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Sunday, July 17, 2005

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.

    Posted by on Sunday, July 17, 2005 at 02:25 PM in Economics, Policy, Social Security | Permalink  TrackBack (2)  Comments (4)

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