WHY DOES THE UNITED STATES and every other developed nation have a system of social-insurance pensions? The simple answer is that social insurance is intended to ensure basic income to those no longer able to work. These include the elderly, the disabled, orphans, and widows and widowers with small children. "Ensure" means that incomes must be available reliably; "basic" means that government's obligation is limited. That is why social-insurance pensions typically replace a larger fraction of earnings of those at the bottom of the wage ladder than those at the top. Social Security benefits also rise as average earnings increase. As Bernard Wasow of The Century Foundation points out, in 1935, when the Social Security Act was passed, "basic" may not have included indoor plumbing and running water in much of the country.
There are alternatives to social insurance. One approach would leave entirely to individuals the task of saving for retirement and of buying insurance against death or disability. But left to ourselves, many of us would save too little and most of us would start saving too late. How many 30-year-olds are prepared to save 20 percent of their income every year of their lives, the portion necessary to buy a pension equal to their pre-retirement income? Most would procrastinate. But if they waited until age 45 to begin saving, they would have to save a whopping 35 percent of their income. Disability and life-insurance premiums would be extra. So would saving for their children's college education, and for new cars, houses, or a vacation. Even with the tax breaks currently on offer, not many of us would rise to this challenge and voluntarily save enough to maintain our living standards during retirement.
A second approach would be to depend exclusively on welfare payments to the indigent. This, however, would destroy social insurance as a program that protects the middle class as well as the poor. It would also create perverse incentives. Why bother to save if the sacrifices of deferring consumption generate no more than one could get on welfare?
Compared with other developed nations, the U.S. system is parsimonious. It provides smaller benefits compared with earnings, and at a later age. U.S. designers of Social Security never expected most people to sustain pre-retirement living standards on Social Security alone. They recognized that most people would need additional income from private pensions or personal savings if they were to avoid sizeable drops in living standards when earnings stopped.
The current system reflects that philosophy. …