Thursday, April 24, 2008

More details on Obama's Social Security plan?

Update: See comments for good reasons why I might be wrong...

This is a couple weeks old, but James Pethkoukis's Capital Commerce blog at U.S. News & World Report has an interview with Obama economic adviser Austan Goolsbee that briefly touches on Social Security reform. Here's the excerpt, followed by a quick comment:

Does Obama want to raise payroll taxes or uncap the income limit to fix Social Security?
What Obama has said is that the problem with Social Security is not a crisis, but that there are fiscal issues associated with the aging of the population. In his view, the place to start is with the regressivity issue of the payroll tax. It is my own view that the majority of Americans do not understand how the payroll tax works. How it is that a guy making $90 million a year is paying the same tax as a guy making $97,000 a year? I think that at best it would strike them as highly weird and at worst grossly unfair.

But he has not called for uncapping it completely, and there are several different ways to do it. But before anybody starts talking about cutting benefits, let's address that issue. It would also get the trust fund to last another 50 or 60 years. An increase in the payroll tax of 6 percentage points phased in over many years or decades doesn't strike me as a dramatic move. They have uncapped the top rates in Ireland, and they have grown extremely well.

The italics are mine. This sentence is interesting since it seems to indicate a willingness to raise the payroll tax rate as well as the cap. (Why? First, it's not clear what raising the payroll tax cap "6 percentage points" means, so I'm inferring it refers to the rate; second, for Obama's plan to lift the cap to keep the trust fund solvent another 50 or 60 years would require it be implemented very quickly, not over decades.) This would seem to indicate a dedication to little or no reductions in scheduled benefits at all.

From my previous work on Obama's tax plan, the payroll tax rate would need to rise by around 4.7 percentage points -- from 12.4 percent to around 17.1 percent -- by 2080 to maintain solvency, even after his plan to lift the tax cap has been implemented.

For what it's worth, Goolsbee's general comments in the first paragraph focus on Social Security taxes distinctly from the benefits that are linked to them. Yes, the Social Security tax is flat when measured up to the cap, and regressive when measured relative to total income. But benefits are paid progressively based on taxes, so low earners can expect to receive a higher return on their contributions than can high earners. Given the program's history, in which taxes and benefits are linked in a single system, to focus on the progressivity of one element rather than the program as a whole seems misguided. The U.S. already has a much higher taxable maximum than most developed countries; eliminating it entirely would put us out of step even with countries with far more extensive welfare states than our own.

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Sunday, April 20, 2008

How much is a child worth to Social Security?

Recently, analysts on the political right have debated the merits of "family friendly" tax cuts versus tax policy designed for economic growth, in particular, reductions in marginal income tax rates. (See also here.) This is a complex question on which I'm not fully qualified to comment, but here are a few basic points, plus a calculation specific to Social Security (on which, presumably, I am qualified to comment).

First, family friendly tax cuts can increase economic growth down the road if reductions in the cost of having children increase the number of children families have. Since today's child is tomorrow's work, total GDP can be expected to increase along with fertility. Whether GDP per capita increases is another story (that is, it's unclear whether a family having an additional child will improve the economic prospects of other children).

Second, if family friendly tax cuts improve the human capital development of children – say, by enabling a mother to stay home with her children rather than sending the child to day care – then this might also improve economic growth down the road, since human capital is an import contributor to output. Of course, policies such as the child tax credit don't alter incentives to work or stay home at the margin, so the effect is unclear. (In other words, families might use the child tax credit to pay for their daycare…) A more effective incentive actually comes through the Social Security spousal benefit, which is available to non-working spouses but is reduced on a dollar-for-dollar basis by their earned retirement benefits. This effectively increases the net marginal tax on working spouses and so encourages them to leave the labor force. Whether this is fair or good policy overall is a question for another day (I suspect it isn't).

Third – and here's where might be able to add some substance – is the question of how having a child affects the federal budget, in this case Social Security. The Social Security Trustees Report tells us that higher fertility improves Social Security's finances. The sensitivity analysis for the total fertility rate tells that Social Security's 75-year balance improves on a basically a one-for-one basis with increases in the average number of children born per woman. If the total fertility rate rose from the projected value of 2.0 children per woman to 2.1, the 75-year deficit of 1.7 percent of payroll would improve to around 1.6 percent of payroll.

However, this method of accounting is flawed for this question because it measures system financing on a truncated 75-year basis. Cutting off measurement at 75-years increases the measured effect of fertility because it counts all the taxes paid by these new children but not all the benefits that would be owed to them, since much would occur after the 75th year. A solution is to calculate the effect of rising fertility in the infinite horizon. The Trustees don't make such calculations. (I could run the numbers, though I suspect the effects would actually be negative, much as the effects of economic growth are negative in the infinite horizon. This result is counterintuitive and probably not appropriate in this context.)

Instead, I'm here calculating the value of a child on an individual basis. According to SSA's actuaries, the "money's worth ratio" – that is, the ratio of the present value of lifetime benefits received to lifetime taxes paid – is around 0.81 for a single medium wage male entering the workforce today and 0.90 for a single female. Put another way, under scheduled benefits, a single male earner can expect to receive back 81% of his taxes in the form of benefits, while a single female could expect to receive around 90% of her taxes back. Social Security effectively keeps the rest, which implies that more people paying into the program are good for the system's finances.

How good? Using projections of the average wage from the Trustees Report and simulated earnings patterns from the SSA actuaries, I constructed a lifetime earnings path for a medium wage earner. Over the course of his lifetime, a medium wage earner entering the workforce can expect to have earnings worth about $1,159,000 in present value. (The present value of lifetime earnings is the amount today that, earning interest, could produce annual payments equal to the individual's annual earnings.) Assuming the worker bears the full 12.4% payroll tax, his lifetime taxes would equal $149,869. Since the actuaries project that a male would receive around 81% of his taxes back as benefits, his lifetime expected benefits have a present value of $121,394; for a women, where the money's worth ratio equals 0.90, lifetime benefits would total $134,883.

What this shows is that, even if Social Security paid these new workers full promised benefits, they would pay more in taxes they receive back in benefits. For a male, Social Security would pocket $28,475 in present value; for a female, $14,987.

