NICHOLAS BARR, London School of Economics
Email: N.Barr@lse.ac.uk
PETER A. DIAMOND, Massachusetts Institute of Technology (MIT) - Department of Economics, National Bureau of Economic Research (NBER)
Email: pdiamond@mit.edu

This article, based on two books (Barr and Diamond 2008, forthcoming), sets out a series of principles for pension design rooted in economic theory: pension systems have multiple objectives, analysis should consider the pension system as a whole, analysis should be framed in a second-best context, different systems share risks differently, and systems have different effects by generation and by gender. That discussion is reinforced by identification of a series of widespread analytical errors: tunnel vision, improper use of first-best analysis, improper use of steady-state analysis, incomplete analysis of implicit pension debt, incomplete analysis of the impact of funding (including excessive focus on financial flows, failure to consider how funding is generated, and improper focus on the type of asset in trust funds), and ignoring distributional effects.

The second part of the article considers implications for policy: there is no single best pension design; earlier retirement does little or nothing to reduce unemployment; unsustainable pension promises need to be addressed directly; a move from PAYG towards funding in a mandatory system may or may not be welfare improving; and implementation matters - policy design that exceeds a country's capacity to implement it is bad policy design. We illustrate the ranges of designs of pension systems that fit the fiscal and institutional capacity constraints typical at different levels of economic development. The potential gains from simplicity imply that a country capable of implementing an administratively demanding plan does not necessarily gain from doing so. New Zealand has a simple pension system through choice, not constraint.

THOMAS K. PHILIPS, Malbec Partners, OTA Asset Management
Email: tphilips@malbecpartners.com
ARUN MURALIDHAR, AlphaEngine Global Investment Solutions
Email: asmuralidhar@alphaengine.net

The disappearance of the defined-benefit (DB) pension plan is one of the greatest financial tragedies to befall the U.S. citizen. As demographics have changed and as defined-contribution (DC) plans have become the primary vehicles for retirement savings, retirement planning has become fraught with uncertainty. This article argues that DB plans, such as the U.S. Social Security system, are fundamentally superior to DC plans and that the Social Security crisis is largely a crisis of demographics and funding. Social Security's assets should be invested in a single portfolio that holds both stocks and bonds, and its risky return should be swapped for a fixed return to enable the provision of a DB. This proposal inexpensively affords insurance against a market decline and allows pensions of any kind to be made portable.

ANDREW G. BIGGS, American Enterprise Institute
Email: andrew.biggs@aei.org

The recent financial crisis and ensuing stock market gyrations have drawn renewed attention to Social Security reform, in particular proposals to establish personal retirement accounts that invest in stocks and bonds. As Barack Obama asked a campaign audience, "Imagine if you had some of your Social Security money in the stock market right now. How would you be feeling about the prospects for your retirement?" But despite the recent market downturn, individuals investing four percentage points of the 12.4 percent payroll tax in a personal account holding a "life-cycle" portfolio and retiring today would have increased their total Social Security benefits by more than 15 percent. Moreover, a simulation of ninety-five cohorts of individuals retiring from 1915 through 2008 found that all of them would have increased their total Social Security benefits by holding personal accounts. These results are not intended to understate the risks of equity investment, but rather put them in perspective. Some analysis has overstated the importance of returns over a short period of time relative to those over the full course of a working lifetime by looking at declines in stock returns over only the last year. While individuals retiring today may have ended with a lower account balance than they expected, they would nevertheless have significantly increased their total retirement benefits by virtue of choosing to participate in a personal retirement account.

BRUCE DAVIS JACKSON, B. Davis Jackson, CPA
Email: djackson@harneypartners.com

In today's Social Security and Medicare business model, children and grandchildren pay six dollars of current taxes to provide six dollars of current benefits for their parents and grandparents. If we convert to a business model which uses compound interest so every generation pre-funds their own annuities, then we will pay just one dollar of current premiums to provide six dollars of future benefits. Compound interest will provide the other five. This article explores how to immediately accomplish the conversion using only the resources we already apply to these programs, and how the resulting massive amount of future resources freed up can greatly improve all forms of social insurance as well as lead us out of the entire mortgage/housing/credit crisis/ financial mess.

JEFFREY B. LIEBMAN, Harvard University - John F. Kennedy School of Government, National Bureau of Economic Research (NBER)
Email: jeffrey_liebman@harvard.edu
ERZO F. P. LUTTMER, Harvard University - John F. Kennedy School of Government, National Bureau of Economic Research (NBER), Institute for the Study of Labor (IZA)
Email: erzo_luttmer@ksg.harvard.edu
DAVID SEIF, affiliation not provided to SSRN

A key question for Social Security reform is whether workers currently perceive the link on the margin between the Social Security taxes they pay and the Social Security benefits they will receive. We estimate the effects of the marginal Social Security benefits that accrue with additional earnings on three measures of labor supply: retirement, hours, and labor earnings. We develop a new approach to identifying these incentive effects by exploiting five provisions in the Social Security benefit rules that generate discontinuities in marginal benefits or non-linearities in marginal benefits that converge to discontinuities as uncertainty about the future is resolved. We find clear evidence that individuals approaching retirement (age 52 and older) respond to the Social Security tax-benefit link on the extensive margin of their labor supply decisions: we estimate that a 10 percent increase in the net-of-tax share reduces the two-year retirement hazard by a statistically significant 2.1 percentage points from a base rate of 15 percent. The evidence with regards to labor supply responses on the intensive margin is more mixed: we estimate that the elasticity of hours with respect to the net-of-tax share is 0.41 and statistically significant, but we do not find a statistically significant earnings elasticity.

BARBARA A. LINGG, affiliation not provided to SSRN
Email: Barbara.A.Lingg@ssa.gov

The Windfall Elimination Provision (WEP) is a method of computing benefits for some workers who receive a pension based on work not covered by Social Security. At the end of 2006, about 970,000 beneficiaries, mainly retired workers, were affected by the WEP. This note provides a brief legislative history, describes the WEP computation, and presents statistical data about beneficiaries affected by the WEP.