FINAL REPORT Long Term Model Development for Social Security Policy Analysis By Eric Toder, Melissa Favreault, John O'Hare, Diane Rogers, Frank Sammartino, and Karen Smith Urban Institute and Kent Smetters of the University of Pennsylvania, and John Rust of Yale University. The Urban Institute 2100 M Street N.W. Washington, D.C. 20037 January 31, 2000 This research was funded by the Social Security Administration, Office of Research, Evaluation and Statistics, Division of Policy Evaluation (Contract No.: 600-98-27332). We remain solely responsible for all errors and omissions. The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders. THE URBAN INSTITUTE 2100 M Street N.W. / Washington, D.C. 20037 / (202) 833-7200 Abstract Long-Term Model Development for Social Security Policy Analysis Policymakers need to understand how Social Security reforms affect income distribution. Existing models range from simple representations of career earnings of typical workers to complex general equilibrium models. Population micro-simulation models, which project the earnings, wealth, and demographic histories of a representative sample of families, are useful for simulating many reform proposals. This report evaluates one such model – the projected cohorts model - and then discusses in detail three important issues in model development: 1) representing saving behavior, 2) capturing macro-economic effects, and 3) accounting for risk and uncertainty. PREFACE This report was prepared by the Urban Institute for the Social Security Administration, Office of Research, Evaluation, and Statistics, Division of Policy Evaluation (SSA/ORES/DPE) under Task Order 0440-99-36156, pursuant to Contract No. 600-96-27332. The report was drafted by a number of authors, both Urban Institute staff and project consultants. Eric Toder of the Urban Institute directed the day to day research on the project and contributed to writing several of the chapters. Principal authors of each chapter in the report were: Chapter 1 Melissa Favreault, Urban Institute Chapter 2 Frank Sammartino and Karen Smith, Urban Institute Chapter 3 John O’Hare, Urban Institute Chapter 4 Diane Lim Rogers, Urban Institute and Kent Smetters, University of Pennsylvania Chapter 5 John Rust, Yale University Joseph Cordes, Daniel Dulitzky, and Frank Sammartino also contributed to the writing of chapter 3. Robbie Howell provided research assistance. In preparing this report, we received numerous helpful comments on earlier drafts from David Pattison and Benjamin Bridges of the Social Security Administration and from a panel of outside experts. The outside experts were Jonathan Gruber of the Massachusetts Institute of Technology, Eric Hanushek of the University of Rochester, Olivia Mitchell of the University of Pennsylvania, John Shoven of Stanford University, and Douglas Wolf of Syracuse University. We also received helpful comments and suggestions from Rudy Penner, Lawrence Thompson, and Sheila Zedlewski of the Urban Institute and Gary Burtless of the Brookings Institution. Theresa Plummer prepared the manuscript for publication. i TABLE OF CONTENTS PREFACE………………….................................................................................................................................................... I INTRODUCTION AND SUMMARY..............................................................................................................................1 I. OUTLINE OF REPORT .......................................................................................................................................1 II. MAIN FINDINGS ..................................................................................................................................................3 1. Microsimulation Models. .....................................................................................................................3 2. The Projected Cohorts Model. .............................................................................................................5 3. Modeling Saving. .................................................................................................................................6 4. Macroeconomic Growth Modeling for Microsimulation of Social Security Reform.................................................................................................................................7 5. Risk and Uncertainty. ...........................................................................................................................8 REFERENCES TO INTRODUCTION AND SUMMARY ...........................................................................11 CHAPTER 1: REVIEW OF SOCIAL SECURITY MICROSIMULATION ALTERNATIVES.............................12 I. INTRODUCTION................................................................................................................................................12 II. WHY MODELS ARE IMPORTANT AND CLASSES OF MODELS FROM WHICH ANALYSTS CAN CHOOSE................................................................................................................................................13 III. DESIRED CHARACTERISTICS OF A MODEL OF SOCIAL SECURITY ............................................15 1. Capacity: Ability to Capture Proposed Reforms................................................................................15 2. Outcomes............................................................................................................................................22 3. Population Definition/Aging Modules ...............................................................................................24 4. Time Horizon......................................................................................................................................25 5. Integration of Social and Economic Research on Social Security Parameters.................................26 IV. ASSESSMENT OF DIFFERENT MODEL TYPES .......................................................................................28 1. Criteria................................................................................................................................................29 Representativeness and Completeness of Starting Data. .........................................................30 Cohort Size (Aside From Stochastic Replications). ..................................................................30 Generalizability. .........................................................................................................................30 Ability to Oversample Parts of The Population. .......................................................................30 Theoretical and Empirical Validity of Updating Algorithms (If applicable). .........................30 Autocorrelation/Serial Correlation (If applicable)...................................................................31 Feedbacks ...................................................................................................................................31 Outcomes ....................................................................................................................................31 Programmatic Detail..................................................................................................................31 Projection Assumptions..............................................................................................................32 Sensitivity Analyses. ...................................................................................................................32 Stochastic Replications Per Individual/Cell..............................................................................32 ii Table of Contents (Continued) January 2000 Stochastic Replications of Aggregate Demographics/Economics. ..........................................33 Ease of Use.................................................................................................................................33 Accessibility. ...............................................................................................................................33 Development and Maintenance Time and Cost. .......................................................................34 2. Type 1: Representative Worker Models ...........................................................................................34 Summary Of Representative Worker Models. ...........................................................................36 3. Type 2: Cell-Based Models...............................................................................................................37 Summary of Cell-Based Models. ...............................................................................................39 4. Type 3: Population Microsimulation Models ...................................................................................40 Aging Algorithms........................................................................................................................44 Open Versus Closed Populations. .............................................................................................44 Simulation Time Dimension.......................................................................................................46 Model