So, purely from Social Security's point of view (emphasis added to avoid confusion), if the program could identify families that are not planning on having additional children, it would make financial sense for Social Security to offer them a cash payment of up to $28,475 to have a boy and $14,987 to have a girl. Anything more than that would be an expected money-loser for Social Security, but anything less than that a money gainer.

Now, this isn't a particularly practical policy, since we can't identify families who would have additional children only for the cash payment, nor can we tell the future earnings of children, which is a big determinant of how much of a financial gain they would be to the program. Nevertheless, this gives a rough idea of the effects of larger families on Social Security's financing.

I've uploaded an Excel file with the calculations for anyone who is interested.

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Kudlow on the Cap

Larry Kudlow comments on Barack Obama's plan to increase the Social Security payroll tax cap:

Uncapping the payroll tax reveals still another cultural misstep by Sen. Obama. He apparently has a difficult time understanding that nowadays, a veteran fireman or a veteran cop, married to a veteran schoolteacher, will make well over $100,000. In fact, they can make close to $200,000. Yet Obama still wants to go ahead and tax both the first and last payroll dollar of this group at a very high marginal tax rate by uncapping the Social Security (FICA) tax.
A couple thoughts:

First, in fairness to Obama, he has said that while he would eliminate the payroll tax cap, we would create a "donut hole" exempting earnings between $100,000 and $200-$250,000. So while he was challenged in the Philadelphia debate that his Social Security plan would raise taxes on individuals earning under $250,000, his Social Security plan would not do so. (Whether he could sustain the exemption is another story.)

Second, Kudlow implies that payroll taxes are levied on the combined income of a married couple, as ordinary income taxes are. In fact, both Social Security and Medicare taxes are paid on a purely individual basis. This can lead to inequities, of course: households with the same earnings may pay different taxes depending on how the earnings are distributed between spouses.

Under current law, for instance, a couple would MUCH rather have a single spouse earning $200,000 than both spouses earnings $100,000 each. Why? On the tax end, the single earner couple would pay 6.2% of their joint $200,000 earnings in Social Security taxes, while the dual-earner couple would pay 12.4%. Moreover, at retirement the non-working spouse in the single earner couple would be eligible to a spousal benefit equal to half the working spouse's. So the single-earner couple pays half the taxes of the dual-earner couple, despite having the same earnings, and receives 3/4 of the benefits. In other words, the single earner couple receives 50% more benefits for its tax dollar than the dual-earner couple. Just another example of quirky redistribution under the Social Security tax/benefit formula...

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New paper: CRS on How the Poor May Be Affected by Social Security Reform

The Congressional Research Service released "Social Security Reform: Possible Effects on the Elderly Poor and Mitigation Options," by Kathleen Romig.

The executive summary:

Social Security has significantly reduced elderly poverty. The elderly poverty rate has fallen from 35% in 1959 to an all-time low of 9% in 2006, in large part because of Social Security. If Social Security benefits did not exist, an estimated 44% the elderly would be poor today assuming no changes in behavior. The Supplemental Security Income (SSI) program, also provides benefits to the poorest elderly, many of whom do not qualify for Social Security benefits. However, despite these programs, about 3.4 million elderly individuals remained in poverty in 2006.

The Social Security system faces a long-term financing problem. The Social Security Trustees project cash-flow deficits beginning in 2017 and trust fund insolvency in 2041. Many recent proposals to improve system solvency would reduce Social Security benefits in the future. Benefit reductions could affect the low income elderly, many of whom rely on Social Security benefits for almost all of their income. Such potential benefit reductions could lead to higher rates of poverty among the elderly compared to those projected under the current benefit formula. Because the low-income elderly are especially vulnerable to benefit reductions, many recent Social Security reform proposals have included minimum benefits or other provisions that would mitigate the effect of benefit cuts on the elderly poor.

This report analyzes the projected effects of four possible approaches to mitigating the effects of Social Security benefit reductions on elderly poverty in 2042, the first full year of projected trust fund insolvency. The options are compared to a payable baseline, which assumes current-law benefits would need to be cut across the board to balance Social Security's annual income and spending at the point of insolvency. The four options examined are (1) a poverty-line Social Security minimum benefit; (2) a sliding-scale Social Security minimum benefit; (3) a poverty line SSI benefit; and (4) a poverty-line SSI benefit with liberalized eligibility.

Major findings include the following:

  • Each of the four options would reduce elderly poverty compared to the payable baseline — ranging from a negligible reduction in the elderly poverty rate for the option to create a sliding-scale Social Security minimum benefit to a reduction of three percentage points for the poverty-line SSI benefit with liberalized eligibility.
  • The elderly poverty rate under all of the options would be higher than under the current law scheduled baseline, which assumes the current benefit formula can be maintained with no reductions.
  • The SSI options examined would target the additional spending more efficiently toward the poor elderly than would the Social Security options.
  • The Social Security options examined would reduce the incomes of some elderly because of interaction effects; the SSI options would not create such interactions.

My comments:

One quibble: I'm really not keen on is this comparison: "If Social Security benefits did not exist, an estimated 44% the elderly would be poor today, assuming no behavioral changes such as saving more or working longer." Well, yes. But lacking Social Security benefits – and presumably the taxes needed to fund them – households would have both the incentive and the means to save more. And the Social Security benefit formula imposes significant net taxes on individuals who continue working, so we can also assume people would also work longer. In other words, these are very large assumptions to attach to a headline that can easily be misused in a policy debate.

Beyond that quibble, however, this paper shows the importance of having a detailed model of the population and of government programs. Without these, it is near-impossible to know who the "poor" are – e.g., do they tend to have low earnings over long periods, or more moderate earnings coupled with time out of the workforce? – and how changes to Social Security benefits may cause interactions with other programs like SSI. Overall this is a very helpful addition to the menu of policy options available to policymakers.




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Thursday, April 17, 2008

Clinton and Obama on Social Security reform

Last night's Democratic presidential debate in Philadelphia contained an extended discussion of Social Security reform. Sen. Clinton's approach was to focus on a bipartisan commission, arguing that this approach led to the 1983 reforms. Obama focused on the one reform he has promoted, eliminating the payroll tax ceiling, albeit with a "donut hole" protecting people earning between $100,000 and $200-$250,000.

