Optimizing Social Security through Poverty Insurance and Retirement Saving

If I were in charge of creating a Social Security system that optimized the outcomes for participants, what Social Security system would I put in place?

Let’s start by clearly distinguishing between two features of our Social Security system that cause confusion because they are mixed together.  The savings and insurance aspects of Social Security perform separate but related functions. Poverty insurance is just what the name implies, insurance against abject poverty brought about by the inability to support oneself as age takes its inevitable toll.  Retirement savings are funds available over and above the amount guaranteed under the poverty insurance provisions of the program.

Let’s begin with poverty insurance.  Who should provide it?  How generous should benefits be? Who should be eligible?  How should poverty insurance be funded?  I believe the government must provide poverty insurance.  If left to the private sector, those most likely to need the insurance are those least likely to insure themselves in the private market due to moral hazard, financial constraints, and myopic behavior.  There is market failure in this market and the solution is very similar to our current system, forced premiums from all (i.e. the payroll tax).  In an ideal system, the premiums would match the probability of needing poverty insurance conditional upon a person’s current state, but I won’t go to that level of detail as this post is running long as it is.  As an economist, means testing so that only those in poverty receive benefits is also attractive, but the politics of such a system worries me because of the ex-post income transfers that occur.  If premiums are adjusted to reflect the probability of needing insurance such transfers are eliminated, but again the politics of a system with premiums linked to wealth levels are of concern to me. 

How generous should poverty insurance be?  That is a question we as a society must answer.  Economics does not tell us what is acceptable.  I am comfortable with a fairly generous level of poverty insurance, certainly more than Nassau Senior would advocate, but as noted in the retirement saving discussion below, this reduces the “deductible” that helps to overcome moral hazard problems in that market.  Finally, on the funding aspect, I disagree with Greenspan and others regarding holding private sector assets.  The government does not have a problem issuing debt to the private sector, and I see no reason why the government cannot invest Social Security funds, through financial intermediaries, in private sector assets rather than government bonds.  The reasons for the government doing the investing rather than each individual are at least twofold.  First, any risk around the poverty level can only be one-sided since outcomes below the poverty level will have to be augmented by the government.  This causes a moral hazard problem since the downside risk is limited.  Second, pooling the funds reduces the risk around the mean return.  Each individual can receive the overall mean rather than some individuals doing better than average, others worse, with the same average return across individuals.

Retirement savings are the means by which individuals can enjoy a retirement above a poverty level.  I believe there are fundamental market failures in this market such as adverse selection, moral hazard, and other problems as noted below.  The adverse selection problem arises because individuals have better information about their health and longevity than insurance companies.  When this happens, a classic "lemons market" emerges, and there is market failure.  There are various solutions to this problem in general, but in this case the obvious solution is to require full disclosure of health information to insurance companies beyond what is currently considered acceptable. There are also questions about the extent to which we wish to link retirement insurance premiums to probabilities determined by information on genetic makeup.  The existence of poverty insurance also brings about a moral hazard problem in the retirement saving market because it limits the downside risk, and there may be problems of myopic decision making among agents.

Another possibility is a wedge between social returns to investment and private returns. Investment improves productivity, and some of the productivity gains are captured by workers and other stakeholders through the bargaining process. Some of the productivity gains are collected by the government in taxes and this causes a substantial wedge to emerge. In any case, I have become convinced that there are market failures in the retirement saving market, so the question becomes how to create the incentives for individuals to attain the optimal level of retirement saving.  One solution is to force people to save a particular percentage of their income, or some other forced saving scheme, other solutions give individuals the incentives to behave properly.

