Social Security

Social security is a social insurance program created in 1935 by the federal government. It was originally designed to protect the elderdly generation shortly after the Great Depression, during which asset values plunged along with many life savings. The U.S. Social Security program is largest government program in the world and the single greatest expenditure, currently at 20.9% of the federal budget. The need for finacial assistance after retirement partially stems from many individuals' inability to plan correctly for thier retirement. This failure to plan accurately is a form of market failure. The basic idea of the program is to fund the retirement benefits of the elderly with the earnings of younger employed Americans. When the number of young workers is much greater than the number of elderly people receiving assistance, this program is effective. However, that number is dropping according to Gruber who states, "...the system is running into trouble: the ratio of working-age taxpayers to elderly recipients was almost 8 to 1 in 1950, but by 2050 is projected to be less than 3 to 1. Indeed, our Social Security system is projected to have insufficient funds to pay promised retiree benefits in less than 40 years." (
Gruber, Johnathan. Public Finance and Public Policy, 2nd Edition. New York: Worth Publishers, 2007. p 20-21.)

There are several other factors contributing to an impending fiscal imbalance. These include: a dramatic improvement in life expectancy, reduction in birth rates, as well as a slowing growth rate in wages. Furthermore, the U.S continues to bear the burden of the "legacy debt", referring to the unfunded payments to the first generation of Social Security recipients. There remains several potential solutions to how we can correct this long-term funding problem discussed in detail under the Social Securtiy Reform section.

For 90% of beneficiaries at least half of their income comes form Social Security. The difficulty comes from Social security being the nation's largest social insurance program, and any reform perceived to reduce generosity would be subject to political attack. Thus, making reform a difficult yet important task for the Obama campign to address.

Social Security Details

  1. Social Security is funded by the Federal Insurance Contributions Act (FICA) tax on wages of employees which is currently at 6.2%. In addition, thier employers pay another 6.2% for tax burdent totaling 12.4%.
  2. FICA only taxes on the first $94,200 of earnings.
  3. To be eligible for reduced benefits, a person must have worked and paid the payroll tax for 40 quarters of their life (10 years), and must be age 62. Full benefits come when the person becomes 65.
  4. The beneficiary receives an annuity payment until the recipient's death. The amount of the payment is a function of the recipients's average lifetime earnings, where each month's earnings are expressed in today's dollars. Government averages a person's earnings over the persons's 35 highest earning years.
(Public Finance and Public Policy, Second Edition. Jonathan Gruber. Chapter 13. Pages 350.)

There are two types of Social Security pay outs, the Full Benefit Age (FBA) and the Early Entitlement Age (EEA). The Full Benefit Age allows the individuals to receive the money starting at age 65, 66, or 67 + months depending on the year when you were born. The Early Entitlement Age allows the individuals to receive the money starting at age 62. If a person uses the EEA, they will have an actuarial reduction in benefits of 6.67% per year. It normally works out that if a person decides to use the FBA or EEA, they will receive the same amount of benefits over time.
For more detailed information visit this
web site

History of Social Security

The ideas of Social Security actually began in Europe, dating back the the Middle Ages. These ideas of security were brought to the States when colonist arrived. (Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 13. Page 356.)

The first financial programs were started by the European trade guilds. As England bagan to assist the needy, they developed a series of Poor Laws (2).These poor laws used taxation as a way to help the poor. During those times, there were no standards to identify who was "poor," so individuals were classified by the elders. (Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 13. Page 356.)

The English Poor Law of 1601 was the first system of classifying the "deserving" from the "undeserving." This law taxed to fund the relief projects. For the individuals on relief plans, Almshouses were established to provide living quarters for those in need. This law of 1601 was helpful yet harmful. Helpful in that it provided assistance to the poor. However, those getting relief were viewed as highly undesirable characters and were treated awful(1). The Poor Laws faced many reforms throughout the years, but the structure is what the Pilgrims brought with them to the New World. (Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 13. Page 356.)