For what it's worth, Sen. Clinton was reasonably convincing in her argument that a bipartisan commission is the best approach to putting together a politically feasible plan. At the same time, given her apparent willingness to hand the issue over to a commission, her criticisms of Obama's plan to lift the payroll tax cap seem weak, especially since lifting the payroll tax cap is the favorite policy option for most Democrats.

Clinton said "there are more progressive ways of doing it than, you know, lifting the cap." If so, she should reveal them. Obama is correct that only around 6% of individuals earn more than the tax cap each year, and fewer still are above the $200-$250,000 range he has talked about. While funding Social Security with income taxes is potentially more progressive than lifting the tax cap -- I would have to run the numbers to be sure -- it is wholly out of character with Social Security's history as a self-financing social insurance program.

Here's what the candidates had to say:

SENATOR CLINTON: I don't want to raise taxes on anybody. I'm certainly against one of Senator Obama's ideas, which is to lift the cap on the payroll tax, because that would impose additional taxes on people who are, you know, educators here in the Philadelphia area or in the suburbs, police officers, firefighters and the like. So I think we have to be very careful about how we navigate this. So the $250,000 mark is where I am sure we're going. But beyond that, we're going to have to look and see where we are.

MR. GIBSON: Very quickly, because I owe Senator Clinton time, but, yeah, you wanted to respond.

SENATOR OBAMA: Well, Charlie, I just have to respond real quickly to Senator Clinton's last comment. What I have proposed is that we raise the cap on the payroll tax, because right now millionaires and billionaires don't have to pay beyond $97,000 a year.

That's where it's kept. Now most firefighters, most teachers, you know, they're not making over $100,000 a year. In fact, only 6 percent of the population does. And I've also said that I'd be willing to look at exempting people who are making slightly above that.

But understand the alternative is that because we're going to have fewer workers to more retirees, if we don't do anything on Social Security, then those benefits will effectively be cut, because we'll be running out of money.

MR. GIBSON: But Senator, that's a tax. That's a tax on people under $250,000.

SENATOR OBAMA: Well, no, look, let me -- let me finish my point here, Charlie. Senator Clinton just said she certainly wouldn't do this; this was a bad idea. In Iowa she, when she was outside of camera range, said to an individual there she'd certainly consider the idea. And then that was recorded, and she apparently wasn't aware that it was being recorded.

So this is an option that I would strongly consider, because the alternatives, like raising the retirement age, or cutting benefits, or raising the payroll tax on everybody, including people who make less than $97,000 a year --

MR. GIBSON: But there's a heck of a lot of --

SENATOR OBAMA: -- those are not good policy options.

MR. GIBSON: Those are a heck of a lot of people between $97,000 and $200(,000) and $250,000. If you raise the payroll taxes, that's going to raise taxes on them.

SENATOR OBAMA: And that's -- and that's -- and that's why I've said, Charlie, that I would look at potentially exempting those who are in between.

But the point is, we're going to have to capture some revenue in order to stabilize the Social Security system. You can't -- you can't get something for nothing. And if we care about Social Security, which I do, and if we are firm in our commitment to make sure that it's going to be there for the next generation, and not just for our generation, then we have an obligation to figure out how to stabilize the system.

And I think we should be honest in presenting our ideas in terms of how we're going to do that and not just say that we're going to form a commission and try to solve the problem some other way.

SENATOR CLINTON: Well, in fact, I am totally committed to making sure Social Security is solvent. If we had stayed on the path we were on at the end of my husband's administration, we sure would be in a lot better position because we had a plan to extend the life of the Social Security Trust Fund and again, President Bush decided that that wasn't a priority, that the war in Iraq and tax cuts for the wealthiest of Americans were his priorities, neither of which he's ever paid for. I think it's the first time we've ever been taken to war and had a president who wouldn't pay for it.

But when it comes to Social Security, fiscal responsibility is the first and most important step. You've got to begin to reign in the budget, pay as you go, to try to replenish our Social Security Trust Fund.

And with all due respect, the last time we had a crisis in Social Security was 1983. President Reagan and Speaker Tip O'Neill came up with a commission. That was the best and smartest way, because you've got to get Republicans and Democrats together.

That's what I will do. And I will say, number one, don't cut benefits on current beneficiaries; they're already having a hard enough time. And number two, do not impose additional tax burdens on middle-class families.

There are lots of ways we can fix Social Security that don't impose those burdens, and I will do that.

SENATOR OBAMA: That commission raised the retirement age, Charlie, and also raised the payroll tax. And so Senator Clinton, if she -- she can't have it both ways. You can't come at me for proposing a solution that will save Social Security without burdening middle- income Americans, and then suggest that somehow she's got a magic solution.

SENATOR CLINTON: But there are more progressive ways of doing it than, you know, lifting the cap. And I think we'll work it out. I have every confidence we're going to work it out. I know that we can make this happen.

Update: See posts from Marc Ambinder and Noam Scheiber.
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Wednesday, April 16, 2008

Treasury releases Issue Brief on pre-funding Social Security

The Department of the Treasury today released its fourth issue brief on Social Security reform, entitled "Mechanisms for Achieving True Pre-Funding." This excerpt summarizes their argument pretty well:

Any reform of Social Security that makes the system permanently solvent and that seeks to maintain contributions and benefits at some stable fraction of people’s wages while working must accumulate resources in the near term when there are relatively more workers (that is, when the old age dependency rate is relatively low) so as to help finance benefit payments in later years when there are relatively more retirees (that is, when the old-age dependency rate is relatively high). This accumulation of resources is known as “pre-funding,” and is accomplished by having current revenues exceed expenditures and by safeguarding the resulting surpluses so that they provide resources with which to fund future benefits. If instead no attempt is made to pre-fund future benefits, then it will be necessary in a solvent system to reduce benefits for the cohorts of retirees that are relatively large and/or to require higher contributions from the later, relatively small cohorts of workers who are paying for the retirement benefits of the earlier cohorts. Either outcome would be viewed as unfair by most people because it causes the net value of Social Security to vary across birth cohorts depending on their size.
The brief explores pre-funding issues in great detail. I recommend it.

Significantly, the Treasury brief examines pre-funding using the Liebman-MacGuineas-Samwick reform plan as a model. In theory, any plan with pre-funding -- either via personal retirement accounts or trust fund investment -- could be used. Unlike almost all other plans, however, the LMS plan is almost totally self-financed. That is, it does not utilized transfers of general tax revenue to finance the "transition" to personal retirement accounts.

