James Kwak at Baseline Scenario asks “are Social Security and Medicare programs that benefit the elderly?”  He then proceeds to answer his question with a no and lengthy (but worth reading) explanation in “The Elderly” for Beginners. I agree and I want to emphasize a couple of points he makes.

As Kwak points out, much political discussion about Social Security and Medicare tries to label these successful programs as simply benefits that the elderly are able to grab from younger taxpayers – a form of redistribution of income for charitable purposes. That’s the wrong way to think of these programs.  Other critics of these programs, particularly Social Security, claim they’re just government-run pension schemes that produce lower rates of return than private pension schemes (usually these critics are using distorted rates of return on private pensions that don’t reflect risk, but that’s another discussion).

So how should we think about Social Security and Medicare?  First off, we need to realize that “the elderly” are not some static group of people that’s different from young people, students,or middle-age folks.  The makeup of just who is “elderly” changes every year.  We all get a year older each year.  That means that if you’re a student now or young person or middle-aged person, you’ll be part of the elderly someday (unless you die first, but that’s not much of an alternative).  We all face the prospect of spending part of our lives as one of the elderly. So it’s not about the benefits to the “elderly” as if that’s some other group.  It’s about benefits for all of us, just with different timing.*

Social Security and Medicare aren’t income redistribution charities.  They’re insurance programs. The “benefit” of Social Security and Medicare isn’t just the financial checks paid each year, it’s the protection they provide to everybody, both this year’s elderly and this year’s younger workers.  Protection against what?  Well, it’s protection against some uncertainties of life and of living in our modern industrial society.  None of us knows how long we will live.  Life’s too uncertain. But unlike 200 years ago, there’s a very high probability that most of us will live longer than we can be productive and earn an income.  That means we have to make arrangement while we’re younger and working to put aside some income (savings) for use in our old age.  But how much?  That depends on three factors: what standard of living we want in old age, how long we will live, and what rate of return we can get on our savings.  While we have some choice over standard of living, we really don’t have as much we think since we don’t know what inflation will be in the future.  More importantly, we have absolutely no good idea about either how long we’ll live (and therefore need income) or what rate of return we’ll get.  You see, “long-run average” rates of return aren’t much help.  Markets fluctuate. Returns vary depending on years.  Ask people who retired in 2009 year after the stock market crash of 2008 about “long-run average rates of return”.

Social Security and Medicare are insurance programs.  They protect all of us from these uncertainties about the future.  How do they benefit workers today?  Well, for one thing, the rate of return is certain and the risk is zero.  Without Social Security workers would need to put away even more money into savings than Social Security taxes right now**.  Workers would assume a tremendous risk.  As Kwak describes it:

 would you pay 12.4 percent of your wages for roughly 40-45 years in order to get back [55% of preretirement income] for about 20-25 years.**** There are a few different ways to think about this.

… Most obviously, there is no way to replicate Social Security for yourself. You can’t find an insurance company that will sell you an annuity on Social Security’s terms in exchange for 12.4 percent of lifetime earnings, and that’s not just because Social Security exists. No insurance company could afford to offer such a product without mandatory participation, because of adverse selection; and if any insurance company does offer you such a product, you shouldn’t believe that they will still be around when it comes time to collect your benefits.

More importantly, you don’t know at age 21 whether you will be a low earner, a median earner, or a high earner, although you may have some idea. The progressive benefit formula gives you insurance against your career not working out as well as you might have hoped. Sure, if you’re a 45-year-old corporate executive making half a million dollars a year, you will be a net loser from Social Security, but that’s not the question; you can’t decide whether to buy insurance after you find out if the insurable event occurs. There are certainly some people who would opt out at age 21 if they could — notably, the scions of the rich, who don’t need old age insurance — but rationally speaking, it’s not just the people with below-median earnings potential who benefit from the existence of Social Security, it’s also a lot of the people with above-median earnings potential.

These type of insurance programs fall into the realm of what economists call “social insurance”.  That is, they only work well if everybody is covered  – all of society without some people being able to opt out.  Second, the program needs to be government operated since it’s the only organization that can be relied upon to be here to pay off. No private corporation can make that assurance.  Programs such as this work very successfully in all developed industrialized nations.

* Social Security also provides significant payments each year to younger people: child survivors of deceased SS beneficiaries and the disabled.

** There’s also a macro economic issue here.  If there were no Social Security, private savings would likely be too high to support ongoing GDP growth in aggregate demand, leading to recurring recession and slow or no growth.