Wednesday, January 14, 2009

New paper: “Will Your Social Insurance Pay Off? Making Social Security Progressivity Work for Low-Income Retirees”

I have a new paper up in AEI's Retirement Policy Outlook series called "Will Your Social Insurance Pay Off? Making Social Security Progressivity Work for Low-Income Retirees." Here's the summary followed by some comments:

Although the Social Security program is progressive--meaning that the replacement rate of preretirement earnings offered by Social Security tends to rise as lifetime earnings decline--this relationship is erratic. While individuals with lower lifetime earnings receive better treatment on average, lifetime earnings are only a weak predictor of how any one person will be treated by the Social Security program. Many high-earning households receive high replacement rates, and many low-earning households fail to receive them. Thus, Social Security is not entirely effective as a social insurance program protecting low lifetime wage earners against a meager retirement. In order to make Social Security more reliably progressive--thus protecting low-earning workers and allowing them to plan more effectively for their financial future--one possible approach would be to offer a flat dollar benefit for each retiree along with an individual account whose benefits are tied directly to contributions.

A few charts give a feel for the main points, which I think are pretty important in policy terms. This first chart shows median Social Security replacement rates by lifetime earnings percentile. The slope of the line is negative, which means that as your lifetime earnings rise your replacement rate tends to fall. In other words, Social Security is progressive, on average.

But only on average. The second chart shows actual data points for couple's replacement rates, taken from the GEMINI microsimulation model. Even if the system is progressive on average, there's a ton of variation in replacement rates even for couples with the same lifetime earnings. The reason is there are a ton of pieces of the benefit formula – wage indexing of earnings; the 35 years averaging period for earnings; the 10-years required for benefit eligibility and divorced spouse benefits; the 50 percent spousal benefit; the tax max, etc – that can make benefits very different even for individuals or couples with the same earnings level.

There are a lot of low earners who receive low replacement rates, and a lot of high earners who receive high replacement rates. What's more, the variation in replacement rates rises for lower income people, who are precisely the ones who need social insurance the most. In other word, for low earners Social Security is like a home insurance policy that may or may not pay off if your house burns down – and sometimes pays off even if your house doesn't burn down.

But now check out the third chart. This shows results from a stylized reform plan: every retiree receives a flat dollar benefit of $600 per month from Social Security. In addition, every worker has a personal account in which they save 3 percent of their earnings; these are invested only in government bonds. The key thing here is that average benefits are around the same as Social Security, and average progressivity is also around the same (meaning the slope of the line is the same, although extremely low earners do receive higher replacement rates here than Social Security). What's different is that there's much less variation in replacement rates: low earners consistently receive high replacement rates, and high earners consistently receive low replacement rates.

What this shows is that for the purposes of social insurance, sometimes too much complexity actually makes things worse. A very simple and understandable reform plan can accomplish the social insurance purposes of Social Security better than current law.


shoffy22 said...

Excellent Paper Andrew! A lot of interesting things to think about, and a strong point you make that the consistency of progressivity in the Social Security system should be an important consideration for policy makers. Right on!

One thing I was curious about was what the corresponding Figure 6 would be for the 1990 birth cohort under current law.

This would be interesting to see to compare with both the corresponding figure for the 1940 birth cohort under CL (Figure 3 I believe), along with the 1990 birth cohort under the Policy Alernative.

Andrew G. Biggs said...

Thanks, Shoffy! I may have current law for the 1990 birth cohort, or it not it wouldn't be hard to do. I'd guess (but only guess) that the distribution might be a bit tighter in the future than it is today, since fewer people will be receiving spousal benefits. But I don't know that for sure. Will let you know what I find out.

shoffy22 said...

Cool! Thanks!

Anonymous said...

I have been reading your blog. I thought it's nice blog.

auto car insurance quote
american auto insurance
state auto insurance quote
low auto insurance
auto insurance company online