In the beginning, the term "Social Security" could be defined as any program that was set up to assist individuals who had minimal resources financially. Social Security helped the poor, elderly, the physically disabled, and the mentally ill(2). During the Civil War was when the United States officially witnessed the firts widespread program of social security. During this time, only Union soldiers who had been injured or the widows of the Union soldiers were given pension payments. No one on the Confederate side was allowed any assistance. Later, the program expanded to giving social security to all Union soldiers; whether injored or not. This led to one-third of all government money being spent on military pensions(2).

The official social security program came into existence during the turmoil of the Great Depression. During the depression, savings were wiped out due to bank failures from the stock market. One of the biggest worries was for the retired elderly who virtually had no ability to provide for their own livelihood. In 1932, in the middle of the Great Depression, Freanklin D. Roosevelt became president of the United States. It was Roosevelt who fathered the idea of social insurance. It was this original idea that eventually became the Social Security system that in place today. (2)

In 1934, the Committee on Economic Security (CES) was formed. This committee was founded and based on Roosevelt's social insurance program. The same program was already in action in 36 European countries. It made a plan that allowed workers to put a small percentage of their monthly income into a savings account. Once retired, these workers could rely on that account to help pay for life's expenses (2). Then in 1935, the Social Security Act (SSA) was signed and made into a law. On the right is the picture taken as Franklin D. Roosevelt was signing the SSA of 1935, and below, there is a video of Roosevelt signing and speaking on the act from 1935.

During the infancy of this program, the first generation of Social Security beneficiaries were the biggest winners under this new social insurance program. For example, Ida May Fuller, the first beneficiary of Social Security retired in 1939 and worked and received payments until the time of her death in 1975. Ida May Fuller took in $22,888.92 over those 35 years. (Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 13. Page 356.)

By the 1980s, some beneficiaries who wrongfully anticipated adequate sums of money from the government without their own private savings found themselves flirting with poverty. The Reagan Administration in 1983 formed the Greenspan Commission to examine the financial strength of social security at that time and into the future. Based on the commission's recommendations, a bill was passed that taxed some of social security's benefits. Federal employees could now be taxed and the retirement age would be bumped up heading into the new millenium. The CPA Journal

For a full detailed history on Social Security visit this website.




Pay-as-you-go System Social security has traditionally been an unfunded plan: taxes collected from a worker today go directly to today's retirees, rather than being saved to pay for benefits when the taxed worker retires, this is what is also referred to as a "Pay-As-You-Go" system. In contrast private pension plans are funded plans: savings today are invested in assets such as government bonds, corporate bonds, or stocks, and the accumulated assets fund the future benefits promisd by the pension. The promises of Social Security are backed by the policies of the government (Gruber, Johnathan. Public Finance and Public Policy, Second edition. 2007. p.354). Social security is a pay-as-you-go system that will be stable if: NbB=tNwWt Nb is number of people receiving benefits B is average benefit amount t is the tax rate Nw is the number of workers Wt is average taxable earnings Note: In essence, NbB represents the outflow of social security benefits being paid out to recipients, while the tNwWt represents the inflow of social security contributions. Nb divided by Nw is known as the "dependency ratio". B divided by Wt is known as the "replacement rate ratio". Equivalently, the "pay-as-you-go" system will be stable if Tax rate is equal to the product of Dependency ratio and Replacement Rate ratio. Attached is an article from the Federal Reserve Bank of Dallas addressing Pay-As-You-Go Social Security and the Aging of America. Dallas Federal Reserve Article Here is a list of changes that can be made in order to maintain stability in this type of system.

  1. Increase the tax rate.
  2. Extend the base of taxable wages.
  3. Raise the retirement age.
  4. Lower benefits.

Follow this link to an in-depth article about the political sustainability of our pay-as-you-go system of social security.

The problems with pay-as-you-go systems:

-Sustainability: pay as you go systems are sensitive to demographic change and system maturation.
C=B/S=B*D, where

C= the contribution rate (as a percentage of wages) required to balance the books given in a year.
B= the average benefit (as a percentage of average wage)
S= the support ratio (the number of workers per retiree)
D= the dependency ratio (the number of retirees per worker)
As the system matures and population ages, the dependency ratio grows and the revenues are equally insufficient to pay the promised benefits, then B must go down or C must go up.

