Possible extensions to the pension system reform the popular flexible way 1.

This article summarises two of my main ideas on social security – state guaranteeing the returns on privately owned pension funds for people with low income, and the "raise the retirement age" idea put into a more public friendly concept by introducing a flexible retirement age, based on the life expectancy. I will first give an overview of the statistics about the current social security system, and give reasons why it is heading towards a collapse. I will then go on and discuss some of the good features that any system should have: namely flexibility and fairness. I will then look how my ideas might be suitable as components in the reformed the social security system. All the data I use is for USA.

Current trends and features of the Social Security system

In USA 4% of the GDP is spent on social security. This figure has doubled over the past 30 years. The life expectancy has also risen from 61.4 in 1935 to 75.8 in 1995 and is expected to increase to 78.4 in 2025. It is clear that one was expected to die before reaching the retirement age, when the system was created. People are expected to live about 10 years in retirement at present, with the number of years increasing one per decade. This has led leading researchers to think that "The coming Social Security disaster will make the savings and loan fiasco of 80’s look like child's play...When today's 20-year-olds retire, they will receive pensions 50 percent less than those of today's Social Security recipients." The social security system will face crises and needs reforming from the purely financial point of view.

It also needs reforms from the people viewpoint. In 1950 60% of the men aged 65-69 were working. This figure had fallen to 26% in 1990. The proportion of men retiring earlier, at 62, has similarly increased dramatically. This indicates how the system actually encourages people to work less. Many researchers have found that although the tax system makes it rational for people to retire at 65, or even later, the fact that the state has allowed the retirement at 62 means that people will take that as a benchmark, and not recalculate their optimal response. It is like with legalising marijuana, some argue that legalisation, when done properly, will not increase the consumption of marijuana among rationally thinking people. However, it is not legalised, because people will take state as an example, and have a tendency to think irrationally – "if the state thinks marijuana is not bad for us, why not try it". Similarity is strong, if the state thinks people could retire earlier, why shouldn’t they.

These two pressures – one mounting from finance and one from the psychological side effects of state becoming more flexible, have led to expectation of crises. In resent survey 20% of Americans think that the retirement system will survive by the time they reach the age. 45% of Americans believe in UFO-s. And they are quite right to think so – current Pay-As-You-Go system is expected to bankrupt in 2030, because in l950 there were l6 workers for every Social Security beneficiary. Today there are 3.3. By 2030 there will be 2 .

Preferable features for the optimal social security system

First issue the reform has to address is flexibility followed by fairness and uniform eligibility. However, political acceptability is also an important factor. Furthermore, with a system as long-term as the pension system, one has to look for the ways to reform it in a financially feasible way, causing as little human distress as possible.

When the Social Security System was originally introduced in 1935, people had neither the high-speed computers, nor the necessary demographics data to take demographic movements into account. This has changed now. We have excellent data on demographic trends. Data on the incentives that various systems create, could be much improved on, but it is still available. And the state has tried to make use of it. For example, one will get a 3% increase per year in the retirement pay when working longer, and will only get 80% of benefits when retiring at 62. Furthermore, the 1981 Retirement Act extended these criteria to reduce the benefit level to 70% when retiring at 62 and increased the retirement age to 67. This will affect people born from l942 through l959.

However, arbitrary changes like that will not benefit the society in the long run. Firstly people will have to remake their lifetime plans and adapt to a different consumption pattern. Secondly, measures like this are likely to be used to gain political popularity, putting the short-term gains before the election, before the welfare of the society. And finally, with the baby-boomers retiring, it becomes increasingly difficult for the government to adjust the retirement parameters in order to keep the system in balance. The system would be much more robust if it included the flexibility and demographic changes, allowing it to stand outside the political influence, and function without intervention.

