Social Security Privatization with Elastic Labor Supply and Second-Best Taxes

This paper shows that many common methods of privatizing social security fail to reduce labor market distortions when taxes are second best, challenging a key reason to privatize. Ironically, providing “transition relief” to workers alive at the time of the reform, in an effort to protect their previous contributions, undercuts potential efficiency gains. Chile’s reform -- the first major privatization that also served as a model for subsequent countries -- actually increased distortions. It is then shown that privatization with limited transition relief can reduce labor market distortions and produce gains to current and future generations without hurting initial retirees, i.e., a Pareto gain even with second-best taxes.

Controlling the Cost of Minimum Benefit Guarantees in Public Pension Conversions

Unfunded defined-benefit (DB) public pension plans throughout the world are being converted to funded defined-contribution (DC) plans that typically contain a minimum benefit guarantee (DC-MB). Risk management techniques must be used to control the cost of these guarantees. The most common technique is to 'over-fund' the benefit: the contribution rate is set high enough so that the expected benefit is much larger than the guaranteed minimum benefit. This paper shows that while over-funding is very effective in controlling guarantee costs in traditional DB plans, it is highly ineffective for DC-MB plans. This result holds even at very large contribution rates and when risky investments are restricted to a very diversified index like the S&P500. Calculations show that the true risk-adjusted value of unfunded guarantees in a realistic DC-MB plan equals 40 to 90 percent (or more) of the value of the unfunded liability in the DB benefit being replaced, depending on design. This result is true even when the contribution rate in the DC-MB plan is chosen to produce an expected benefit five times larger than the DB benefit. This paper considers two approaches to controlling guarantee costs. The first approach borrows from the recent catastrophic insurance literature. A 'standardized' portfolio is guaranteed, requiring agents to accept 'basis risk' if they chose a non-standard portfolio. However, for large conversions from DB to DC-MB plans, in which there is little or no DB benefit remaining the government must still worry about any 'implicit guarantee' extending beyond the standardized portfolio, thereby enticing agents to accept a lot of basis risk (a 'Samaritan's Dilemma'). The second method, therefore, uses a more brute force approach: private portfolio returns in the good states of the world are taxed while returns in the bad states are subsidized. Both options are very effective at controlling guarantee costs, and they can be used separately or together. Calculations demonstrate that all of the unfunded liabilities associated with modern pay-as-you-go public pension programs can be eliminated under both approaches even at a modest contribution rate.

Does Social Security Privatization Produce Efficiency Gains?

While privatizing Social Security can improve labor supply incentives, it can also reduce risk sharing when households face uninsurable risks. We simulate a stylized 50-percent privatization using an overlapping-generations model where heterogenous agents with elastic labor supply face idiosyncratic earnings shocks and longevity uncertainty. When wage shocks are insurable, privatization produces about $21,900 of new resources for each future household (growth adjusted over time) after all households have been fully compensated for their possible transitional losses. However, when wages are not insurable, privatization reduces efficiency by about$5,600 per future household despite improved labor supply incentives. We check the robustness of these results to different model specications and arrive at several surprising conclusions. First, privatization actually performs relatively better in a closed economy, where interest rates decline with capital accumulation, than in an open economy where capital can be accumulated without reducing interest rates. Second, privatization also performs relatively better when an actuarially-fair private annuity market does not exist than when it does exist. Third, introducing progressivity into the privatized system to restore risk sharing must be done carefully. In particular, having the government match private contributions on a progressive basis is not very effective at restoring risk sharing -- too much matching actually harms efficiency. However, increasing the progressivity of the remaining traditional system is very effective at restoring risk sharing, thereby allowing partial privatization to produce efficiency gains of $2,700 per future household.

Dropping Out of Social Security

The liability facing a pay-as-you-go social security system can be calculated in several ways. The exact liability measure chosen can significantly affect the conversion of a public pay-as-you-go system to a system based on individually funded accounts. Most conversions, including that which took place in Chile, as well as in many plans to convert the US system, assume the largest measure, known as the “shutdown liability.” That measure pays many workers who have contributed to the public system more money than the public system is actually worth to them, thereby placing a larger burden on future generations. Other liability measures, though, are hard to implement due to an information asymmetry between the government and individuals about an individual’s skill level. This paper demonstrates that a very simple reform plan –– simply letting people drop out of social security –– generates a truthful revelation equilibrium in which agents reveal private information about their skill level. The new assumed liability measure can be as little as half of the shutdown liability as the new measure more accurately assigns a liability for each individual based on their true value of remaining in social security. A smaller liability, therefore, is passed to future generations which also generates quicker transition paths. Moreover, interestingly, the drop out method also does a better job of protecting the welfare of the initial elderly when general revenue is used to pay for the transition. Simulation evidence is provided using a large-scale lifecycle simulation model that allows for heterogeneous skill levels. The evidence demonstrates the importance of the dropping out approach relative to the traditional conversion method that assumes the shutdown liability.