- Growth: Pay-as-you-go systems have negative effects on economic growth.
- High payroll taxes may increase unemployment
- Early retirement (below the age of 60) reduces the supply of
experienced labor
- Giving benefits to the first generation of retirees and
continuing to provide public annuities to future generations may
discourage private saving
- A pension debt occurs and crowds-out the government’s ability
to provide other important goods

- Equity: In many countries, the rich live longer, collect benefits for more years and often collect higher pension benefits per dollar contributed, creating equity issues among the classes. Those who retire early and nonworking spouses of high-earning breadwinners tend to win in the system while unmarried heads of households and dual career families tend to loose.

Since the first generation to retire under this system only contributed small amounts, but received generous benefits for retirement, a large unfunded debt occurred. Because of this, today’s workers as well as future generations who will get a low return on their contributions will inherit this debt.
(National Center for Policy Analysis. “Social Security Reform Around the World: Lessons from Other Countries”. 2002.

Consumption-Smoothing Benefits

Unlike the days of Ida May Fuller, Social Security should be thought of as only one of the many ways to broaden your portfolio for retirement. Americans can relate health insurance and Social Security alike because these "social insurance programs" provide a means for consumption-smoothing.

Why Social Security?
There are two reasons why the government has intervened in people's decision to save for retirement.
- The first is due to "market failures in the annuities market." Adverse selection is the culprit of this market failure because individuals tend to know their family history and lifestyle better than an insurance company.
- The primary reason is due to paternalism which implies a distrust with the individual to make sound financial decisions with regards to future savings.

With regards to consumption-smoothing, Social Security may or may not provide the best option for retirement. In fact, "all that Social Security may be doing is crowding-out the savings that individuals would otherwise set aside for their retirement." (Gruber 361)

The final consideration for consumption-smoothing should consider the living standards of the elderly. An article which supplements the discussion in the textbook can be found at
Lessons from the Social Security Debate

(Public Finance and Public Policy, Second Edition. Jonathan Gruber. Chapter 13. Pages 359-361.)

Examples of Smoothing Consumption

People will try to avoid the abrupt changes in their standard of living, or smooth consumption. There are two ways that this can be done.
1) They can borrow in order to increase their current consumption
2) They can save in order t increase their future spendable income
Borrowing will require them to lower their standard of living, because they will have to pay back the debt. Saving will also require them to lower their standard of living, since they will have to cut spending. This can be difficult for many people since they usually cannot increase their retirement savings.

For an example using two couples, please see the article at: .

(National Center for Policy Analysis. “How Much Do Americans Depend on Social Security?” 2004. <>.)

Normative Model of Social Insurance

In cases where the smoothness of consumption is the result of high-risk aversion and not efficient private insurance markets – social insurance could yield welfare gains. These gains arise from reduced reliance on costly consumption-smoothing mechanisms, leading to improvements.

The following study, a normative model of social insurance, show the welfare gains form social insurance. These gains are determined by the product of the percentage consumption drop caused by the shock (∆c/c) with the coefficient of relative risk aversion (y). Holding y fixed, a smoother consumption path implies smaller welfare gains from social insurance. It is important to observe that y and ∆c/c are inversely related. Highly risk aversive households will take costly measures to have a smooth consumption path. Therefore, in order to understand whether social safety net is valuable the reason ∆c/c is small must be evaluated. If it is small because agents have good private insurance, social insurance may be unnecessary. If it is small because y is large, small consumption fluctuations may belie large welfare gains from insurance because the product y∆c/c could be quite large.

( Chetty, Raj; Looney, Adam. “Consumption Smoothing and the Welfare Consequences of Social Insurance in Developing Economies”. Journal of Public Economics. 90 (2006) 2351-2356.

Social Security Reform

Is there a need for social security reform?