Being self-financing allows for much greater confidence that a reform plan actually will accomplish pre-funding. If transition costs are financed with general revenues, which in effect means that much of the cost will likely be borrowed, it is very difficult to determine how the financing burdens are distributed over generations. Given that pre-funding is all about distributing financing burdens over generations, self-financing plans have a strong advantage in this regard.

Update: Also see posts from Andrew Samwick and Angry Bear.
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Tuesday, April 15, 2008

Life expectancy and Social Security

A number of commentators on Andrew Sullivan's blog bring up this table published by the SSA as evidence that rising life expectancies don't play a big role in Social Security's funding problems. Referencing the right hand columns, they point out that since 1940 life expectancies for men have increased by less than three years.

Leaving aside that an increase in life expectancy from 12.7 to 15.3 years implies a 20% increase in costs, these commentators also ignore the left-hand columns: these show the probability of a 21-year old surviving to collect benefits at 65. These probabilities have risen sharply: from 53.9% to 72.3% for men; from 60.6% to 83.5% for women. Now, this isn't simply a cost increase for the program, since people who survive longer also pay taxes longer.

Nevertheless, if you multiply the percentages in the left-hand columns by the life expectancies in the right-hand columns, you get the expected years of retirement the program would have to finance for a 21-year entering the program. For men, this rises from 6.8 it 11.1 years, for women it rises from 8.9 to 16.4. That’s a pretty big increase in costs.

Obviously, declining fertility also plays a major role. Nevertheless, even after the fertility rate stabilizes, life expectancies are projected to continue increasing. This is the factor that tends to drive costs up in the long term (e.g., from the 2030s onward).

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How accurate is the Social Security Statement?

I have an article in today's Christian Science Monitor about the benefit projections in workers' annual Social Security statement. The short story is that the statement tends to underestimate future benefits by about 1.1% (the rate of real wage growth ) for each year between the time you receive the statement and the time you'll retire. So if the statement projects you'll receive around $1,000 per month and you're currently 45 years old, the best guess of your true scheduled benefits would be around $1,245.

One way to think about it is that the statement's projections would be accurate if we switched today from wage indexing to price indexing of initial benefits.

First, here's the article. Later I'll post with more technical details and upload the data I used in simulating the statement's projections.

Good news on Social Security?

An inflation gap means you may get more than you think – even if benefits are cut. It's a 'good' glitch, but it needs fixing.

Americans recently received some good news regarding Social Security. While the retirement and disability program still faces significant funding shortfalls, the annual trustees report released last month showed improved long-term finances. But there is more "good" news, this time for workers who receive an annual benefit statement from the Social Security Administration.

To help with retirement planning, the "Social Security Statement" estimates the benefits workers will be entitled to at retirement. The statement significantly underestimates promised benefits for younger workers. In fact, even if we fixed Social Security's solvency entirely by reducing future benefits, most workers would still receive higher benefits than their Social Security Statement indicates. Though the glitch means higher benefits for future retirees, it hurts Social Security's credibility with the public. Correcting the error is essential.

Social Security mails workers a statement each year about three months prior to their birthday. Based on earnings to date, the statement projects future retirement benefits. Social Security was never meant to be the only source of retirement income, so the benefit estimate helps workers plan how much to save on their own. This is important, since the Social Security benefit formula is so complex that many people simply couldn't calculate benefits themselves.

The Social Security statement is actually quite good at determining future retirement benefits. Using the statement's methods, I was able to project the benefits of selected current retirees based on their earnings through age 45 with an average error of less than 2 percent. While more sophisticated methods could be used to close even that gap, this is not where the statement's drawbacks lie.

The difficulty comes in translating these future benefits into terms that are understandable. The statement claims that estimated benefits are "in today's dollars," which means subtracting inflation to express them in today's purchasing power. For instance, a typical new retiree 20 years from now may receive an annual benefit of $33,000. That sounds like a lot, but if inflation runs at 3 percent per year, the real purchasing power of that benefit is only around $18,000. Expressing future benefits in today's dollars helps workers know how much their future benefits will actually buy years down the road.

But here's the problem: Despite what the statement says, its benefit estimates are not "in today's dollars." Benefits are expressed in what are called "wage-indexed dollars." Wage-indexing accounts not just for the growth of prices but also for the growth of average wages. Wages grow around 1 percent faster per year than prices, so adjusting for them reduces the statement's estimated benefit by around 1 percent for each year between now and when the worker would retire. While not a big deal for those about to retire, for younger workers – who need this information to plan their other savings – the annual errors compound. For instance, the $33,000 benefit for a typical retiree in 20 years would be wage-indexed back to only $15,000, 17 percent less than the true inflation-adjusted value.

Some might argue that it's OK for the statement to underestimate future benefits, since reform will likely reduce benefits anyway and low-balling estimated benefits might scare Americans into saving more for retirement. Maybe so. Social Security reform is a daunting task and, whether politicians will admit it or not, younger workers probably won't receive everything they have been promised. Given the statement's errors, benefits under reform could at least exceed workers' expectations.

But the statement's underestimate of future benefits is so large that most workers would come out ahead even if we fixed Social Security entirely by reducing benefits. An individual who relied on this estimate would tend to over-save, making it harder to meet current expenses such as a mortgage or education.

Higher retirement benefits hidden in the numbers is a nice surprise, but the Social Security Administration should nevertheless correct the statement's benefit calculations.

Right or wrong, Social Security already has credibility problems. For Americans to accept the sacrifices involved with reform, they need confidence that official numbers coming from the agency are accurate.

Andrew G. Biggs, a former principal deputy commissioner at the Social Security Administration, is a resident scholar at the American Enterprise Institute in Washington.

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Friday, April 11, 2008

How long is forever?

Philosophers may ask the question, 'How long is forever?' Rep. Robert Wexler (D-FL) has provided his own answer to that question: 75 years, but not longer.

The Sun Sentinel reports on the reintroduction of Rep. Wexler's "Social Security Forever Act." To begin, here's how the Congressman's press release describes the bill:

Today, Congressman Robert Wexler (D-FL) reintroduced his plan to save Social Security – the Social Security Forever Act of 2008. Wexler’s legislation closes the Social Security gap, without cutting benefits or raising the retirement age, by imposing a 3 percent hike on payroll taxes for incomes above $102,000 a year. Currently, individuals do not pay any taxes for Social Security purposes on earnings above $102,000. By raising the cap on Social Security taxes, the Social Security Forever Act not only ensures the solvency of this vital program but restores tax fairness in America at a time when income inequality is sharply on the rise.

