Social Security for Beginners

In Monday's Atlantic column, the part that upset the most people was (not surprisingly) the following paragraph on Social Security:

“The dollars are in programs like Social Security ($740 billion), which, per dollar, has a relatively small impact on the economy. Social Security doesn't say what businesses can or can't do, and it doesn't say what people can do with their money: it mainly moves money from people's working years to their retirement years, which means that in part it's doing something that they would have done anyway.”

One commenter, for example, said that Social Security does tell you what you have to do with your money: you have to buy an annuity. Another said that if he could opt out of Social Security right now, he would, since he thinks it is a losing proposition for him.

I don't think that any of the criticisms really addressed the main point I was trying to make: that Social Security has a smaller per-dollar economic impact than a regulatory agency like the CFPB. They are fairly typical of criticisms of Social Security, however, so I want to address them in a little more detail.

The debate is really about what Social Security is. A lot of people take the starting point that Social Security is an individual investment vehicle, and then they decide they don't like it because it doesn't look like the other individual investment vehicles they are familiar with (brokerage accounts, 401(k) plans, etc). Other people think that Social Security is a welfare program, and since they don't like welfare, they don't like Social Security. But it isn't either.

Before you can say what kind of animal Social Security is, you have to understand how it works. That's actually pretty simple. Almost all working people pay a payroll tax of 12.4 percent of their wage earnings up to a cap of $106,800.* In exchange, you get monthly benefits after you reach retirement age. The full benefit retirement age right now is 66 (and will go up to 67 gradually). If you start collecting benefits then, you get a monthly check equal to a percentage of your average monthly contributions while you were working; that percentage declines from 90 percent to 32 percent to 15 percent as your average contributions increase.** So the higher your average contributions, the higher your benefits, but your marginal benefit declines.

What about inflation? While you are working until you start collecting benefits, your contributions are indexed to the average wage level in the economy, which grows faster than inflation. So the effect of Social Security's benefit calculation is to give you a specified percentage of the earnings that people like you were during your career are making now, not that percentage of the earnings that you made in the past.***

Those are the basics. Social Security also pays benefits to surviving family members and to disabled workers—an important benefit overlooked by most people who say they don’t need Social Security.

So what is that? It's most similar to a traditional defined benefit pension plan where you get a monthly pension based on your earnings while you worked. It may look different because it's financed by a payroll tax, but that's a cosmetic difference. Back in the heyday of defined benefit plans, employees didn't always have to make explicit contributions to their pensions, but they were paying for them implicitly in the form of lower wages. The main difference between Social Security and a defined benefit pension is that Social Security is less generous to high earners. Traditional pensions were often based on your last few years' earnings (Social Security, by contrast, averages your top thirty-five years) and paid a fixed percentage of your earnings (Social Security pays a declining percentage).****

That brings us to the other thing that Social Security is like: an insurance plan. Even leaving aside the most obvious insurance features of Social Security—survivors' benefits and disability insurance—it still provides two huge forms of insurance. One is insurance against living too long, which you get because benefits are paid as an inflation-indexed annuity. The other is insurance against not making enough money during your working career, which you get because of the progressive benefit formula. If benefits were just a fixed percentage of contributions, then you would have insurance against living too long, but you wouldn't have insurance against your career not working out (which could be due to a recession in your early twenties, family emergencies, health problems, or any number of reasons short of full disability).

So Social Security is basically a pension plan that is partially used to fund an insurance plan. Although it has a progressive component, it isn't welfare because you don't qualify by being poor: you qualify by making contributions. (There's no minimum benefit level anymore.) And it isn't an individual investment vehicle because it's not your money to invest any more than the money in your defined benefit pension plan or on your insurance company's balance sheet is your money to invest.*****

The reason Social Security has a relatively small per-dollar impact is that it moves money from your working career to your retirement years, which is something that people do anyway to some extent. The claim that it forces you to buy an annuity is wrong and mainly irrelevant. It's wrong because at age 66 you don't have a cash balance that you are then forced to convert into an annuity: what you have is more like a pension plan that entitles you to a monthly benefit. (You may wish you had a cash balance, but you don't, and I'll come back to that later).

It's mainly irrelevant because when you reach retirement age, you either have plenty of money or you don't. If you have plenty of money, being forced to buy an annuity is irrelevant because you can just spend your other money sooner. If you don't have plenty of money, you really should take the annuity rather than the lump sum and the shiny red pickup truck,****** and this is a case where I'm willing to argue that a little paternalism is a good thing.

The other important thing to realize about Social Security is that in the aggregate, over its history, it is completely fair—by construction. All the money that comes in goes out to pay benefits. Unlike most insurance products or investment vehicles, there are no shareholders and bondholders that have to be paid, and the administrative expenses are low (because the program is so big). So in the long term, the average person breaks even. It is true that the first generations did better than break even because they didn't make contributions for very long before collecting benefits, so from now forward the rest of us will do a little worse, in aggregate. But we can spread that aggregate loss over any number of generations, so in the limit it can be vanishingly small.

