Social Security, known as OASDHI - is the largest federal transfer payment program in the world ($350B/year) - Old Age, Survivors, Disability and Health Insurance.  Started in 1935 as a compulsory, national retirement insurance, comparable to a private pension fund.  However, SS does not operate on the principles of private insurance company or a private pension fund.

For example, private insurance companies and pension funds have not been complaining about the problem of babyboomers retiring, there is no "pending crisis" for life insurance companies or for any private pension fund.  Why?

Big difference between private insurance/pension funds and SS.  SS operates more like a Ponzi scheme.  1916 - Italian immigrant named Charles Ponzi created a large investment fund that paid very large dividends initially, but no investments were actually being made.  What seemed in the beginning like a very profitable investment attracted new investors trying to get rich.  Money from new investors was transferred to the old investors.  The system had flexibility and boldness, and worked as long as an ever-expanding pool of suckers could be found - a "pyramid scheme."  What causes a Ponzi/pyramid scheme to break down???

In contrast to SS, a private insurance company or pension operates on sound financial, economic and legal principles, following a Saving-and-Investment model.  For a life insurance company, current customers pay in premiums.  What does the insurance company do with premiums???  Operates as an "actuarial sound" operation.  Pension fund takes current contributions and makes investments on behalf of the client.  Unlike SS, fund is portable, transferrable, redeemable, etc.

SS operates on a "pay-as-you-go" basis, that is really an intergenerational income transfer program, intergenerational welfare program.  Current SS tax collections are paid out to SS recipients, no investments are made, no wealth is created.  The system relies totally on future generations to pay in enough taxes to support SS recipients.  When it started in 1935, there were lots of workers and few eligible retirees.  Even in 1950 there were 16 workers for each SS beneficiary.  In 1970, there were 4, in 1982 there were 3, in 2025 just 2!  See page 520.

From 1937-1949, the combined employer/employee payroll tax was just 2%, on only the first $3000 annual income, Max SS tax = $60.  In 1960, the tax was 3% for employer and 3% for employee up to $4800, Max SS Tax = $288 ($144 each).

Now the tax is 7.65% for employer and employee up to $72,600, MAX = $11,107.
Illustrates the problem: More and more people are living longer and receiving more benefits.  Consider that in 1950, life expectancy was 67 years, and average retirement age was 68.5, so the expected number of years receiving SS was 0.

In 1973, life expectancy was 70 and retirement was 64, and in 1990 life expectancy was 75 and retirement age 63.6 years, 11.4 average years in retirement.

Because SS taxes used to be so low, and current benefits are so high, and current recipients live so long, most retired get everything back that they paid in within about 3 years of retirement and everything else is a pure transfer payment or "welfare."  Return to these workers is enormous - 25%, better than could have done if they invested the funds privately.  People currently in their 30s can expect a return of only 2-3% on SS, far worse than if they invested privately.  For two-earner couples just entering the workforce, the expected rate of return from SS is negative.  And there is no direct relationship between individual "contributions" and benefits received.  For example, what if you die as a single person at age 65??

Point: SS has been a great deal for current and past retirees, terrible deal for current workers.  We would be better off investing funds privately.

For example, the first recipient was Ida Fuller of Vermont who retired in 1940 after paying SS taxes for 3 years.  She and her employer togehter paid in $44 total
and Mrs Fuller lived to 100 and collected $21,000.

Important point: Separate the two issues: a) whether to have a mandatory retirement program and b) if so, whether to have the government running the program.   Example; auto insurance.

Now that people live longer, a crisis is pending.  See page 520.  The number of people over 70 will double within the next 30 years.

Milton Friedman: Says SS is a combination of a particular tax and a program of transfer payments (welfare).  Has never met anyone who would separately defend either the tax by itself or the benefit system by itself.  If the two had been considered separately, neither would have been adopted.  Imaginative packaging resulted in an unacceptable tax and an unacceptable benefit program in the form of an acceptable SS program.

Consider SS tax.  Flat rate on wages up to a maximum, regressive tax falling disproportionately on low income people.  Tax on productive effort, which discourages employers from hiring workers and discourages people from working.  Also discourages private saving.  People in the U.S. save less for retirement because of SS, but there is no increase in savings since SS funds are not invested or saved.  Reduction in private savings leads to higher interest rates, reduction in capital investment, lower rate of capital formation, less economic growth in LR.  Economists have been critical of SS because of the negative effect of reduced savings on capital formation - lower output growth.

Consider the benefit.  SS pmts are not determined by the amount paid in by the retiree, or their financial status at retirement.  They are therefore not a fair return for prior pmts, and are not an effective way of helping the poor.  Another issue: elderly are no longer usually poor, see page 430.  Elderly are in poverty (6.5%) at about half the rate of the nonelderly population (12.6%).

There is some loose connection between taxes paid and benefits received, but benefits depend on a complex formula that is somewhat arbitrary.  The loose connection at least makes SS resemble a private insurance program.

The LR financial problems of SS, "a ticking financial time bomb"  are from one simple demographic fact: The number of people receiving payments has increased and will continue to increase faster than the number of workers paying in. Two factors: 1) Demographic trend toward decreasing fertility rates + 2) people are living longer = Unfunded Pension Liabilities  Ponzi scheme.
 
There are currently more taxes paid in than are paid out as benefits creating a current SS surplus, see page 521.  But because of the demographics of the population, medical advances, etc., the fund will go into deficit around 2012 and will be broke by 2032.

WHAT TO DO?
1. Raise eligibility age from 65 to 68 or higher?
2. Remove full indexing of future benefits.  Slow the growth in benefits.
3. Raise SS taxes.
4. Convert SS to a privatized system, e.g. Chile.

Chile recognized that its SS program was unsustainable - combined SS taxes were up to more than 20% (10% employer, 10% employee), and it still wasn't enough.  Remember that there are also federal, state and city taxes to pay.

Chile's System, started by Jose Pinera in 1981:
1. Neither the worker nor the employer pays a SS tax to the govt.  SS taxes = 0.
2. Workers do not collect a pension from the govt.
3. Workers pay 10% of wages (mandatory) into a private PSA (pension saving account), collected by employer and deposited on their behalf.
4. Over 20 privately run mutual fund companies, AFPs, compete for worker's investments, are regulated by the govt.  Free entry to AFP industry.
5. Workers can change AFPs at any time, have their accounts transferred, if they think they can get better service, higher returns, lower commissions, etc.
6. Workers can contribute more than 10%, up to 20%, tax-free, as a form of voluntary savings, if they want to retire early or receive higher benefits.  There is no fixed retirement age, system allows for individual preferences.
7. Workers get quarterly statements from the AFP showing the amount accumulated and the fund's performance.
8. There are no unfunded pension liabilities.

Results so far:
Average real return on investment has been 13% per year.
Average pension payments are significantly higher than under the govt system.
Average retiree receives a pension of almost 80% of their average salary over the last ten years of their career!!

Average US SS retiree gets $9360/year about 20% of average U.S. income.