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Anna Leonard 3/20/12 Economics 320 Social Security The government should move in the direction of a defined-contribution plan.

Pensioners should have to contribute more to their pension funds in the form of higher taxes. However, it should also protect its citizens against loss of income due to uncertainties in the financial markets. An individuals savings may decrease due to an increase or decrease in interest rates. If interest rates rise, the price or value of assets decreases. This means that if the asset were sold the investor would receive less than what he or she paid for it. On the other hand if interest rates decrease, the investor will get a lower return on his or her financial asset. This essay will explore the differences between government pensions and private pensions. It will also discuss in what direction Social Security will move in the future. The debate about pension plans is important because a majority of American employees use pension funds to support themselves and often their spouse after they retire. These employees and future retirees need to know the difference between private and government pension funds and how to adjust to the change in pension funds. The Social Security Act of 1935 mandated Social Security under President Roosevelt. The system involved a tax from the income of the employer and the employee. As time went on the tax grew due to an increasing number of people in the program, greater longevity, improvements in benefits voted repeatedly by Congress, an introduction of Medicare benefits for the aged, inflation, resistance in Congress to the

possibility of financing Social Security (in part) from the general revenues of the Treasury. In 1976 Social Security ran into its first deficit. The system paid out an estimated $4.3 billion more than it took in from payroll taxes and the levy paid by the selfemployed. The deficit was financed by the old age trust fund. By the end of 1976, the assets had dropped by $34.3 billion. As time has gone on the elderly have become increasingly worried about what will happen to their Social Security checks. During the early years of Social Security the fund was used as a rainy day fund. The size of the fund was bigger than the money that was taken out of it. As time went on more money was being taken out of it. Through 1976-1950 the outlays, or expenses, were to exceed the payments. There are two reasons as to why Social Security has gone into so much debt. The first has to do with a falling birth rate: the number of beneficiaries is increasing while the number of workers is decreasing. The second has to do with inflation. In 1972, there was an amendment to the Social Security Act that provided for automatic increases in benefits according to inflation. This amendment also increased the PIA with increases in the CPI. An effect of this increase in benefits meant that the replacement ratios increased as time goes on. The problem occurs when the replacement ratios change with changes in the price level and inflation, and not a conscious decision from Congress. In 1976, a panel of consultants to Congress suggested that the benefits be calculated from the earnings indexed in proportion to the changes in price levels during the earnings-averaging period. This means that benefits would be calculated from workers income that would increase as goods and services became more expensive.

A consideration in the question of Social Security is the debate of earned entitlements versus need. The original goal of Social Security was something to help older people, not support them. An issue that relates to earned entitlements versus need is the earnings test. For every $2 above $3,000, $1 is lost to Social Security. For example if a worker earned $51,000, $24,000 would be lost to Social Security. If the worker earned 360,000, $178,500 would be lost to Social Security. This seems unfair to higher earners because they earn more yet they lose more to Social Security. However, lower earners who need more benefits lose less to Social Security. The Social Security market is the alternative to the private pension funds. Social Security is financed like the money market because money is needed monthly to finance Social Security checks for retirees. The taxes that current workers pay into Social Security are like loans that are spent on current retirees. Those loans are paid back to the worker when he or she retires. However, very little interest is earned on those loans because they are immediately spent. Private pension funds, however, are financed in the capital market when a worker forms a contract with an investment firm to receive his or her funds when he or she retires. The reason why private pension funds are held in the capital market is because whatever assets the investor holds are being used to finance a long-term investment. These assets have a long maturity meaning they will earn interest over a long time period. Because they have a long maturity there is a greater possibility that their assets will lose value over time. This is due to changing interest rates, but also due to illiquidity. To combat this they are offered a higher interest rate to entice them to purchase long-term

financial assets. This can be attractive to someone who holds his or her assets in the capital market for 25 years. Pension funds sold in the financial markets allow savers to store wealth until those funds are needed for spending. Government pension funds, i.e. Social Security, do not have the opportunity to store wealth because pension funds that are taken in by the government are immediately spent. On the other hand, pension funds invested in the private sector grows and compounds. The financial markets protect the individual against loss of income due to retirement. The risk protection function of the financial markets is split into two functions. The first function is risk sharing. This function is performed when an individual who wants to invest in a pension fund transfers risk to the contractual institution. The second function is risk reduction. This function is performed when an individuals retirement funds are diversified across a wide range of assets to reduce risk. The occurs primarily in risky funds, such as mutual funds or hedge funds, where individuals could lose all their retirement funds if they were not diversified. The two functions often perform together when risk is transferred to the contractual institution and the individuals portfolio is diversified. Social Security, on the other hand, utilizes the credit function of the financial markets. Current workers pay into Social Security expecting future payment when they retire. The problem is that Social Security has not been paying down its deficit, like an individual pays down his or her credit card balance at the end of the month. This deficit could lead to Social Security ultimately running out of funds.

