Friday, July 10, 2015

Social Security Explained

I was recently trying to find a debate topic with a friend economist. She suggested an idea of privatizing social security. It seemed a decent topic, so I started looking for pros and cons. After a while I came up with some arguments that are never mentioned in the discussions on the Internet. But before I proceed to introduce them, a little presentation explaining social security is in order. So that everybody knows what we are talking about.

What is social security?

Social security is often associated with pension systems. The first national pension system was introduced in 1883 in Germany by chancellor Otto von Bismarck. In the United States it was introduced in 1935 by President Roosevelt as a part of the New Deal. Initially, it was focused mostly on pensions. In 1954 social security started to include disability benefits and in 1965 it started to include Medicare. Probably for historical reasons, people often speak separately about social security when they mean pensions and disability benefits and Medicare when they mean health insurance for the elderly, even though all these programs are currently managed by Social Security Administration and are governed by the same laws.

Currently, Social Security Administration manages four main programs:
  • Old Age and Survivors Insurance (OASI) responsible for retirement,
  • Disability Insurance (DI),
  • Medicare Hospital Insurance (HI) – basic health insurance for elderly that does not require insured to pay premiums,
  • Supplementary Medical Insurance (SMI) – additional health insurance for elderly that requires premiums.
Each program has its own revenues, expenditures and a separate trust fund. If the revenues exceed expenditures, then the difference is accumulated in the program’s trust fund. With the surplus of money, the trust fund buys government bonds. When the revenues are exceeded by expenditures, the trust fund sells the bonds back to the government to cover the difference.

As a result, trust funds reduce the amount the government needs to borrow in the financial markets (that is from actual investors). As a result, it seems that trust funds are used to finance the government debt. However, the government pays market interest rate on the bonds issued to trust funds (that is trust funds get whatever regular investors would get). Also, when trust funds want to redeem their bonds, the government cannot refuse – such a refusal would mean an immediate default of both government and social security. To pay trust funds off, the government needs to raise money in the financial markets. Similarly, to pay off regular investors, the government has to roll over its debt that is find new investors. So, in practice, social security trust funds are treated by the government similarly to any other investor.

Main sources of revenue for OASI, DI and HI are payroll taxes. On the other hand, SMI is mostly financed by general revenue from the government (meaning government just gives them money it gets from taxes or selling bonds) as well as beneficiary premiums. Another significant source of income is the interest earned on the government bonds kept in the funds. Remaining sources of funding are minuscule.

On the other hand, the expanses of each program can be divided into two categories: benefits paid and administrative expenses.  Overall, administrative costs constitute almost exactly 1% and benefits constitute 99% of the total costs. This is actually pretty decent compared to other countries.

How much I pay and how much I get paid?

Let’s now discuss the main source of revenue: wages which are subject to payroll taxes. As of 2015, social security tax amounts to 12.4% of earnings. Half of this amount is deducted from employee’s paycheck and the other half is matched by the employer. Now, the resulting payroll tax revenue is split into two categories. 10.6% of the earnings goes to the OASI fund and 1.8% goes to the DI fund (all these percentages change over time; usually increase; although there was a recent decrease thanks to tax cuts enacted during Bush junior administration; it was temporary though). People, who make less than 118500 dollars, have to pay the tax on every dollar they make. People, who make more, pay the payroll tax only on the first 118500 dollars they make and everything above is exempt. This maximum-earnings-taxed amount is increasing every year. 

The situation with the Medicare payroll tax is similar – 2.9% of earnings are split into 1.45% employee contribution and 1.45% employer contribution. This tax however does not have a maximum-earnings-taxed amount. On the contrary, additional 0.9% is paid on every dollar made above $200000 for individuals and above $250000 for married couples (this feature was introduced by The Affordable Care Act, so called Obamacare).

To qualify for social security retirement benefits you need to work for at least 10 years. Then, Social Security Administration takes 35 years in which you earned the most, and calculates your average monthly salary over that period. If you worked less than 35 years, they will use zeroes in the years you did not work. Based on this average, social security calculates your primary benefits in the following way. The calculated average is split into three buckets. In 2015, the size of the first bucket is $826, the size of the second bucket is $4154 and the third bucket is limitless. Social security puts as much of your calculated average monthly salary as possible to the first bucket. Everything that’s left goes to the second bucket and if there is still something left, it goes to the third bucket. Then, they take 90% of what’s in the first bucket plus 32% of what’s in the second bucket plus 15% of what’s in the third bucket, and add it up to calculate your primary benefits. This is the amount of money that will be given to you in the form of a monthly pension if you retire at your retirement age. One more little complication: your retirement age may be anywhere between 65 and 67, depending on when you were born. And bucket sizes change from year to year. 