A common solution to the moral hazard problem is deductibles and co-payments that cause individual to share in the cost of a negative outcome.  Two proposed solutions to market failure in retirement savings markets have this deductible feature.  The first is well-known, opt-out, add-on accounts.  These tend to work better when the default outcome is very unattractive, and the difference between the outcome with active participation and the outcome with passive participation can be viewed as the deductible the individual pays for behaving in a manner leading to sub-optimal outcomes.  The other is a money match program where the government matches, say dollar for dollar but the exact ratio could vary, money put into retirement savings accounts.  In designing a system, I would implement a combination such as an opt-out add-on accounts with the amount matched in some ratio by the government (and capped) unless one of my really smart economic advisers convinced me some other program would work better.

The opt-out solution has the problem that short-run considerations may interfere with following the optimal long-run plan, and there is an argument for forced individual saving because of this.  A family responding to the pressures of the moment may make decisions that, in retrospect, were not the best in the long-run, and forced saving overcomes the short-run temptations (IRAs have this feature).  Forced retirement saving is not my preferred solution, but it needs to be mentioned, and, if the opt-out system appeared to allow sub-optimal behavior to emerge even with the incentives described above in place, I would consider dropping add-on accounts and adding forced retirement saving to the forced poverty insurance payment.  That would result in a system resembling the current system in many ways.

The other source of retirement saving is employer provided programs.  I have not devoted as much attention to this aspect of retirement saving.  It is absolutely clear this leg is weakening and may collapse soon, but I hesitate to offer prescriptive solutions without more knowledge.  However, to the extent that such programs are failing and may disappear, the necessity for add-on accounts with strong incentives or forced retirement saving becomes more important.

I believe our Social Security system has functioned well as a combination poverty insurance and retirement saving program, but it has not functioned very well in providing the incentives for individuals to take control of their own retirement and increase the accumulation of retirement assets.  To the extent the system can be redesigned to provide better incentives for individuals to participate in retirement savings programs voluntarily, particularly those who are substantially above the poverty level, it will be a welcome improvement.

Comments

[Bruce Webb]

If I were asked to design a Social Security system from scratch I think I would come up with something pretty close to the current system. Once you subtract "insolvency" from the equation it starts looking pretty good.

For starters it is progressive but only mildly so. Your check out is dependent on what you put in. If you do well in life and retire with a paid off house and a company pension you end up with a Social Security check that is about 2 1/2 times what that guy that graduated with you and made a bunch of bad choices gets. You don't want Biff to be starving, you are happy to know that he can make his rent and buy his groceries, but you are free to enjoy that bigger SS check because after all you are subsidizing Biff's check to start with.

On the other hand it is not flat out charity from Capital. It is not largesse handed down from above, it is a benefit you earned. Maybe it requires accepting a little boost from co-workers, but qualifiying for benefits means putting in the time to make those quarters of eligibility.

What I see is a totally worker funded program that is financially sound going forward that rewards hard work and success while still shifting funds progressively to ensure that the elderly worker can maintain respect. What is wrong with that picture?

(Well of course there is an answer: Medicare. That Social Security check might be enough to live on if you were not faced with $300 a month in prescriptions. But that is a different problem and one that in principle should be looked at in isolation from Social Security. Medicare is fixable. But first we need to move on from the notion that Social Security is broken.)

And two problems are getting mixed here. You have the problem of poverty insurance. You have the problem of a low national savings rate. It is not at all clear that these problems need to be tackled with the same mechanical solution. Maybe it is not wise for a minimum wage worker to rely entirely on Social Security to meet their material needs, maybe it would be better if you could afford to eat out at some time other than the early-bird special, but I don't see that forcing a minimum wage worker to divert a portion of their income to savings is the appropriate tack here.

You want to boost national savings you go where the money is, you provide incentives for the middle class to invest rather than consume. Though at some point you need to step back and realize that consuming is investing. Every dollar you spend in injected into the economy and will be utilized usefully or foolishly. But it will be utilized. Locking down money "just in case" seems sensible, but clearly can be taken to excess - see Japan. If you are fully confident that your future income stream will meet your minimum payout needs then savings is to some degree a mugg's game - why bother?