Second issue a reformed social security system has to face is fairness. At present one will receive 90% of the first dollar they earned as retirement pay, and only 15% of their last one. This will mean that the higher one’s lifetime earnings, the less is the percentage that is replaced by the benefits when one retires . For low earners 55% of the earnings are replaced by the benefits, for individuals with higher than average earnings only 25% is replaced. It is politically popular and morally right to support lower income families, however, I will try to show later that this can be done without introducing distortions of this magnitude into the system.

There are at present three main arguments as to how to reform the system. One is to increase taxes and reduce the benefits. Others are to privatise the system and/or raise the retirement age. I will only mention some of the privatisation issues, my main aim is to describe a system with flexibly increasing retirement age. I will not describe the option of raising taxes and reducing benefits, because that is not really a reform, more like postponing the crises.

Flexible guarantees on private pension funds

Privatisation of the pension system was first implemented in Chile in 1981. It is the opinion of many researchers, that the highly successful system can be a model for Social Security reforms in other countries. Many of the problems of state inflexibilities can be solved by privatisation.

The particular aspect I am concentrating on, is the necessary state guarantees on returns. Taking Chile as an example, where everyone is guaranteed a minimum return, one can show that the state gets into a hard financial situation when stock market crises happen. It could take the security out of Social Security, because investments, especially in the stock market, could be risky. However, this situation can be avoided by guaranteeing the returns on investment only to lower income individuals and not to higher. Selective guarantee will have several advantages:

One possible way would be to index the security guarantee to the income of the individual – as one starts receiving more income, the guaranteed percentage return decreases. It will not create poverty traps, because people will not actually get paid anything, thus nothing stops them earning more. And it will increase income equality in slumps. For example, when taking 8% a year as a reasonable minimum risk investment, those with median income could be guaranteed 5% a year on their investment, those with income on the mode 6% and those below that 7%.

Some officials point out that Social Security does much more than just pay retirement benefits. It protects wives and children when a breadwinner dies. It protects families against disabilities. It is an insurance system for society as a whole in many ways. Changing any part of that to a system involving uncertainties and risks would be a mistake, they say. However, the system of disability protection is called SSI, and it can be maintained separately, together with income support for low paid and unemployed.

Guaranteeing returns in crises also has macroeconomic advantages. When returns fall below the guaranteed value in recessions, it is actually economically right for the state to intervene. By expanding its outlay (e.g. by monetary expansion, increasing the national debt) the government can actually lift the economy out of recession. As there is normally spare capacity in existence during recession years, it will not bring about significant inflationary pressures.

By internalising the stock-market state can make it a normal part of the economy where long-term returns dominate, unlike now, where stock-market is often dominated by speculators, hot money and short term return requirements.

Making the retirement age depend on the life expectancy.

The idea of raising the retirement age is normally only found on the publications of radical organisations, like "Cato". However, a recent national survey says many Americans would accept raising the retirement age somewhat. They would also accept some tax increases to keep Social Security solvent. But they think most tax increases or other changes to keep the system solvent should be aimed at high-income people. In November 1995, another poll found even stronger doubts about Social Security's future. When asked what changes, if any, the respondents would make to Social Security, only 24 percent would leave the program alone; nearly as many (22 percent) would make Social Security completely voluntary; another 29 percent would either raise the retirement age or cut cost-of-living increases for current retirees.

Thus the idea is not such a political suicide, as it seems on the first impression. It does have two main reasons for implementation. Firstly, it makes the system cheaper and sustainable. This is especially needed during the reform period. Secondly, as the life expectancy rises, people are more able to work at the age of 65. Furthermore, they will soon want to work longer, if the state would not influence the formation of different social patterns. When the life expectancy rises to 100 years, I will very much doubt that anyone would dream about living 35 years of his or her life as retired.