Fiscal and generational imbalances: new budget measures for new budget priorities

This paper describes the deficiencies of the measures used to calculate the federal budget, make revenue and spending projections, and assess the sustainability of current fiscal policies. The nature of the deficiencies hides the tremendous impact that Social Security and Medicare commitments will have on the budget in the future, given the way the programs are structured currently and the momentous demographic shift underway as the baby boom generation approaches retirement age. This paper proposes two new simple measures that will enable government officials and the public to calculate more accurately the costs of maintaining these programs into the relevant future. The measures provide a better understanding of the costs involved, when they will be incurred, and by whom.Budget ; Fiscal policy

Moral Hazard in Reinsurance Markets

This paper attempts to identify moral hazard in the traditional reinsurance market. We build a multi-period principle agent model of the reinsurance transaction from which we derive predictions on premium design, monitoring, loss control and insurer risk retention. We then use panel data on U.S. property liability reinsurance to test the model. The empirical results are consistent with the model's predictions. In particular, we find evidence for the use of loss sensitive premiums when the insurer and reinsurer are not affiliates (i.e., not part of the same financial group), but little or no use of monitoring. In contrast, we find evidence for the use of monitoring when the insurer and reinsurer are affiliates, where monitoring costs are lower, but little use of price controls.

Ricardian Equivalence with Incomplete Household Risk Sharing

Several important empirical studies (e.g., Altonji, Hayashi, and Kotlikoff, 1992, 1996, 1997) find that households are not altruistically-linked in a way consistent with the standard Ricardian model, as put forward by Barro (1974). We build a two-sided altruistic-linkage model in which private transfers are made in the presence of two types of shocks: an 'observable' shock that is public information (e.g., public redistribution) and an 'unobservable' shock that is private information (e.g., idiosyncratic wages). Parents and children observe each other's total income but not each other's effort level. In the second-best optimum, unobservable shocks are only partially shared whereas, for any utility function satisfying a condition derived herein, observable shocks are fully shared. The model, therefore, can generate the low degree of risk sharing found in the recent studies, but Ricardian equivalence still holds.

The Optimal Design of Social Security Benefits

The United States Social Security system is fairly unique in that it explicitly allows for a progressive formulation of retirement benefits by assigning a larger replacement rate to workers with small pre-retirement wages. In contrast, the public pension systems in other countries often replace a constant fraction of pre-retirement wages, although the length of the “averaging period" is typically shorter relative to the U.S. This paper examines the ex-ante optimal U.S. Social Security benefit structure using the model developed in Nishiyama and Smetters (2007). On one hand, progressivity in the benefit structure provides risk sharing against shocks that are difficult to insure privately. On the other hand, progressivity introduces various marginal tax rates that distort labor supply. Rather surprisingly, we find that the ex-ante best U.S. Social Security replacement rate structure is fairly “flat.” Intuitively, the relatively long averaging period used in the U.S. system formulation already provides some insurance against negative idiosyncratic shocks, but in a manner that is more efficient than explicit redistribution.

Measuring Social Security's Financial Problems

The U.S. Social Security system has helped keep many retirees out of poverty. However, according to the Social Security and Medicare Trustees, Social Security faces a future financial shortfall of $10.4 trillion in present value. This enormous imbalance has received little attention in public debates about Social Security. Instead, the media and policymakers continue to focus on the program's trust fund and several other ad-hoc measures that create a misleading impression of the size of Social Security's financial problem. Although the Social Security Trust Fund is not projected to be exhausted until 2042, Social Security's$10.4 trillion present value imbalance is accruing interest and will grow by $600 billion during 2004 alone. The current cash-flow federal budget, however, is biased against reforms that would improve Social Security's finances. As shown herein, a new federal accounting system would remove this bias.