“Social Security is a fundamentally sound program; however, its future solvency is endangered because not all wages and salaries are subject to Social Security taxes,” said Congressman Wexler. “There is a simple and fair way to solve this problem. By lifting the Social Security earnings cap, Congress can ensure the long term solvency of a program that keeps millions of seniors out of poverty each year. At a time when our economy is struggling, my plan protects Social Security without raising the retirement age or slashing benefits.”
A couple comments:

First, if you go to the actual text of the legislation (available here), it also includes a 3% surtax applied to employers. This seems worth mentioning. Since the employee bears the full burden of the payroll tax, this is effectively a 6% surtax on earnings over the cap, currently $102,000. While not as high as Senator Obama's plan to eliminate the taxable maximum, this would increase the top marginal tax on earned income from 37.9% to 43.9%.

This surtax is equivalent in size (if not incidence) to an increase in the current payroll tax from 12.4% to around 13.7%, an increase of around 1.3% of payroll in the steady state. Since the Social Security actuarial deficit is 1.7% of payroll, and even higher under the 2005 Report when the plan was first constructed, this tells me Wexler's plan would probably not be solvent for 75 years under Trustees' assumptions. (More likely, Wexler constructed his plan around CBO projections, which then showed a much smaller deficit although the current gap between CBO and Trustees projections is fairly small.) This chart shows the annual income and cost rates for the Wexler plan:

Second, the plan wouldn't actually fix Social Security forever. In fact, it actually wouldn't quite make it to 75 years. The chart below shows the trust fund ratio (trust fund assets divided by the annual cost of paying benefits) for the Wexler plan compared to current law.
The Wexler plan is very much like the 1983 reform plan, which changed taxes and benefits only enough to reach 75-year solvency but made no effort to assure solvency thereafter. You can see that the trust fund ratio peaks in 2018 and declines thereafter, a clear sign of unsustainable financing. To achieve sustainable solvency, in which the trust fund ratio is stable or rising at the end of the period, requires that you raise the surtax rate up to around 12%. (This is basically equivalent to eliminating the payroll tax ceiling.)

This highlights why experts have promoted the idea of sustainable solvency. This report from the Social Security Advisory Board's 1999 Technical panel says:
When reformers aim only for 75-year balance, therefore, they usually end up in a situation where their reforms only last a year before being shown out of 75-year balance again. The 1994-96 Advisory Council wisely tried to accept only reforms that produced sustainability over the longer term— sustainability defined in a way that would ensure that taxes and benefits were more or less in line after the 75th year.
75 years is precisely what Rep. Wexler aimed for, and precisely what he got. If your plan is solvent only for the years 2008-2083, once the time period shifts to 2009-2084 you're no longer solvent. Put another way, without the unexpected improvement in solvency in the 2007 Trustees Report, Wexler's "Social Security Forever" plan would already be significantly out of balance since it was constructed to fix only the 2005 actuarial deficit, forgetting that deficits tend to rise as time passes. Some people don't care about this; I do.

Third, the plan would entail a larger build-up of the trust fund followed by a spend-down. If you don't believe the trust fund build-up has improved the unified budget deficit or added to national saving (here's why I don't), then this doesn't make much sense.

For anyone interested, here's the excel file I used in putting these numbers together.

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Wednesday, April 9, 2008

David Francis on the latest Trustees Report

If only for completeness (and because I'm quoted), here's the latest from Christian Science Monitor columnist David France on the 2008 Social Security Trustees Report. The article is available online here. While I don't agree with Francis's views, he is correct that the improvement in Social Security's long-term financing was generally missed in press reports. The reason, I believe, is that the press focuses on the years in which the program begins to run cash deficits (2017) and the year of trust fund exhaustion (2041), neither of which changed in this year's Report. The total 75-year deficit, however, did fall significantly, but this improvement was largely overlooked.

Social Security sounder than you might think:The latest report from the trustees of the system show improvement in its finances, despite some grim coverage.

The 1 in 4 American families who receive some form of Social Security benefits should be cheered by the latest annual report of the system's trustees.

That report, issued March 25, shows "a really significant improvement" in the finances of the system, says Andrew Biggs, who helped draft the report while serving as deputy commissioner of the Social Security Administration (SSA).

That's not the way some in the press saw this report. One headline used the word "grim." That description would be true in regard to the report of the Medicare trust fund that pays hospital benefits. While the four trustees signing the report foresaw "enormous challenges" for both programs, they expected Medicare's financial difficulties to come sooner and be "much more severe" than any problems tied to Social Security.

What perhaps caused some confusion among the public is that the report calculated that benefits paid would exceed revenues from taxes on payrolls in 2017, same as last year's report. That prospect is based on the fact that the nation's 80 million baby boomers have now begun to retire.

But the reserves of special Treasury bonds in the system's trust fund will not be exhausted until 2041, as was also stated last year. Yet any fix for the Social Security system should be financially easier, the report indicates.

The system's actuaries now project that an increase in immigrants and their children mean that the number of tax-paying workers in relation to retirees will be higher after 2041 than previously estimated. More immigrants paying taxes means that the actuarial deficit over the next 75 years has dropped from $4.7 trillion in last year's report to $4.3 trillion in the 2008 report.

Those numbers may seem huge, but they are "manageable," says Paul Van de Water, an economist with the National Academy of Social Insurance (NASI) in Washington. "Social Security is structurally sound and does not require drastic changes."

It would take a permanent boost in the payroll tax from 12.4 percent of wages to 14.1 percent (half paid by the employee, half by the employer) to keep the program fully solvent for the next 75 years. Or benefits could be cut a little.

But the important message here is that the system is not bankrupt. Tax revenues will still be rolling in after 2041. If Congress fails to pass remedial legislation and the long-term forecasts of the SSA are correct, the system will still have enough revenue to pay 78 percent of the benefits promised in 2041.

Because of rising productivity over the decades, retirees in 2041 would reap greater Social Security benefits in real terms than the average $1,081 per month that today's retirees receive.