Yes, as much as the poverty rate among the elderly has declined since social security was introduced, it is predicted that by 2042 this will not be the case, and funds will not be sufficient to pay social security benefits to the elderly. The article attached shows a graph with the poverty rate of the elderly by the year 2042 and options that can be used to avoid the dilemma of insufficient funds for social security.
Social Security Reform Other reasons are that Americans are living a longer life, which means that social security will be paid out longer; women are having fewer children, which means that the dependency ration is decreasing; and baby boomers are getting older, which means that a large portion of the U.S. population will be entering retirement. Read more in the article by Hakkio Craig "Social Security and Medicare: The impending Fiscal Challage"

Types of Reforms:
1. Incremental Reforms - This type of reform was discussed under the section of changes that can be made in order to maintain stability in the pay-as-you-go system.

2. Fundamental Reforms - These two type of reforms are fundamental because they change the way social security is invested.

One type of fundamental reform is investing the trust fund in stocks where the primary purpose is to invest this trust fund in an efficient manner. The logic behind this reform is to invest portions of the trust fund in stocks and other portions invested in government bonds. Although this type of reform works in theory, in reality it has two problems. First, if the trust fund is going to be used to finance other government projects, Social Security's long-term problems will not be solved by investing in the stock market. Second, there is a legitimate concern that government might abuse its position to manipulate capital markets for its own good.

Another type of fundamental reform, perhaps the most radical one is privatization. Privatization is a proposal to reform Social Security by allowing individuals to invest their payroll taxes in various assets through individually controlled accounts. In this type of reform, Social Security would become like a private pension instead of a public pension. Proponents in favor of privatization argue that this system would be funded by individual savings, thereby increasing the capital stock and long-run well-being of the United States; and this system would respect consumer sovereignty with respect to their investment decisions.

Although privatization will allow individuals to earn a higher rate of return on their Social Security payroll taxes, this system has a number of problems. First, if we consider the need to pay back the legacy debt, a privatized Social Security system would not provide a higher rate of return than our existing system. Second, such a system could have much higher administrative costs. Finally, with privatization policy makers may not want to respect consumer sovereignty with respect to retirement savings.

(Public Finance & Public Policy, Second Edition. Jonathan Gruber. Chapter 13. Pages 374-8.)

Social Security in Politics

The 2008 Presidential election, along with the current economic crisis, brought the social security reform issue to the forefront of both John McCain and Barack Obama's campaigns.

The main political problems President-elect Barack Obama outlined during his campaigning were insecure retirement savings and the income security for seniors based on rising health care and energy costs. Obama strongly opposed any privatization of social security, a concept supported by John McCain. Obama promised to protect the benefits for current as well as future beneficiaries. He acknowledged that in order to finance the program, he would support a plan to raise the taxes for people making over $250,000 by 2 to 4 percent. Major points of Obama's plan for income security include: the elimination of income taxes for seniors making less than $50,000; the requirement for employers to create automatically enrolling workplace pensions for employees. Obama also plans to negotiate lower drug prices for Medicare and supports importing safe generic drugs.
John McCain supported allowing workers to invest at least 20% of their social security payroll taxes in private accounts, based on his view that the Social Security Trust Fund is "a ticking time bomb". McCain also called for the elimination of the earnings test that punishes seniors for working during retirement by taxing their benefits by $1 for every $3 they earn over $15,500. McCain also supported investing a portion of the budget surplus into the social security fund.

The Transition Problem

The Transition Problem refers to the difficulty of maintaining current benifits while investing current contributions,as well as the limited options that Social Security has to reform (raising taxes,cutting benefits or privitization). In 15 years, Social Security will be in a deficit,which means that it will pay out more in benefits than it does in taxes. When this happens Social Security would then have to use the Social Security trust fund. By 2042, that avenue will be completely exhausted and Social Security will only be able to pay approximately 75 cents per dollar.

In an interview with Meet the Press, President-Elect Barack Obama stated before the election that he would push to increase the payroll tax and rejected cutting benefits. "I think the best way to approach this is to adjust the cap on the payroll tax so that people like myself are paying a little bit more and people who are in need are protected." Opponents of raising payroll tax argue that that it will eliminate jobs and worsen the economy.

