In the March 2004 issue of the the American Economic Review, Peter Diamond defends the structure of Social Security. (I cannot find the article on the web, unfortunately.) He argues that in the absence of Social Security, individuals would save too little, under-utilize annuities, and under-purchase life insurance.

To my mind, the heart of the context for thinking about Social Security is that it substitutes for poor decision making and for missing insurance opportunities…

significant numbers of workers do not insure their lives adequately…Since the government cares about the different family members (and not just the worker), direct allocations to family members matters since they will change the allocation of resources within the family. Protecting family members is a role governments have recognized for centuries.

I think that I would agree with just about all of Diamond’s positive analysis (economic description) of Social Security and just about none of his normative analysis (value judgments).

For example, Diamond considers it a big deal that the market for private annuities is not well developed. As a result, my mother-in-law, who has liquid assets but no annuity, could over-spend or under-spend, depending on how long she lives. If she dies unexpectedly early, then she will leave a relatively large bequest. If she lives unexpectedly long, she could leave a small bequest or even end up depending on her children for support in her last years.

I think that many familes do not mind sharing this risk. I certainly would not have a problem with supporting my mother-in-law if she lives into her 90’s. By that time, my own children will be well past college and should be on their own. Looking at my own situation, if I die early and leave a large bequest “by mistake,” that will come when my children still need it, whereas if I live longer and the bequest is diminished, that will be after my children have had time to establish themselves. For me, purchasing an annuity would not necessarily be optimal relative to the multi-generational life cycle.

Furthermore, for elderly people, it oversimplifies things to think that you go directly from living in good health to sudden death. Instead, you may go from living in good health to incapacitation, or to contracting a terminal illness, such as cancer. How you wish to allocate your resources over the remainder of your life could be affected by those developments.

Leaving your wealth in a lump sum, rather than purchasing an annuity, gives you more choices in case of incapacitation or terminal illness. I think that this is a valid, rational reason–an option value, if you will–to hold onto one’s savings rather than purchase an annuity.

For Discussion. How comfortable are you with Diamond’s paternalistic assumption that if people do not act optimally for themselves then government should step in to correct their behavior?