The Optimal Design of Social Security Benefits

The United States Social Security system is fairly unique in that it explicitly allows for a progressive formulation of retirement benefits by assigning a larger replacement rate to workers with small pre-retirement wages. In contrast, the public pension systems in other countries often replace a constant fraction of pre-retirement wages, although the length of the “averaging period" is typically shorter relative to the U.S. This paper examines the ex-ante optimal U.S. Social Security benefit structure using the model developed in Nishiyama and Smetters (2007). On one hand, progressivity in the benefit structure provides risk sharing against shocks that are difficult to insure privately. On the other hand, progressivity introduces various marginal tax rates that distort labor supply. Rather surprisingly, we find that the ex-ante best U.S. Social Security replacement rate structure is fairly “flat.” Intuitively, the relatively long averaging period used in the U.S. system formulation already provides some insurance against negative idiosyncratic shocks, but in a manner that is more efficient than explicit redistribution.