An article from a conservative policy analysis website by Rea S. Hederman, Jr., William W. Beach, and Andrew Grossman argues why an increase in the payroll tax would hurt the average American worker:

"If payroll taxes were increased by 1.89 percentage points, a worker earning $35,000 would forego an additional $662 in pay every year. Raising payroll taxes by 1.89 percentage points would cost this worker, on average:

  • As much as he spends on gasoline over three months;
  • As much as he spends in two and a half months on clothing;
  • As much as he spends in one month on food for consumption at home; or
  • As much as he spends in two months on food outside of the home.

In other words, this “small change” in the payroll tax would have a major impact on most workers’ household budgets.
Using the Global Insight U.S. Macroeconomic Model, economists at The Heritage Foundation’s Center for Data Analysis simulated a 1.89 percentage point increase in the payroll tax".Another option is to reduce the benefits of Social Security by nearly a third of its present amount,although this is would be extremley unpopular politically and would therefore be incredibly difficult to legislate.The third option would be to privatize social security,but the costs of such a move could be devastating. It is estimated that private accounts would cost about $2 trillion over a span of 10 years. Proponents of privitization argue that this would elimintate the unfunded liablilities in Social Security that would total $10 trillion over an indefinite time span. However,in an article from the Center on Budget and Policy Priorities,Jason Furman disputes this notion:"The $10 trillion number is taken out of context; it refers to the Social Security shortfall not over 75 years, but into eternity. Social Security does face a long-term deficit, but it is relatively modest as a share of the economy; in fact, it is considerably smaller than the cost of the tax cuts passed in 2001 and 2003, if those tax cuts are made permanent. More fundamentally, borrowing $2 trillion to fund individual accounts does nothing to reduce Social Security’s long-term deficit. Individual account plans that eliminate the long-term deficit in Social Security, such as the principal plan the President’s Social Security commission proposed, do so entirely by reducing future Social Security benefits, not because of borrowing."

Social Security Topics and Additional Links and Information

Here is a page put up by the Economic Policy Institute. It has all sorts of useful information on issues involving social security. There are a few charts and tables along with several links to other interesting articles, all relating to the issue of social security.

Here is an interesting article that goes into a little more detail about Social Security, and takes a somewhat interesting position.

Article This page gives an opinion which calls for no reform but an abolition of Social Security for the sake of individual liberty.

Article Here is an article that explores the problems with the current social security program and takes a negative perspective on creating a proper solution

Article Here is an article that has opinions about the truths and myths of Social Security.

Social Security Act of 1935

According to
Will Social Security Be There For You?, by 2042 social security benefits will be reduced by 27% and will continue to decline every year. The article explains why there will be problems with the social security system and the potential solutions.

  • Why there's a need for social security - cnn articleThis is a good article describing the spending habits of Americans and why we struggle as a country to save for retirement.

What sort of benefits will I get when I retire?
Follow this link to the
Social Security Administration web site to get an estimate of your retirement benefits. This calculator uses a lot of soft numbers though so its actual accuracy may not be very good, but it is still interesting to check out.

Railroad Retirement vs. Social Security

As a future railroader with the BNSF Railway Company I am interested in providing information regarding another social insurance program established by the Railroad Retirement Act.

$1,890/month – retired rail employees
$1,050/month – under S.S.
In addition, supplemental railroad retirement annuities are between $23-$43/month to retirees with at least 25 years of service with the railroad.

Like Social Security, railroad retirement is adjusted for inflation so the amount withdrawn from a retiree in 2007 will be larger than someone who withdrew in 1997.

Railroad employees can receive retirement benefits earlier than under Social Security because it is not based on age and years of service. For example, railroad employees can start receiving benefits as early as age 60 with 30 years of service without any reductions in benefits.

Survivor benefits:
$1,165/month – to all aged and disabled widowers
$995/month - under S.S.

An important distinction:
Railroad retirement is broken into a two-tier tax system meaning
Tier I: 7.65% social security taxes
Tier II: 3.9% tax rate on rail employees

As defined under the U.S. Railroad Retirement Board: