters in one calendar yearBut can earn all 4 quarters for the year as soon as you earn 4*$970=$3,880

Calculating AIME

Take all of your years of earnings, and index them to age 60 by growth in average wages (AWI)Average the 35 highest yearsConvert to a monthly value to get Average Indexed Monthly Earnings (AIME)

1235

earnings of arsHighest ye35

1i

iAIME

Calculating PIA

Take AIME and feed it through a non-linear benefit formula to get “Primary Insurance Amount” (PIA)If retire at the Normal Retirement Age, your benefit = PIA

Actuarial reduction if claim before NRADelayed retirement credit for later claiming

The Benefit (PIA) FormulaPIA

AIME

1st bendpoint

2nd bendpoint

.9

.32

.15

$656 $3,995

$590.40

$1646.08

The Normal Retirement Age

“Normal retirement age” (NRA) used to be 65 years. Now 65 years + 8 months got those turning 65 this year. It is rising to age 67 for those born in 1960 or later.

Note: There is nothing “normal” about this age, since 80% of workers are retired prior to this

Also known as “Full Benefit Age” – age at which your benefit is equal to the PIA.The Politics of the NRA

Early Entitlement Age

You can claim SS benefits as early as age 62, but there is an “actuarial reduction” in your benefits to reflect the fact that you will be receiving the benefits for more yearsWhen NRA is age 67 (those born after 1960)

Roughly a 6% reduction per year of benefitsBenefit at age 62 will be 70% of benefit at age 65Adjustment is same for men and women, despite longevity differences

Delayed Retirement

If you wait past the normal retirement age to claim benefits, you receive a “Delayed Retirement Credit”

Increases your benefit for each year of additional workThose born after 1960 will get 8% increase per year of delay

Spousal BenefitsIf Joe is eligible for SS worker benefits, and Mary is not, then she can receive a spousal benefit that is 50% of his (couple gets 150% of Joe’s PIA)If Joe and Mary are both eligible for benefits, then they receive the higher of:(150% of Joe’s; 150% of Mary’s; Joe’s+Mary’s)

Upon death, survivor benefit = 100% of PIA

Spousal Benefits - 2

Spouse of high income worker gets bigger spousal benefit than spouse of low income workerSystem transfers resources, on average, from single individuals and from two-earner couples to one earner couplesOne earner couples tend to be higher income

Does Social Security Redistribute?Replacement Rates (PIA / AIME) are higher for people with lower AIMEIt is “progressive”See chart on next page …

Replacement Rates = PIA/AIMEBenefit at 65 for those turning 65 in 2006

$ Benefit Replacement Rate

Low earner 45% of AWI

9,354 55.9

Medium earner 100% of AWI

15,413 41.4

High earner 160% of AWI

20,367 34.6

Max earner 23,578 28.9

SS and Redistribution

What is the complication?Some low income individuals are part of high income householdsSpousal benefits are higher for individuals married to high earnersSome individuals with high potential income choose to consume it via leisure or home productionIndividuals with higher lifetime earnings live longer, on average

Does Social Security Redistribute?

Yes, between generationsMore on this next time!

Yes, if compare today’s taxpayers to today’s elderlyYes, if we simply compare replacement rates across the income distribution at age 65But on a lifetime, household basis, the extent of redistribution is much lower (and maybe non-existent)