So let’s work out an example. (Disclaimer: this is simplified version of what social security actually does!) Let’s say that you were born in 1945 and between ages 22 and 30 you were making $300 a month. Then, you were unemployed for 3 years. Then, between 33 and 40 you were making $700 a month and between 40 and 62 you were making $2000 a month. Now it is 2007 and you want to retire. Note that you have 8+7+22=37 years of work (and paying social security contributions) which is greater than 10, so you definitely qualify.

Now, the social security adjusts each year of your earnings with a wage index to see how much would your wages be worth close to your retirement date given inflation, economic progress, etc. Then, they take the 35 highest after-adjustment numbers (in our example they would discard the years 1973 and 1974 which were at the end of the period were you were making $300 – these years gave you the lowest after-adjustment earnings). Then, they take the remaining years and average them. In our case the average is around $2500. Note that this is higher that you have ever earned! This is because you earned $2000 a month in the 1980s. Making $2000 a month in 1985 was like making over $4000 in 2007. The difference is mostly due to inflation and economic progress.

The (almost) final step is to distribute this calculated average into the buckets. In 2007 the buckets were $680 and $3420. So the first bucked gets filled entirely and remaining $1820 goes into the second bucket. There is nothing left for the third bucket. So you add buckets up: 0.9 * $680 + 0.32 * $1820 + 0.15 * $0 = $1200 (around). This is your primary benefit that is your new monthly pension! Actually... not really. Since you are currently 62 years old, you qualify for early retirement. If you choose it, you can retire immediately but your benefit will be between 70 and 80% of your primary benefit. So you may be better off by waiting until your retirement age (66 in our example) to get the full amount. You can also keep on working until 70 which will increase your benefits by between 15 and 33%. The actual percentages depend on when you were born and when you want to retire.

To be eligible for disability benefits, you need to have a medical condition that makes you unable to work for at least a year or which results in death. Also you need to be working (and paying payroll tax) for at least five years within past ten years. This condition is more lenient for younger people who just entered the work force. This part of social security is often considered very prone to fraud. According to a recent report, nearly half of beneficiaries are overpaid, and the amount of overpayment exceeded 17 billion dollars over the past decade.

People eligible for social security retirement benefits (and their spouses) are generally eligible for Medicare. The basic version of Medicare (part A) is a government insurance program for most essential medical services. It is possible to extend this coverage with additional services by paying monthly premium which is often heavily subsidized by the government (especially part D).

So what’s the problem?

Many people are concerned because of the amounts accumulated in trust funds and the speeds at which they are being depleted. OASI fund held 2.6 trillion dollars at the beginning of 2013. And although since 2010 payroll taxes are no longer enough to cover the benefits, the reserves in the fund are still increasing thanks to sizable interest income. They are projected to keep on increasing until 2022. After that year the reserves will continue to decrease until 2034 when they become depleted. The DI fund had to tap into interest income in 2005 and by 2009 its costs exceeded revenues. It is projected to run out of money by the end of 2016. HI will have to tap interest income in 2021 and its fund will start shrinking in 2023 and will become depleted in 2030.  SMI is not projected to have any of these issues as it is funded mostly from the general budget, not separate payroll taxes.

So what will happen once the funds run out of money and nothing is done about it? The benefits will have to decrease. Pensions would have to be cut by around 25%, disability benefits by 20% and Medicare benefits by 15%. After these cuts, the social security budget balances itself and no further dramatic cuts are projected. This sums up the concerns about social security being insolvent.

What would save social security from the above scenario? According to Congressional Budget Office:
  • Removing the cap on taxed earnings will solve social security problems for the foreseeable future.
  • Raising the payroll tax by two percentage points will solve social security problems for the foreseeable future. 
Another option that would potentially solve problems of social security forever is indexing retirement age to life expectancy. However, since it takes a lot of time to implement, this option is not going to solve the forthcoming problems.

Finally, there is an option to privatize social security. This means creating private savings account in which workers would store their savings and which would be managed by private companies. I will discuss some of the arguments for the privatization in a different post sometime soon.

Stay put.

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