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Social Security Policy in a Changing Environment

The University of Chicago Press

Contents

Acknowledgments...............................................................................................................................................xiIntroduction Jeffrey R. Brown, Jeffrey Liebman, and David A. Wise............................................................................................11. Removing the Disincentives in Social Security for Long Careers.............................................................................................212. Notional Defined Contribution Pension Systems in a Stochastic Context: Design and Stability................................................................433. Reforming Social Security with Progressive Personal Accounts...............................................................................................734. Who Chooses Defined Contribution Plans?....................................................................................................................1315. The Importance of Default Options for Retirement Saving Outcomes: Evidence from the United States..........................................................1676. Reducing the Risk of Investment-Based Social Security Reform...............................................................................................2017. Pricing Personal Account Benefit Guarantees: A Simplified Approach.........................................................................................2298. Reducing Social Security PRA Risk at the Individual Level: Life-Cycle Funds and No-Loss Strategies.........................................................2559. Changing Progressivity as a Means of Risk Protection in Investment-Based Social Security...................................................................29910. The Decline of Defined Benefit Retirement Plans and Asset Flows...........................................................................................33311. Demographic Change, Relative Factor Prices, International Capital Flows, and Their Differential Effects on the Welfare of Generations.....................38512. Is the U.S. Population Behaving Healthier?................................................................................................................423Contributors..................................................................................................................................................447Author Index..................................................................................................................................................451Subject Index.................................................................................................................................................455

Chapter One

1.1 Introduction

When Social Security was instituted in 1935, the period life expectancy at age twenty for males was sixty-six and for females sixty-nine. Today, twenty-year-old males have a period life expectancy of seventy-six and females eighty. This increase in life expectancy has been accompanied by a corresponding improvement in health at all ages. Cutler, Liebman, and Smyth (2007) find that, in terms of mortality, men at age sixty-eight in 2000 have roughly the same mortality risk as men at age sixty-two in 1960. Thus, at a same age, men in the year 2000 are roughly six years younger. In terms of self-assessed health status, they find that the difference is even larger, approximately ten years. Their bottom line is, "Our best guess is that people aged 62 in the 1960s are in equivalent health to people aged 70 or more today" (p. 14). In related work, Shoven (2004) suggests that the age of elderly people is more appropriately measured by remaining life expectancy than by years since birth.

These improvements in life expectancy and health status enable individuals to prolong their careers and delay retirement. However, the length of retirement has actually grown by more than the increase in life expectancy at retirement. Figure 1.1 shows labor force participation rates by age in 1965 and 2003. Both early retirees and median retirees are retiring earlier in 2003 than they were in 1965. Figure 1.2 displays labor force participation rates by remaining life expectancy rather than age and shows that the average length of retirement for men has increased almost 50 percent since 1965. In 1965, the average length of retirement for the median male retiree was thirteen years. By 2003, it was nineteen years. Roughly half of the additional years were due to improvements in life expectancy, and half were due to earlier retirement.

Individuals may choose to use increases in their life expectancy for additional leisure or additional consumption, and it is possible that the shift toward longer retirements is optimal. However, there are a number of features of Social Security that distort incentives toward increased retirement length by imposing high implicit tax rates on longer careers and working at older ages. For example, Social Security benefits are computed based on the average of an individual's highest thirty-five years of earnings. An individual with fewer than thirty-five years of earnings has a relatively strong incentive to work for an additional year as the additional earnings clearly raise the average upon which the benefit is based. On the other hand, an individual who has already worked for thirty-five years has a diminished incentive to work an additional year-the earnings from that year will, at best, replace one of the previous highest thirty-five in the benefit computation. Thus, the benefit formula encourages careers of thirty-five years or less. Several other features of the benefit computation-which we will discuss in detail in the following-contribute to the disincentives for long careers.

In this chapter, we examine the disincentives for long careers created by Social Security. Our main finding is that the structure of these programs imposes high implicit tax rates on workers late in their careers. As a result of this distortion, we believe retirements are suboptimally long. The consequences of this distortion are significant: a lot of the stress on public and private pension systems is caused by the increased length of retirement. We also outline ways to reduce or eliminate the implicit taxes on long careers and working at older ages. The potential benefits of a larger work force for Social Security and Medicare (and gross domestic product [GDP]) are large.

1.2 Work Incentives in U.S. Social Security

In this section, we investigate the impact of Old Age and Survivors Insurance (OASI) on the career-length incentives of both stylized and actual workers. In each year of their working life, we compute the workers' present value of Social Security taxes minus benefits under the assumption that they stop working after the current year (i.e., they accumulate no further earnings). The implicit Social Security tax rate is defined as the increase in the net tax burden from working an additional year as a percentage of the current year's earnings. In other words, this is the additional net tax the worker incurs by prolonging his or her career by one year. This variable captures the worker's incentive to continue working for an additional year as opposed to retiring. Throughout our analysis, OASI benefits...