However, just raising the retirement age will be a one-time solution, and the problem will appear again. Much more reasonable will be to make the retirement age depend on the demographic changes. Besides avoiding crises in the future and making it unnecessary to introduce further reforms it will:

Besides this, there are numerous advantages that apply to the increased retirement age in general:

There are no proposals that don't have some drawbacks. For this one, the disadvantages are:

One way to model the dynamic retirement age will be to take it as a percentage of expected lifetime at birth. I understand that one can elaborate on that by taking expected lifetime at 20 years of age, not at birth, because children do not think of retirement. Also, it might be sensible to use the expected life expectancy at the retirement age, for people who are 20 and keep that as a constant proportion. This will take changes in the age distribution into account. However, let me stick to a much simpler model. In 1960 one was expected to spend 7% of their life in retirement. By taking that as a suitable figure (economies were doing quite well in 1960-s) and assuming we should keep that constant, then the retirement age will look like:

Raw data can be obtained by clicking on Appendix 1. Data.

According to this model the retirement age should go above 65 in 2030 –about the time when system runs out of money. It will then increase gradually. Once obtained, the arbitrary 7% can be optimised for the optimal return and benefit. It will allow people to be confident, that their pensions can be financed. It will also be a lot cheaper, much more flexible and out of political influence.

An important characteristic of this model is its political feasibility. Most current voters will still be retiring at 65, but will start receiving increased benefits, due to the fact that there are reduced number of claimants when they are retired.

Now let me answer some of the frequently asked questions about the increased retirement age and private investment schemes.

Will it increase unemployment among youth?

No empirical study has proven that an increase in labour force will bring about significant unemployment. Just the opposite, the fixed retirement age is a restriction on the flexibility of labour markets. The evidence when comparing UK and USA to Europe shows that flexible labour markets will have lower unemployment. It can be understood in terms of a simple model – it takes an experienced worker and a non-experienced one to produce one unit of output. When the experienced one has to retire, then there is no point for the firm to employ the young worker, thus youth unemployment is actually increased.

At present the age limit 65 is fixed, firms cannot obtain younger people because of the age discrimination laws, when they need to. Also, people who reach 65 have a social and psychological pressure to leave, although they might be worth more to the firm. With flexible retirement age and private system, it is not a disaster to the person when she is fired at 60, because she only loses the extra five years of her contribution, which might mean 10-15% lower pension (assuming 30-40 years work before). Thus firms are more willing to swap old people not able to cope with younger ones.

Will the favourable guarantees given to the poor distort the labour market and make rich unwilling to participate? Or will the privatisation increase poverty?

It will induce minimum distortion, much less than there is now, because the government guarantee will very unlikely to be used, thus people are operating in a competitive free market and will likely reach a Pareto efficient outcome. Rich can normally afford better financial advice, and thus can guarantee their returns through diversification. Also, if everybody is already a shareholder, the volatility of stock-markets will decrease, because there are no new shareholderrs to be drawn into speculative bubbles.

There must be requirement to contribute to the pension funds, because pensions are merit goods. People do not realise how much they really want money at retirement. The situation is similar to the healthcare and education.

Lastly, the unemployment benefits and disability insurance will not be privatised. The benefits to keep poverty out will be paid by the state. As the state’s expenditure on the pension component of social services is eliminated, there might be more money left for these benefits (assuming people will not avoid the reduced social security tax as much as before). Furthermore, the competition is likely to reduce administration cost overheads and lead to higher returns that were previously obtained by the state.

We do trust a bank enough to give it all our money, why should we trust the private pension funds any less?

 

Appendix 1. Data.

 

Life expectancy

 

expected time in retirement as a % of total

Ideal retirement age at Birth (1960 value of 7% retireers)

1st+last column

  At Birth At 65              

Year

Male

Female

M

F

M

F

Average

M

F

Average

 