But some analysts hold that the most relevant number for future retirees is the replacement rate – what typical workers would receive in Social Security benefits relative to what they had earned before retiring. That rate would drop from 36 percent today to 28 percent in 2041.

Alicia Munnell, director of Boston College's Center for Retirement Research, finds that drop troubling, especially since many corporations are replacing standard pension plans that carry fixed benefits with 401(k) plans, in which benefits often hang on trends in the stock market or other financial markets.

As of 2004, the typical 401(k) or Individual Retirement Account for a male, head of household age 55 to 64, had only $60,000 in assets. That sum would do little to improve the living standard of most Americans over many years of retirement.

In any case, the analysts interviewed agree that current declines in stock and home prices have enhanced the perceived value of Social Security. Only half of American workers are covered by pensions of any kind outside of Social Security.

Moreover, the recent stock market and real estate woes have further diminished any possibility for privatization of Social Security. The Bush administration proposed partial privatization of Social Security (or private accounts), but public reaction and the last federal congressional election decidedly shot down that plan.

Even Mr. Biggs, who several years back worked for a leading advocate of privatization, the Cato Institute, concedes that the only feasible political possibility at present would be government-encouraged private accounts on top of the existing Social Security system, not carved out of it. That, plus a cut in benefits, might be a "reasonable compromise" between Republicans and Democrats, suggests Biggs, now at the American Enterprise Institute, a conservative think tank in Washington.

Republican presidential candidate Sen. John McCain of Arizona ducks the Social Security privatization issue by proposing a commission led by former Federal Reserve Commission Chairman Alan Greenspan. His somewhat ambiguous words suggest he might support an add-on system of private accounts.

The Democratic candidates oppose privatization. But no action on Social Security is likely until after the November election.

Read more!

Nancy Altman on reform (with editorial comments)

In today's Los Angeles Times, Nancy Altman outlines her proposal for Social Security reform, modeled after the plan put forward by the late SSA Commissioner Robert Ball. (Click here for more details on Ball's plan and here for the actuaries' analysis.)

Following her piece, I've pasted in a letter to the editor I wrote this morning which argues that her proposal appears easy simply because she lowers the bar on what is considered success in reforming Social Security. While due to space restrictions the letter confines itself to the core criticism, I do believe that anyone who argues that Social Security needs prompt action and who is willing to put concrete reform options on the tables deserves credit. Following the letter is some additional detail on what it means for a reform plan to be "solvent."

The right fixes for Social Security

Along with baseball and cherry blossoms, spring in the nation's capital brings a ritualized dance over Social Security. Every year for the last two decades, Social Security's trustees have issued a report alerting Congress that action is needed to keep the program solvent. And every year, Congress answers with silence.

It was not always this way. In 1973, the trustees projected a deficit. By 1977, Congress had responded with corrective legislation. In 1981, when that action proved insufficient, Congress began work on a new solution. President Reagan announced his own set of reforms, including a proposal to cut benefits sharply for people about to retire early. That set off a firestorm of protests. To quell the uproar, Reagan quietly dropped the plan and called for the formation of a bipartisan commission. The commission developed a package that Congress passed and Reagan signed into law in 1983. Subsequent trustees' reports again showed Social Security in balance.

Beginning in 1989, however, the trustees again started alerting Congress to deficits caused mainly by changing assumptions, including those about the economy and disability rates. Why didn't President George H.W. Bush, President Clinton or Congress offer serious solutions? Why did President George W. Bush promote a privatization proposal that would have made Social Security's deficit larger? Where did the political courage go?

In fact, political courage was in no greater supply in the 1970s and early 1980s than it is today. The circumstances were simply different. Back then, Social Security faced a short-term deficit: inadequate funding to pay full benefits by the early 1980s. Congress and the White House were willing to make some hard decisions to avert the political catastrophe of millions of beneficiaries not receiving their promised benefits, perhaps just before the next election. Today, there is no such danger on the near horizon.

Social Security will run a surplus until 2027, when it will have accumulated $5.5 trillion. At that point, if no action is taken, the trust fund will begin to cash out the Treasury obligations it holds. That will allow all benefits to be paid until 2041, according to the latest trustees' report.

Despite the long time frame, the trustees are right to alert Congress, which should act without delay so changes can be modest and phased in. Moreover, the quicker Congress acts, the sooner it will restore an intangible benefit. As its name suggests, Social Security is intended to provide security -- peace of mind -- in addition to cash benefits. Peace of mind is lost when politicians and pundits make alarmist statements like "Social Security is going broke" or "it's unsustainable." Eliminating the projected deficit would end those frightening, hyperbolic claims.

But without an imminent crisis to force some action, what would give Congress and the president the backbone to make the necessary changes? Fortunately, it would take only three reforms and not much backbone to put the program back in balance.

First, instead of repealing the estate tax, as President Bush wants to do, Congress should dedicate its revenue to Social Security. The accumulation of huge fortunes depends, in part, on the productivity and infrastructure of the nation. Requiring heirs to contribute to the basic security of all Americans seems a reasonable minimum to ask of those who have benefited so greatly from the common wealth.

Second, Congress should restore the practice of subjecting 90% of aggregated wages nationwide (i.e., the sum of all wages, taken together, of corporate executives, janitors and everyone else) to Social Security taxes. Because the wages of the highest-paid workers have increased much more rapidly than average wages over the last several decades, only about 84% of all wages is currently subject to Social Security taxes, resulting in billions of dollars of lost revenue every year. Restoring the 90% level, by gradually increasing the maximum amount of earnings subject to taxing, would have no effect on workers earning less than the maximum -- currently $102,000 a year. If this proposal were now law, those earning more than $102,000 -- just 6% of the workforce -- would have paid a mere $120.90 in additional contributions this year.

Third, Congress should permit Social Security to improve earnings by diversifying its portfolio and investing some of its assets in equities, as just about all other public and private pension plans do.

These reforms would restore Social Security to balance -- without benefit cuts, without raising the retirement age and with only a very modest tax increase on 6% of the workforce. Politicians should leap at the opportunity to do so much good and reap so much political gain at such little cost.

Nancy Altman is the author of "The Battle for Social Security: From FDR's Vision to Bush's Gamble."

Following is a letter to the editor I drafted this morning:

Re. “The right fixes for Social Security,” by Nancy Altman; April 9, 2008

To the editor:

Nancy Altman endorses three steps to fix Social Security’s financing shortfalls: first, dedicate estate tax revenues to Social Security; second, increase the wages on which payroll taxes are applied from $102,000 to around $185,000; and third, invest part of the trust fund in stocks.

These steps would not come, as Ms. Altman believes, at “little cost.” Dedicating estate tax revenues to Social Security would break the historical link between taxes paid by workers and benefits received by them – a link that differentiates Social Security from so-called “welfare” programs. Increasing the maximum taxable wage would raise the top marginal tax rate by 12.4 percentage points, and, while it would hit only around 6% of workers each year, would affect over 20% of workers over their lifetimes. Investing the trust fund in stocks would involve so-called “transition costs” and the risk of market downturns in the same way as President Bush’s plan to introduce personal retirement accounts.

While Ms. Altman claims these steps would “restore Social Security to balance,” the Social Security actuaries found these three steps would leave around one-quarter of the program’s 75-year deficit unaddressed. To reach “sustainable solvency,” meaning that Social Security would be solvent through 75 years and financially healthy thereafter, would require changes roughly twice as large as those proposed by Ms. Altman.

Sustainable solvency has been a bipartisan goal of Social Security reformers for the last decade. Thus, Ms. Altman’s solution appears attractive relative to other reform plans only because it fixes much less of the problem. Fixing Social Security will depend on insight, compromise, and the ability to make difficult choices, not on lowering the bar for success.


Andrew G. Biggs

The American Enterprise Institute, Washington DC

Here is some more background on the three measures of "success" for a reform plan:
  • Sustainable solvency: Almost all current reformers aim to restore Social Security to "sustainable solvency." This means that the program is solvent through 75 years and ends the period on strong financial footing. Sustainable solvency was a standard devised by SSA's actuaries which enables plan designers to avoid the shortfalls of the 1983 reforms, in which the program was solvency for 75 years but fell off a financial cliff in the 76th year. Sustainable solvency has been a standard since the 1994-96 Advisory Council and reform plans across the spectrum have met this standard. Reaching sustainable solvency would require improvements in the actuarial balance of somewhere around 3 percent of payroll.
  • 75-year solvency: Prior to the mid-1990s, reformers aimed to keep the program solvency for 75 years, but didn't pay much attention to whether the program ended the 75-year period on strong financial footing. This is a significant shortfall, since many of the individuals who paid taxes during the 75 years, and thus contribute to 75-year solvency, would be retired after the 75th year and thus face benefit cuts if the program were not sustainably solvent. Based on current projections, reaching 75-year solvency requires an improvement in the actuarial balance of around 1.7 percent of payroll.
  • Close actuarial balance: Roughly speaking, this standard is met if the 75-year actuarial deficit is less than 5% of total 75 year costs. (The definition is available here.) Since the 75-year summarized cost rate is equal to 15.63% of payroll, 5% of which equals 0.78% of payroll, any reform plan with a 75-year deficit of less than that amount would meet the test of close actuarial balance. Thus, a plan could improve the 75-year balance by less than 1% of payroll and still meet this test.
To my knowledge, only Altman and the late Robert Ball have applied this standard to a reform plan. In short, success by Altman's standards can require as little as one-third the tax increases or benefit reductions of a plan that aims to reach sustainable solvency. This seems, to me at least, to not move the debate in the right direction. Read more!

Tuesday, April 8, 2008

I won’t tell you what investments to pick if you won’t…

Marketwatch’s Irwin Kellner comments on the latest Social Security Trustees Report. You can read the entire column for yourself, but here I’ve pulled some key excerpts followed by commentary.

Kellner's comments are indented:

In 2000, the system’s actuaries thought the assets of this fund would be exhausted by 2032. Two years later it was 2037. Now the projected exhaustion date is 2041. Meanwhile, the Congressional Budget Office, which makes these projections as well, recently thought the system will remain solvent until at least 2052.

Two thoughts: First, the trust fund exhaustion date, while important, is also a volatile measure, since even a small change in assumptions can shift it by a year or two. Second, while CBO “recently thought the system will remain solvent until at least 2052,” they more recently amended that projection to 2046. Given that CBO uses slightly more optimistic assumptions and that their model tends to show smaller shortfalls even with constant assumptions, this is a relatively small difference.

Judging by past history, assumptions underlying the intermediate projection are very conservative -- especially when it comes to economic growth…. The intermediate projection assumes that the economy will grow by an annual rate of 2.3% per year between now and 2085… well below the 3.4% that the economy grew on average between 1960 and 2005.

Please, I’m begging you, stop these comparisons of past to projected GDP – they just miss the point. As far as Social Security is concerned, “GDP” doesn’t matter. The closest thing to GDP growth that matters for Social Security is the sum of real wage growth and labor force growth. The Trustees projected rate of real wage growth (1.1% annually) is – cue the music – slightly higher than the average from 1960-2007. What’s lower is the rate of labor force growth, but this makes total sense: from 1960-2007, labor force growth grew rapidly (around 1.7%) principally due to Baby Boom birth rates and rising female labor force participation. But birth rates have fallen significantly, meaning fewer new workers, and female labor force participation isn’t going to get much higher than it is today. As a result, total GDP growth is projected to slow, even if output per worker – a better measure of the economy’s health – continues along just fine.

And as you might imagine, the speed at which the economy grows has a lot to do with the other variables -- including the interest the fund earns from investing its surplus in Treasuries.

Actually, GDP growth is the product of the other variables, not an input to them. Moreover, the correlation between real GDP growth and real interest rates on the trust fund – around 0.18 – while positive, isn’t terribly strong.

You might ask the question why this more realistic [low cost] projection has escaped politicians from both major parties. I don't know why, but I can only theorize that it's because they haven't taken the time to read the entire report.

Alternately, it may be because they have read the entire report. The arguments here are typical of those you read in the press and see on the web, not what you hear from people who really spend a lot of time with this material. Read more!

Monday, April 7, 2008

Myths of Entitlement Reform, and a Call to Action

The Washington Post reports on a joint document signed by analysts at a number of think tanks urging a more disciplined approach by Congress on entitlement reform. Specifically, the joint document – signed by analysts from the Brookings Institution, the Heritage Foundation, the Urban Institute, the American Enterprise Institute and other organizations – calls for Congress to set 30-year budgets for Social Security, Medicare and Medicaid.