When individuals are confident about the financial markets ability to perform these functions they are more likely to invest their savings in the financial markets and help grow the economy. This growth in the economy happens because individuals pension funds are not idle in the capital markets. Older workers retirement funds are used to support younger workers who have a greater propensity to borrow. The Classical Theory of Interest (see Figure 1) illustrates this point. As savings increase, move to the right, interest rates are pushed down. This decrease in interest rates will increase borrowing, which will increase investment and help grow the economy. The Gurley-Shaw Equation measures an individuals income to his or her debt. Private accounts have an advantage in this respect because more funds are put into the account than are taken out. Government-funded Social Security incurs more debt than income. More income is needed to fund Social Security through higher taxes, and benefits are being cut to reduce expenditures. When projected revenues have fallen short of projected benefits, Congress has most often cut benefits and raised revenues. Ordinarily, cuts in benefits for current retirees or for those soon to retire have comprised only a small part of the measures taken to close deficits, presumably because Congress is not aware that most retirees and many older workers have little or no ability to adjust to benefit reductions without serious hardship. Employers have two methods for offering pension funds to their employees. The first method is called a defined-benefit plan. The employees are guaranteed a pension fund based on whether they work long enough. This system is most beneficial for the workers, but it is a financial burden for the firms. Firms may have to raise prices on commodities that they sell and cut workers to finance the pension funds. Social Security

also is a defined-benefit plan. Retirees are guaranteed benefits based on their earnings. The government takes on the risk involved with providing its citizens with pension funds. Taxes, instead of prices, are raised to finance Social Security. The alternative to defined-benefit is defined-contribution. As the name might suggest, the employee is required to manage his or her pension fund, and the risks involved in managing ones own pension fund. The reason why employers favor this plan is that with this plan employers do not lose profits. Employees may earn higher returns from this plan, however they may also lose all their savings that they invest into their pension fund. Many employees are going to invest their funds in safer, less volatile, funds that will still offer a return. Defined-contribution plans are risky because the economic climate is so uncertain. During the 90s defined-contribution plans offered high returns when interest rates are high and it was cheap to invest in financial assets to add to ones portfolio. On the other hand in the early 00s when the economy was not doing well it was better to have a defined-benefit plan. The reason for this is that individuals lost potential returns on assets because interest rates were low and financial assets were expensive. Potential returns are returns that investors could have received if interest rates had not declined. Investors also are at risk because of when they draw from their private accounts. Individuals who retire when interest rates are low receive smaller pensions than those who retire when interest rates are high. What is sometimes most unnerving about investment choices is the chance that they will not perform as expected. Investment risk addresses the probability that our investment choices will not perform well enough to fund retirement. Investment risk is a

function of the defined-contribution plan. Because the economy is uncertain whenever an individual invests in a financial asset there is a risk that the firm that sells the individual the financial asset will default on the financial asset. There is also the possibility that interest rates will fall and the individual will receive a lower return than he or she expected. There are two philosophies for the role that Social Security could play in the future. If the philosophy of moderatism largely prevails, the relative role of the Social Security program will not change significantly. Its provisions will be modified from time to time to keep it up to date and to solve such problems and anomalities (irregularities) as arise, especially those which are not being handled in a reasonably satisfactory manner by the private sector. On the other hand, if the expansionist philosophy prevails, the role of the Social Security program would be greatly enlarged. I believe that the role Social Security will play will lean towards the philosophy of moderatism. Social Security will not get bigger, yet it will try to ensure a comfortable future for its beneficiaries. Complete privatization of Social Security yields too many uncertainties for retirees. Social Security is slowly cutting benefits and raising taxes. Yet because of an increase in benefits due to inflation, the funds that are paid into Social Security will always be less than the funds that are paid out to current retirees. Because of the deficit that Social Security has incurred benefits might have to be cut faster than anyone is comfortable with. If Social Security runs out of money, the government might be forced to privatize Social Security. As time has gone on workers and retirees have become more dependent on Social Security. Because they have grown so dependent Social Security needs to be reformed so that it better fits the needs of the current workers and the retirees. Current retirees need to

save funds in the financial markets so that they finance investment by current workers. They also should be able to receive some benefits from the government. Future workers, rich and poor, should put a strong emphasis on saving because it may be more guaranteed than Social Security if Social Security does run out of money.

A glossary and citations and a graph will be added later.

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