This means that the average participant basically breaks even with Social Security. But that doesn't mean that the program helps exactly half of us and hurts the other half, because the program is insuring all of us. Social Security pools risks—the risks of not making enough money and of living too long—and therefore provides benefits to anyone who is risk-averse (that is, virtually all of us). People value insurance and are willing to pay for it even when it has a negative expected value. (Most insurance has a negative expected value for most people—that's how insurance companies make money.) So the total value provided by Social Security is greater than the amount of money that we contribute

(Social Security arguably reduces people's utility by reducing their control over when they consume. The question is whether in our society this cost outweighs the benefits provided by insurance. I think it doesn't, especially given that most people don't save enough as it is (that is, they are already over-consuming in the present). Furthermore, if you're upset about the timing of when you receive Social Security benefits, there are other ways to move your consumption around in time (loans). But I can't quantitatively prove that the insurance utility exceeds the timing constraint disutility. You can disagree with me about this, but you should be clear that this is where the disagreement lies.)

This is why Social Security should be popular –and why it is popular. Of course, there are people who don't like it—mainly ideologues who think that anything the federal government touches is bad by definition and rich people who are convinced they will be net losers. Some of the people who are convinced they will be net losers are suffering from optimism bias, but some of them are probably right: if you have ten million dollars in the bank at age thirty-five, you don't need the insurance, so Social Security isn't very attractive to you. (If you plan to keep working, that is; if you never work another day in your life, then Social Security is a net benefit to you, as long as you made contributions for at least ten years.) Hey, I don't have ten million dollars in the bank, but I will probably be a net loser, too.

Well, I have two answers for you. The first is that you can't decide whether or not you want insurance after the event you're insuring yourself against has already occurred. Complaining about Social Security then is like paying for homeowner's insurance for twenty years, selling the house, and complaining that the house didn't burn down.

The second is: tough luck. Social Security delivers net positive social benefits, and to deliver those benefits it has to be a compulsory program. If you allowed people to opt out, you would get adverse selection, both rationally and because of optimism bias, and the program would melt away. Depending on your theory of democracy, the question is whether it provides net benefits in the aggregate, or provides net benefits to a majority of the citizenry, or provides net benefits to a majority of people behind a Rawlsian veil of ignorance. Saying you should be able to opt out of Social Security makes as much sense as saying you should be able to opt out of the Iraq War and get the appropriate share of your income taxes back. We make some decisions on the national level for the national benefit.

Of course, if you are a rich person who expects to lose money to Social Security, you could say, “I understand that I don't have a cash balance at age 66; I want to eliminate Social Security so I can invest my payroll taxes however I want.” There's nothing illogical or hypocritical about that, and I can’t stop you from trying. I also can't stop you from trying to frame Social Security as a poor alternative to a 401(k) plan (or as “big government”). This post is just my attempt to explain to everyone else why Social Security is good for most people. Even with higher payroll taxes (or lower benefits), Social Security still benefits a majority of the population—because it’s cash-neutral in the aggregate, it pools risk, and it increases savings. And if people will just vote in their economic interests—no sympathy for the poor necessary—Social Security should do just fine.

*Right now the payroll tax is 10.4 percent because of the 2010 tax cut. The cap on earnings is indexed for inflation. Some state and local employees are not covered by Social Security, which means they don't pay taxes and they don't get benefits.

**If you start collecting benefits earlier, you get lower monthly benefits; if you start collecting benefits later, you get higher monthly benefits. These adjustments are supposed to be actuarially fair: that is, if you start collecting benefits earlier, you get smaller monthly checks because you are going to get more of them before you die.

***After you start collecting benefits, benefit amounts are indexed to inflation, not to average wages.

****There's a good historical reason for that. In the postwar period, companies offered defined benefit pensions as a way of attracting desirable workers; their benefits were even skewed toward the highest-income employees because they were allowed to count Social Security benefits toward their low-income employees' pensions. In other words, the traditional defined benefit pension was primarily intended to serve the needs of employers, not employees (not that there's anything wrong with that in itself). For more on the history of Social Security, see “The Divided Welfare State” by Jacob Hacker.

*****The money in a defined benefit plan is held in trust for all plan participants and beneficiaries, so it is your money in that sense, but there's no chunk of it that's yours. Social Security's money is also held in trust for beneficiaries.

******One state, I believe it was West Virginia, started offering lump sum payouts to state employees on retirement. Several years later, they switched back to mandatory annuities after realizing that many people had spent their lump sum payouts on new pickup trucks and were now destitute.