The report also outlines a number of myths regarding entitlement reform:

Myth: We can grow our way out of difficult budget choices.

Reality: Strong economic growth will make the choices somewhat easier. Hence, it is important to resolve the budget problem and reform social insurance in ways that enhance growth. However, we cannot grow our way to a sustainable budget outlook. The Government Accountability Office calculates that—if present trends and policies continue— it would take decades of “double digit” growth rates to eliminate the deficit. But, because of the structure of Social Security, that growth in productivity and wages automatically translates into higher future benefits, offsetting a significant portion of the fiscal gains from a larger economy. In short, if the status quo continues and entitlement programs are not reformed, there is no feasible growth rate of the economy that will produce a sustainable budget path.

Myth: Eliminating waste in government programs will solve the deficit problem.

Reality: Improving the efficiency of government programs is important as a matter of fiscal responsibility and restoring trust in government, but it will not significantly reduce future deficits. It is an illusion to think that eliminating waste in government programs will come anywhere near closing the projected gap between spending and revenues. In fact, if present trends and policies continue—and the growth of entitlement programs is not restrained—even entirely eliminating all non-entitlement spending will not close the budget gap.

Myth: The deficit problem can be solved by delivering health care more efficiently.

Reality: Making the health system more efficient can slow the rate of growth of medical care spending and reduce the gap between federal spending and revenues. High priority should be given to eliminating wasteful health spending and increasing value obtained for

public and private health spending. However, even if these efforts are successful, medical care spending is almost certain to grow faster than the economy, and federal health spending will still grow faster than federal revenues.

Myth: We just need to raise taxes starting with rolling back some or all of the Bush tax cuts.

Reality: Higher taxes could contribute to paying part of the rising social insurance bill, but we cannot simply tax our way out of the problem. Even restoring tax rates to pre-2001 levels will not close the gap between spending and revenues. Raising taxes will not address the underlying forces—population aging and health care cost growth—driving spending and revenues apart in the coming decades. Even raising revenues as a percent of GDP to European levels—levels that are unprecedented in the United States—will not be sufficient. If the wedge between spending and revenues attributable to social insurance programs continues to grow, taxes would have to be raised continuously and would eventually cripple the economy. Finally, even if taxes were to be raised, it is not at all clear that Social Security, Medicare, and Medicaid should receive automatic priority for these resources over other needs such as education, homeland security, and infrastructure investments.

Myth: Cutting taxes will increase revenues.

Reality: Lowering tax rates can stimulate long-term economic growth, but at today’s rates not by enough to pay for the lost revenue. Tax cuts used to stimulate the economy during a recession are a different matter, but they should be kept temporary and ideally should be paid for once the economy recovers.

Read more!

Thursday, April 3, 2008

Immigration and Social Security financing

In an editorial entitled “How Immigrants Saved Social Security,” New York Times discusses how changes to modeling of immigration improved the long-term financing projection for Social Security in this year’s Trustees Report. the

Immigration is good for the financial health of Social Security because more workers mean more tax revenue. Illegal immigration, it turns out, is even better than legal immigration. In the fine print of the 2008 annual report on Social Security, released last week, the program’s trustees noted that growing numbers of “other than legal” workers are expected to bolster the program over the coming decades.

One reason is that many undocumented workers pay taxes during their work lives but don’t collect benefits later. Another is that undocumented workers are entering the United States at ever younger ages and are expected to have more children while they’re here than if they arrived at later ages. The result is a substantial increase in the number of working-age people paying taxes, but a relatively smaller increase in the number of retirees who receive benefits — a double boon to Social Security’s bottom line.

For what it’s worth, here’s the mental framework I use to think about immigration and Social Security financing. Roughly, I divide the Social Security program into two parallel systems – one for native born workers and their descendants, and a second for immigrants and their descendants. (Since immigration often marry native-born and have children, this isn’t flawless, but it will work for these purposes.) For immigration to help Social Security financing as a whole, the immigrants’ system has to be more than solvent over the long-term; it has to throw off additional money that can then be used to subsidize the native-born system and thus improve solvency overall.

What are the factors that determine whether this will happen? Among them:

  • Earnings: Since immigrants tend to have lower earnings and shorter work lives (which makes them appear even poorer to the progressive Social Security benefit formula), those who collect retirement benefits will tend to get a good deal. To the degree they receive an internal rate of return (IRR) exceeding the trust fund’s interest rate, these immigrants will receive more in benefits than they pay in taxes, and thus be a drain on the program.
  • Likelihood of collecting retirement benefits: As noted in the Trustees Report, many immigrants do not end up collecting retirement benefits. They may be illegal immigrants and thus ineligible to collect; likewise, they might return to their home country and not collect benefits, or fail to work the 10 years necessary to qualify for retirement benefits. These workers are a net gain to the program, since they pay taxes but don’t collect benefits.
  • Earnings levels of immigrants who don’t collect benefits: Social Security’s financing benefits from high income immigrants who don’t collect benefits, since these individuals pay more taxes. There is good reason to believe, however, that illegal immigrants and immigrants who return to their home countries will have below-average earnings levels. In part this is because illegal immigrants’ wages tend to below, and in part because those who succeed economically in the U.S. are more likely to remain here. The earnings levels of immigrants of any kind are not, to my knowledge, modeled by SSA’s actuaries; rather, they are treated as having the same average earnings as native-born. This is a weakness in the current model that SSA should aim to address.
  • Fertility of immigrants, legal and illegal: In general, fertility rates for immigrants are higher than those for native-born; this will tend to help long-run system financing. At the same time, fertility for immigrants varies more by education level than it does for native-born. Thus, lower educated (and presumably lower earning) immigrants may have disproportionate numbers of children. To the degree that these children have lower than average earnings, and thus higher than average benefits relative to earnings, the net gain to system financing may be reduced.
In sum, modeling the effects of immigration on long-run Social Security financing is a very complex issue and work in this area should not be considered finished. My instinct is that to do examine these issues in detail will involve a shift from the semi-aggregated “cell based” models currently used by the SSA actuaries to microsimulation models, such as CBO’s Long-Term model (CBOLT), the GEMINI modelPolisim model from the Policy Simulation Group, or the under joint development by SSA’s Office of Policy and Office of the Chief Actuary. Read more!