1940

61.4

65.7

11.9

13

-5.9

1.1

-2.4

57.1

61.1

59.1

1999

1945

62.9

68.4

12.6

14

-3.3

5.0

0.8

58.5

63.6

61.1

2006

1950

65.6

71.1

12.8

15

0.9

8.6

4.7

61.0

66.1

63.6

2014

1955

66.7

72.8

13.1

16

2.5

10.7

6.6

62.0

67.7

64.9

2020

1960

66.7

73.2

12.9

16

2.5

11.2

6.9

62.0

68.1

65.1

2025

1965

66.8

73.8

12.9

16

2.7

11.9

7.3

62.1

68.6

65.4

2030

1970

67.1

74.9

13.1

17

3.1

13.2

8.2

62.4

69.7

66.0

2036

1975

68.7

76.6

13.7

18

5.4

15.1

10.3

63.9

71.2

67.6

2043

1980

69.9

77.5

14

18

7.0

16.1

11.6

65.0

72.1

68.5

2049

1985

71.1

78.2

14.4

19

8.6

16.9

12.7

66.1

72.7

69.4

2054

1990

71.8

78.8

15

19

9.5

17.5

13.5

66.8

73.3

70.0

2060

1995

72.2

79.1

15.3

19

10.0

17.8

13.9

67.1

73.6

70.4

2065

2000

72.9

79.7

15.5

19

10.8

18.4

14.6

67.8

74.1

71.0

2071

2005

73.7

80.1

15.8

20

11.8

18.9

15.3

68.5

74.5

71.5

2077

2010

74.3

80.5

16

20

12.5

19.3

15.9

69.1

74.9

72.0

2082

2015

74.6

80.8

16.2

20

12.9

19.6

16.2

69.4

75.1

72.3

2087

2020

74.9

81.1

16.4

20

13.2

19.9

16.5

69.7

75.4

72.5

2093

2025

75.2

81.4

16.6

20

13.6

20.1

16.9

69.9

75.7

72.8

2098

2030

75.5

81.7

16.8

21

13.9

20.4

17.2

70.2

76.0

73.1

2103

2035

75.8

82

17

21

14.2

20.7

17.5

70.5

76.3

73.4

2108

2040

76.1

82.2

17.2

20

14.6

20.9

17.8

70.8

76.4

73.6

2114

2045

76.4

82.5

17.4

21

14.9

21.2

18.1

71.1

76.7

73.9

2119

2050

76.7

82.8

17.6

21

15.3

21.5

18.4

71.3

77.0

74.2

2124

2055

77

83.1

17.8

22

15.6

21.8

18.7

71.6

77.3

74.4

2129

2060

77.2

83.3

18

22

15.8

22.0

18.9

71.8

77.5

74.6

2135

2065

77.5

83.6

18.1

22

16.1

22.2

19.2

72.1

77.7

74.9

2140

2070

77.7

83.8

18.3

22

16.3

22.4

19.4

72.3

77.9

75.1

2145


  1. Note: There are possibly many factual misconceptions. Also I might have missed some references, I am very sorry for that. This is only the second draft, please do correct me by mailing keith@ieg.ee. No part of this can be copied or reproduced ... blah blah ... without Keith Siilats’ written permission. Also the endnotes do not work properly in Internet. Please download the Word97 version for that.
  2. "Social Security and retirement in the US" Peter Diamond, NBER WP6097
  3. U.S. Department of Commerce, Bureau of the Census, Population Projections of the United States, by Age, Sex, Race and Hispanic Origin, 1993-2050, Current Population Reports P25-1104 (Washington: Government Printing Office, 1993), Table 2.
  4. Walter Williams at George Mason University
  5. Can’t remember the reference
  6. A. Hardy
  7. Money magazine, AARP director Horace Deets
  8. conducted by Matthew Greenwald and Associates
  9. conducted by the Charlotte, North Carolina-based polling firm GrassRoots Research
  10. "Social Security: Facing The Facts" Mark Weinberger
  11. 1995 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, April 3, 1995, U.S. Government Printing Office, Washington, DC, 1995. All numbers are from the intermediate projections series. Table IID2, pg 62 (Intermediate Serries. ęCopyright 1995, Michael Rosenberg
  12. J. Mirrlees on Optimal Taxation