9.2 Social Security and Pension Systems

Social Security and pension systems form the backbone of financial security for the elderly and disabled. These programs, born from 19th-century German social insurance, have evolved to combat poverty and ensure stability for vulnerable populations worldwide.

Today, these systems face challenges from aging populations and changing work patterns. Reforms like raising retirement ages, exploring new funding sources, and encouraging individual savings are being considered to maintain their sustainability and adequacy for future generations.

Social security and pension systems

History and purpose

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• Social security and pension systems established to provide financial security and income support for elderly, disabled, and dependent individuals
• Concept of social insurance originated in Germany in late 19th century under Chancellor Otto von Bismarck
  • Introduced first national old-age social insurance program
• In United States, Social Security Act signed into law by President Franklin D. Roosevelt in 1935 as part of New Deal
  • Created Social Security program
• Pension systems, both public and private, evolved to supplement social security and provide additional retirement income for workers
• Primary purposes are to alleviate poverty, promote social stability, and ensure basic standard of living for vulnerable populations (elderly, disabled)

Types and evolution

• Public pension plans for government employees usually funded through combination of employee contributions, employer (government) contributions, and investment returns
• Private pension plans can be categorized as defined benefit (DB) or defined contribution (DC) plans
  • DB plans guarantee specific benefit amount based on factors such as years of service and salary, with employer bearing investment risk
  • DC plans, such as 401(k)s, rely on employee contributions and sometimes employer matches, with employee bearing investment risk
• Structure and funding of these programs vary across countries
  • Some rely more heavily on government funding (social security)
  • Others place greater emphasis on individual and employer contributions (private pensions)

Structure and funding of social security

Funding mechanisms

• Social security programs typically funded through payroll taxes, with contributions from both employees and employers
• In United States, Federal Insurance Contributions Act (FICA) mandates payroll taxes to fund Social Security and Medicare
  • Employees and employers each pay 6.2% of wages up to taxable maximum for Social Security
  • Additional 1.45% of wages paid by each for Medicare, with no taxable maximum
• Some countries supplement payroll tax funding with general tax revenues or sovereign wealth funds
  • Norway's Government Pension Fund Global invests surplus oil and gas revenues to finance future pension obligations

Benefit calculations and eligibility

• Social Security benefits in US based on worker's average indexed monthly earnings (AIME) over 35 highest earning years
  • AIME adjusted or "indexed" to account for changes in average wages over time
• Primary Insurance Amount (PIA) calculated as percentage of AIME, with lower earners receiving higher percentage
  • Maximum monthly Social Security benefit for worker retiring at full retirement age in 2023 is $3,627
• Eligibility for Social Security retirement benefits based on age and work credits earned
  • Full retirement age ranges from 66 to 67, depending on birth year
  • Early retirement available at age 62 with permanently reduced benefits
  • Delayed retirement past full retirement age increases benefits by 8% per year up to age 70

Sustainability and adequacy of social security

Demographic challenges

• Many social security systems face long-term sustainability challenges due to aging populations and declining birth rates
  • Increasing ratio of retirees to active workers puts pressure on pay-as-you-go systems, where current workers fund current retirees
• Longer life expectancies and earlier retirement ages further strain financial viability
  • In 1940, life expectancy at age 65 in US was 12.7 years for males and 14.7 years for females
  • By 2020, life expectancy at age 65 increased to 18.2 years for males and 20.8 years for females
• Fertility rates have fallen below replacement level (2.1 births per woman) in many developed countries
  • US fertility rate declined from 3.65 in 1960 to 1.64 in 2020

Benefit adequacy concerns

• Adequacy of retirement benefits is a concern, as many retirees may not have sufficient income to maintain pre-retirement standard of living
  • Social Security replaces about 37% of pre-retirement earnings for average earner in US
  • Most financial advisors recommend 70-80% income replacement rate for comfortable retirement
• Shift from DB to DC pension plans has transferred investment risk to employees
  • Leads to potential disparities in retirement preparedness based on individual investment decisions and market performance
• Sustainability and adequacy challenges exacerbated by factors such as wage stagnation, income inequality, and changing nature of work (gig economy, automation)
  • Median real wages in US grew only 6.1% between 1979 and 2019, while productivity increased by 69.6%
  • Gig workers often lack access to employer-sponsored retirement plans and face income volatility

Reforms and alternatives for social security

Parametric reforms

• Raising retirement age gradually to account for increased life expectancy is common reform proposal
  • US is increasing full retirement age from 66 to 67 for those born in 1960 or later
• Increasing payroll tax rates or removing cap on taxable earnings could generate additional revenue
  • Removing taxable maximum would eliminate about 71% of Social Security's long-term deficit
• Means-testing benefits, where higher-income retirees receive reduced or no benefits, could target resources to those most in need
  • However, this could undermine universal nature of Social Security and reduce political support

Structural reforms

• Transitioning from pay-as-you-go to funded systems, where contributions are invested to build up reserves, could improve long-term sustainability
  • Requires careful management and transition planning to ensure sufficient funds for current retirees
  • Examples include Chile's pension privatization in 1980s and Sweden's notional defined contribution system
• Exploring alternative funding sources, such as sovereign wealth funds or dedicated tax revenues, could supplement traditional funding mechanisms
  • Australia's superannuation system requires employers to contribute percentage of employee earnings to individual retirement accounts
  • Funds invested in diversified portfolio and supplement means-tested Age Pension

Encouraging work and savings

• Automatic enrollment in employer-sponsored retirement plans and increasing default contribution rates could boost participation and savings in DC plans
  • US Pension Protection Act of 2006 encouraged auto-enrollment and auto-escalation of contributions
• Providing financial education and literacy programs can help individuals make informed decisions about retirement savings and investments
  • Countries like New Zealand and Denmark have implemented national financial education strategies
• Encouraging longer working lives and flexible retirement options, such as phased retirement or part-time work, can alleviate pressure on retirement systems
  • Germany introduced partial retirement scheme that allows older workers to reduce hours while receiving partial pension benefits
• Promoting policies that support caregiving, lifelong learning, and healthy aging can enable individuals to remain productive and engaged in later life
  • Singapore's SkillsFuture program provides subsidies for continuing education and training throughout individual's career