It makes perfect sense for Sears to have me buy and hold Sears stock, but absent some need for me to tap into that capital asset somewhere down the line it may not make sense for me.

[ken melvin]

Grover's mission, and he has accepted it, is to insure that as the work force shrinks none of the costs for social programs such as social security get shifted to the moneyed class.

[JimPortlandOR]

Since so often national legislation has unanticipated outcomes, and national programs are frequently modified in the dark of night to warp and bend to the advantage of some income group - usually the wealthy or corporations - we are very fortunate to have a well established Social Security program where we know the outcomes and they are not negative, and is so popular that Congress is very reluctant to change things and possibly create outcomes that turn out to be negative.

So, I'd leave the program as is, with some tweaking to ensure long term viability - raising the income subject to tax, and legislatively mandating projections on the trust fund be made based on more realistic assumptions, e.g. productivity factors that reflect moving averages of real data. Perhaps government investment in a small part of the trust fund in non-US-government debt or investment vehicles would be ok as well.

But since it is clear that privately funded corporate pension plans are an endangered species, I'd consider a add-on to the Social Security system. I'd put in place an opt-out program of retirement savings, keyed to income, funded only by the employee - with perhaps 2 or 3 contribution percentage leves - and deducted from earned income to the extent of the contribution (like IRA's). The amounts contributed would be paid out in accordance with a limited set of choices made by the individual, starting at the time Social Security begins paying out benefits. Withdrawals would either be forbidden or taxed substantially as a deterrent. The funds received by the government would be invested by the government in a mix of US government treasuries and non-government investments, perhaps with a larger ratio of private to public. Participants would not control where the investments are made. In effect, phase down private pensions by replacing them with an add-on to social security with most of the features of an IRA or Roth IRA. Perhaps the amounts contributed would be no taxed at withdrawal, but the gains over contributions would be like standard IRA's (taxed).

Summary: make Social Security even more popular and comprehensive as the standard old age insurance and retirement savings vehicle.

[Bruce Webb]

I understand where JimPortlanOR and Brad DeLong as coming from, and as long as there is opt-out in the program I am okay with these plans.

But there is a whiff of middle-class paternalism coming from the forced savings crowd. Yes our national savings rate is abysmal (perhaps) but insisting that minimum wage workers put their shoulder to the wheel is maybe not placing the solution where it belongs. A single mother may need those nickels and dimes now, and while she might appreciate your focus on a comfortable retirement for her in principle, her most pressing need today is a new box of Pampers.

(Lower income people would get a lot bigger bang in retirement benefits if we simply raised the minimum wage. 12.4% of every payroll dollar would go towards calculating their initial benefit check and they would have more dollars right now. And who knows, maybe they would toss a dollar or two into the bank.)

Built into this discussion is the notion that the standard social security minimum benefit is not sufficient for retirement. It may not be sufficient for your retirement, but it might look like a pretty good deal to someone working low wage jobs all their lives, particularly as it is looking more likely by the month that Social Security will be able to pay out 100% of scheduled benefits.

Also built into this discussion is the notion that we need a vast pool of national savings to redeem the bonds in the Trust Fund. Increasingly it appears that that may not need to happen or at least will happen substantially beyond the current projection of 2017. There are two ways of looking at the Trust Fund: looming amount of debt to be repaid OR rainy-day fund. Tiny tweaks in initial numbers transform it from one to the other, and the operation is psychological as much as economic. National savings rates, reliance on overseas banks to continue buying bonds, affordability of tax cuts, affordability of national health care, opinions on all of these are radically transformable simply by internalizing one set of economic projections and abandoning another.

I am supremely confident that the American economy will turn in better numbers than Low Cost would have it. At this point it could hardly not. And nobody that has examined the numbers openly disputes that. But at some deep level they just don't get that it is a straight line from Table V.B1 to the Trust Fund Ratios in Figure II.D7. It just cannot be that easy. And yet -

2005 Report