1

Chapter 6

Social Security

Prepared and Taught by
Lecturer: YIN SOKHENG, Master in Finance
2
Instructed by YIN SOKHENG, Master in Finance
INTRDUCTION
Under the U.S. Social Security system, a
payroll tax is levied on workers and
employers, and the revenue is used to pay
benefits to retirees.
Although you are a long way from
retirement, Social Security is already
relevant to you.
3
Instructed by YIN SOKHENG, Master in Finance
FOUR WAYS TO PREPARE FOR RETIREMENT
It is important to pause to carefully consider
the possible ways to prepare for retirement
and the advantages and disadvantages of
each way.
Table 6.1 Preparing for Retirement
Description Individually Collectively
Workers support retirees Historical U.S. Social Security
Each generation self-sufficient Recent Possible
2
4
Instructed by YIN SOKHENG, Master in Finance
Workers Support Retirees
Historical: Their own children took care of
them by providing food.
Advantage: Between people and
personal bonds workers are helping
their own parents.
Disadvantage: Not everyone has
children who are able and willing to
care for them.

5
Instructed by YIN SOKHENG, Master in Finance
Collectively: Each old person is supported
collectively by all children(workers) in society.
The government taxes all workers and then
sends benefit checks to all retirees.
Advantage: Achieve a partial
redistribution from high-to low wage
workers
Disadvantage:
Any compulsion is always somewhat
regrettable.
There are tax payments and benefit checks
among strangers.

6
Instructed by YIN SOKHENG, Master in Finance
Each Generation Self-Sufficient
Recent:
Workers to save for their own retirement
Workers can put their saving in the bank
or buy government bonds, corporate
bonds, or corporate stock.
Individuals can build up wealth for
retirement in the form of a bank account ,
bond, or stock.

3
7
Instructed by YIN SOKHENG, Master in Finance
Each Generation Self-Sufficient
Possible :
The government would tax all workers
and save the revenue.
When workers retire, the government
would gradually draw down.
Collectively, each generation would be
saving for and financing its own
retirement.

8
Instructed by YIN SOKHENG, Master in Finance
The Rate of Return
The rate of return r* is defined as:


Where: B
2
is the person benefit as a retiree.
T
1
is the sacrifice person made as
a worker.
Suppose a worker sacrifices $100 while
working and then receives a benefit or $150
in retirement.
1
) (
*
1
2
1
1 2

|
|
.
|

\
|
=

=
T
B
T
T B
r
9
Instructed by YIN SOKHENG, Master in Finance
Rate of Return When Workers Support Retirees
The benefit to retiree is defined as:


Where: t is the payroll tax rate
W is the wage per worker
L is the number of workers
B

is the benefit per retiree
R is the number of retirees
T is the tax per worker.
TL tWL BR Benefit = = =
4
10
Instructed by YIN SOKHENG, Master in Finance
Table 6.2 A Rate of Return Example
Period Workers Wage Tax Revenue Retirees Benefit Rate of Return
1 100 $10,000 $2,000 $200,000
2 125 10,000 2,000 250,000 100 $2,500 25%
1 100 10,000 2,000 200,000
2 100 12,000 2,400 240,000 100 2,500 20
1 100 10,000 2,000 200,000
2 125 12,000 2,400 300,000 100 3,000 50
TL tWL BR Benefit = = =
W L W L
g g g g
T
B
T
T B
r + + =
|
|
.
|

\
|
=

= 1
) (
*
1
2
1
1 2
Where g is the growth rate per period
11
Instructed by YIN SOKHENG, Master in Finance
The Impact on the Economy
Workers-support-retirees system has two
disadvantages relative to a self-sufficient
system.
First, the rate of return is lower
Second, the capital stock and output of
the economy are lower
=> Breaking out of a workers-support-
retirees system is hard to do.
12
Instructed by YIN SOKHENG, Master in Finance
Effects on Economic Behavior: Saving
Behavior
Social Security affects these incentives
Wealth substitution effect: Households view
the government as doing some of this saving
for them (S)
Retirement effect: Social Security may induce
people to retire earlier, thus more periods of
retirement to finance (S)
Bequest effect: Social Security redistributes
from the young to the old, and parents may
offset this with larger bequests (S)
5
13
Instructed by YIN SOKHENG, Master in Finance
The Impact on the Economy
Workers-support-retirees system has two
disadvantages relative to a self-sufficient
system.
First, the rate of return is lower
Second, the capital stock and output of
the economy are lower
=> Breaking out of a workers-support-
retirees system is hard to do.
14
Instructed by YIN SOKHENG, Master in Finance
Table 6.3 Collective Workers-Support-Retirees System
versus Individual Self-Sufficient System for Social Security
Description Collective Workers
Support Retirees
Each Individual
Self-Sufficient
Average rate of return r* g
t
+ g
w
+

g
t
g
w
= 3% mpk = 6%
Capital and output Lower Higher
Individual ownership and
control

No

Yes
Benefit depends on Wage history
Defined-benefit
Investment income
Defined-contribution
Risk of variation of r* Lowe High
Benefit automatically an
annuity paid monthly as long
as retiree lives


Yes


No
Benefit automatically inflation
protected

Yes

No
Partial redistribution from
high-wage to low-wage
workers


Yes


No
15
Instructed by YIN SOKHENG, Master in Finance
Long-Term Stresses on
Social Security
Benefits received:
Where N
b
=number of retirees, B=average benefit per
retiree, t=tax rate, N
w
=number of workers, and
w=average wage per worker.
N B
b
tN w
w
Payments collected:
6
16
Long-Term Stresses on
Social Security
For solvency, we must have:
N B tN w
b w
=
Or rearranging:
t
N
N
B
w
b
w
=
|
\

|
.
|
|
\

|
.
|
The first term on the right hand side is the
dependency ratio, and the second term is the
replacement ratio.
Instructed by YIN SOKHENG, Master in Finance