The Uncertainties of Life

A century or two ago, if you were unlucky enough to fall into serious poverty, there was very little in the way of government help, even in the richest countries. You were likely to end up in the poorhouse (sometimes called a workhouse or an almshouse), where you obtained the bare minimum of shelter and food in exchange for grueling work. For those who were old and poor, the poorhouse was a place to die an ignominious death:

Social Security in the United States and other countries was set up largely to save old people from this fate.

Carlo did not face any of the problems suggested by the quotation. In Carlo’s world there was no uncertainty: working and retirement income were known at the start of his working life, and his dates of retirement and death were also known with certainty. Carlo had no risk of using up all his savings before he died, or of losing his money in “unwise investments.” But Carlo’s world is not the world in which we live. In practice, individuals face enormous uncertainty both about their lifetime income and their consumption needs in retirement.

The mere fact that we live in an uncertain world is not, in and of itself, a reason for the government to intervene. Private insurance markets might be available that allow individuals to purchase insurance to cover themselves against these kinds of risks. As an example, many people have disability insurance that they either purchase individually or obtain through their employer. Disability insurance means that if you are unlucky enough to suffer an accident or illness that prevents you from working, you will still receive income. It is also possible to purchase annuitiesAn asset that pays out a certain amount each year while you are alive and insures against the uncertain time of your death. (which are sort of a reverse life insurance): these are assets that pay out a certain amount each year while you are alive and allow you to insure yourself against the uncertain time of your death.

Early discussions of Social Security highlighted the insurance role of the program. During the Great Depression, it became clear that insurance provided through markets was woefully incomplete. Thus the government created a variety of safety nets, financed by public funds. Social Security was one of these programs. An early pamphlet on Social Security summarizes this view:

Financial sophistication has increased markedly since the 1930s, but insurance markets are still far from perfect, so most people agree that the government should continue to provide the insurance that private markets fail to deliver. As President George W. Bush’s Council of Economic Advisors wrote, “To protect against this risk [of living an unusually long time], a portion of the retirement wealth that a worker has accumulated must be converted into an annuity, a contract that makes scheduled payments to the individual and his or her dependents for the remainder of their lifetimes.”Economic Report of the President (Washingon, DC: GPO, 2004), accessed July 20, 2011, http://www.gpoaccess.gov/usbudget/fy05/pdf/2004_erp.pdf, p. 130. Once we acknowledge two things—(1) there is major uncertainty in life, and (2) insurance markets are lacking—we see a clear role for Social Security.

The Complexity of Optimization

There is another reason to think that our analysis of Carlo was much too simple. For Carlo, it was quite straightforward to determine his optimal level of consumption: all he had to do was to calculate his lifetime income, divide by the number of years of life that he had left, and he knew his optimal level of consumption.

We said earlier that the basic idea of this life-cycle model continues to hold even in a more complicated world, where incomes are not constant, real interest rates are not zero, and consumption needs may vary over one’s lifetime. If you have a PhD in economics, you even learn to solve these problems in a world of uncertainty.

Yet when one considers all the uncertainties of life, the problem certainly becomes very complex. Most individuals do not have PhDs in economics, and most people—even including those with economics PhDs—are not able to forecast their income and consumption needs very accurately. As a result, it seems likely that many people are not capable of making good decisions when they are thinking about consumption and saving over their entire lifetimes. As stated in the 2004 Economic Report of the President, “Some individuals may not be capable of making the relevant calculations themselves and may not be able to enlist the service of a financial professional to advise them.”Economic Report of the President (Washingon, DC: GPO, 2004), accessed July 20, 2011, http://www.gpoaccess.gov/usbudget/fy05/pdf/2004_erp.pdf, p. 130. Social Security can therefore be seen as a program that provides assistance to individuals unable to make optimal decisions on their own.That said, figuring payments under the current social security system is not easy either. To understand why, check out the information on benefits at the Social Security Administration website. “Your Retirement Benefit: How It Is Figured,” Social Security Administration, January 2011, accessed July 20, 2011, http://www.ssa.gov/pubs/10070.html.

In general, economists believe both that people are aware of their own self-interests and are capable of making good decisions. Economists tend to be suspicious of arguments that suggest that the government can make better decisions for people than they can make for themselves. At the same time, research by economists and psychologists suggests that individuals are subject to biases and errors of judgment in their decision making. And if government paternalism makes sense anywhere, then it is likely to be in the context of lifetime saving decisions. After all, we are not talking about deciding which kind of coffee to buy or what price to set for a product this month. There is no room for learning from your mistakes, there are no second chances, and the consequences of error are enormous. In life, you only get old once.

Distortions and Administrative Costs

The key arguments in favor of Social Security are therefore that it provides some insurance that may not be available through private markets and protects people in the face of their inability to make sound decisions when they are planning for the distant future. But just because there are some shortcomings of private insurance and annuity markets, we should not presume that government can do things better. Against the benefits of the Social Security system must also be set some costs.

First, any government program requires resources to operate. It costs about 1 percent of the benefits paid to administer the Social Security system. This is a direct cost of the program. Second—and more interestingly in terms of economics—whenever we have a government scheme that affects the taxes that people pay, there will be some distortionary effects on people’s willingness to work. Taxes lower the relative price of leisure compared to consumption goods, which may induce people to work less. Because Social Security imposes a tax on the incomes of working people, it distorts their choices. This is another cost of the Social Security system.

The Effect on National Savings

There is another effect of Social Security that is much more subtle. It reduces the savings of the nation as a whole. This means less capital and ultimately lower living standards. The intuition is as follows. When individuals save, they make funds available in the financial markets for firms to borrow. Thus saving leads to investment and a buildup of the economy’s capital stock. But as we saw, Social Security reduces the individual incentive to save. People don’t need to save if the government will provide for them in retirement. Furthermore, the taxes being collected by the government are not being used to finance capital investment either; they are being paid out to old workers.

A pay-as-you-go system thus tends to reduce overall national saving. In a fully funded Social Security system, this is not an issue, and indeed this is one of the most compelling arguments in favor of a gradual shift to a fully funded system.

Redistributive Effects of Social Security

Social Security redistributes income in ways that may not be desirable. After all, those who benefit the most from Social Security are those who live the longest. Thus the scheme effectively redistributes money from the unlucky people who die young to the lucky ones who live for a very long time. This is a politically charged argument, for life expectancy is correlated with poverty, race, and sex. The life expectancy of poor African American men is significantly lower than the life expectancy of rich white American women, for example. Social Security may redistribute resources, from poor African American men to rich white American women.