Academic journal article Federal Reserve Bank of St. Louis Review

A Primer on Social Security Systems and Reforms

Academic journal article Federal Reserve Bank of St. Louis Review

A Primer on Social Security Systems and Reforms

Article excerpt

This article reviews the characteristics of different social security systems. Many configurations arise depending on the nature of a system's funding and determination of benefits. Many reforms propose changing the social security systems. The authors focus their analysis of the transition from a pay-as-you-go to a fully funded system. They argue that the key component of any reform is the treatment of the implicit liabilities of a country's social security system. The welfare gains accruing to some cohorts as a result of such reforms usually stem from either a partial or complete default on the implicit debt of the system, and in that sense the gains imply only a redistribution of welfare across agents. In contrast, the elimination of existing distortions in social security financing can generate efficiency gains, allowing for welfare improvements for all agents. This result shifts the focus from the nature of the system itself and centers the debate on the distortions associated with social security. (JEL H2, E62, D31)

Federal Reserve Bank of St. Louis Review, January/February 2011, 93(1), pp. 19-35.


Social security," by its simplest definition, is a contract between a government and its constituents. Under this contract, citizens provide funding to a social security system, and in exchange they receive benefits from the system during their nonworking years, generally during old age or prolonged illness (disability). The U.S. Social Security system was implemented in 1935 under President Franklin Roosevelt. This system, formally known as Old-Age, Survivors, and Disability Insurance (OASDI), is a pay-as-you-go (PAYG) system in which workers provide financing through a Social Security tax; these contributions provide benefits to the currently retired or disabled. The system requires an implicit guarantee that future generations will then provide the same support for them. In contrast, fully funded (FF) social security systems require that benefits accrue based on individual contributions paid over time. In such systems, future obligations are fully funded by earlier contributions.

Financial sustainability of the U.S. Social Security system is an important policy concern because of the aging population, particularly the baby boom cohorts. The recent recession, combined with the renewed political focus on health care and long-term health costs, has led to increased interest in the long-run financial stability of the U.S. Social Security system. While the Board of Trustees of OASDI has expressed the need for long-term reform for several years, their 2009 report described how lower gross domestic product (GDP) and fewer covered workers affect the long-term outlook (see Board of Trustees, 2009). The Board moved forward its projections for the year in which outlays will exceed revenues (2016) and the year in which current trust funds will be exhausted (2037). The 2010 Trustees Summary Report concludes that these imbalances "demonstrate the need for timely and effective action. The sooner the solutions are adopted, the more varied and gradual they can be" (see Social Security and Medicare Boards of Trustees, 2010). These solutions include higher taxes, lower benefits, or a combination of both to replenish the trust fund. However, some analysts advocate a transition to an FF Social Security system.

Building on the seminal work of Auerbach and Kotlikoff (1987), several quantitative analyses simulate the transition from a PAYG to an FF system and find substantial efficiency and welfare gains in the long run. However, the gains often come at the expense of the transition generation. For example, Huang, Selahattin, and Sargent (1997) show that partial or full privatization implies large short-run welfare losses that cannot be compensated by the long-run gains. Conesa and Krueger (1999) show that in the presence of uninsurable labor income uncertainty the welfare losses of the initial cohorts are large and constitute a political barrier to potential reforms. …

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