EXECUTIVE SUMMARY
Few dispute that Social Security faces a long-term financing crisis. The program's true condition, however, is even grimmer than many acknowledge. Beginning around the year 2017, Social Security benefits can be maintained only through higher taxes, cuts in spending or a return to budget deficits. Between 2017 and its "official" insolvency date of 2040, Social Security will require at least $2.5 trillion (in 1998 dollars) of additional revenue to maintain promised levels of benefits. Beyond 2040, deficits grow worse.
Social Security reform is about much more than simply balancing the books, or "quick fix" patches designed to keep a leaky ship afloat for a few additional years. Past reforms have taken that approach and failed, because they did not appreciate the true nature of the problem and because the underlying values the American people hold regarding Social Security had not evolved to a place that would welcome lasting reform.
The task facing reformers is two-fold: first, devise solutions to the structural problems Social Security faces while second, ensuring that these solutions mirror the core public beliefs and opinions that have made Social Security such an admired program. The second task is in many ways more challenging than the first. Therefore, two distinct issues are addressed:
Structural Problems: Social Security was established as a pay-as-you-go social insurance system, in which current taxpayers support current retirees. But pay-as-you-go financing depends upon a) high growth in workers' incomes, and b) a high ratio of workers to retirees. In the future, neither income growth nor growth in the size of the labor force will be sufficient to provide a good rate of return to a growing population of Baby Boomer retirees. The only way to avoid trillions of dollars of tax increases or spending cuts is to improve the rate of return from Social Security by making it a fully-funded pension program.
Public Opinion: As important as the structural problems facing Social Security are, an even more important component of reform is public opinion. In short, there are three core values or opinions around which public opinion revolves on the Social Security debate. They are:
*Security: A guarantee against poverty in retirement. Social Security provided it in the past, but doubts about its solvency mean that it no longer provides peace of mind.
*Return on investment: In Social Security's early years, workers contributed only 2 percent of their wages and the return was good. They now contribute 12.4 percent, and the return is much lower. Workers are not receiving value for their money, and oppose tax increases or benefit cuts that make the return from Social Security even worse.
*Distrust in government/Personal control: Failed reforms of the past caused deep public skepticism that the government can reform Social Security in a way consistent with their values and best interests. Doubts regarding Social Security caused individuals to plan for retirement on their own. The public wishes to shift more of the responsibility for retirement planning away from government and toward them. Proposed reforms should address these key issues and values. Those that do not will likely be unsuccessful.
Proposed reforms should address these key issues and values. Those that do not will likely be unsuccessful.
What began as a relatively modest social insurance program to ward off poverty in old age has become the largest and most expensive government program in the world, upon which millions of Americans depend for their retirement incomes.
What began as a tax of only two percent of wages now takes over 12 percent. As a result, Americans have less money to save on their own and expect much more from Social Security than they used to.
A worker putting 12.4 percent of her wages and salary into a stock fund returning the historical average could retire with a nest egg providing an income three times what he had while working. Out of this, she could easily provide for retirement, disability and survivors expenses. The government depicts Social Security as a base for retirement income, as insurance against poverty. But 12.4 percent of wages should provide much more than a base, and workers have demanded more for their money.
As Social Security has changed, Americans' perceptions of it have changed as well. Former Speaker of the House Tip O'Neil called it the "third rail of American politics," which politicians could touch only at their peril. Yet today, the public says they are substantially more likely to vote for a candidate who favors changing the system than one who wants to keep it as it is.
Both political parties place Social Security reform at the top of their agendas. The most difficult challenges are not of high-level finance. It is easy to discuss subtleties of tax rates, salary ceilings, retirement ages and cost of living increases. More difficult is addressing the basic structure of Social Security, the core public values behind it, and the way that these basic values are no longer met.
In many ways, the answers to Social Security reform aren't nearly so hard as the questions:
*Some people count only the employee's payroll tax contribution while others count both employee and employer. This makes a big difference in computing the program's return.
*Some believe the Trust Fund can delay Social Security's insolvency, while others consider it a "polite fiction" filled with "phantom assets." On this question alone hinges whether financing problems are a speck on the horizon or a steam train just around the corner.*Some see investment in the market as fraught with risk, while others see greater risk in remaining with the current system. The answer to this question can determine the safest route to reform.
Clarifying basic issues like these is essential. If we disagree on how Social Security works, how large a problem it faces, and what risks are included in the alternatives, we can use all the econometric models we want but will never agree on anything.
But Social Security's structure is merely a start. Social Security is as much an American ideal as a government program. Americans feel that Social Security belongs to them as much as to the government. Just as important as the questions above are the public's beliefs, values and opinions about Social Security.
*What do Americans want from Social Security?
*Whom do they trust?
*What risks are they willing to take, and who should take them?
*What tradeoffs will they accept?
Any reform must appreciate Social Security as an American ideal as much as a social insurance or compulsory pension program.
Politicians frequently hear the advice to "speak in terms of values." Here, we must think in terms of values as we consider and evaluate proposals to reform Social Security. Reformers should consider the public's core beliefs and opinions as well as Social Security's structural issues in ensuring that the program continues to protect the things Americans prize about the program.
2. UNDERSTANDING SOCIAL SECURITY
Much of the talk about Social Security — of how much money is in the Trust Fund, how long it will last, what rate is paid on the bonds in the Fund, and so forth — focuses on factors peripheral to its survival and success. It is only by breaking Social Security down to its essential factors — how it is financed, how it pays a return, what return it will be capable of paying in the future — that reformers can avoid past mistakes and ensure a secure future for the program.
Financing: Pay-as-you-go vs. Fully Funded
We must first distinguish between two methods of financing, "pay-as-you-go" and "fully-funded," which are central to understanding how Social Security works, why it faces problems in the future, and how it might be reformed.
Pay-as-you-go is a vertical system, where each working generation supports the generation that preceded it. Under a pay-as-you-go system, there is no saving or investment, merely the continual transfer of wealth from younger generations to older ones.
Pay-as-you-go financing is often dismissed as a "Ponzi scheme." Yet, Americans have long relied on pay-as-you-go without even realizing it. For generations, the elderly lived with their children. Their children would be supported by their own children when the time came. There is nothing inherently wrong or dishonest with this approach; under favorable conditions pay-as-you-go can continue forever, with each generation supporting the one that preceded it and being supported by the one that follows.
But if a family does not have enough children, or if their children do not have very much money, then pay-as-you-go financing becomes problematic. The same conditions apply when pay-as-you-go is applied to a national pension and social insurance plan, as we shall see.
Fully-funded financing is similar to the modern practice of saving for retirement. It is a horizontal system, in which each person or generation saves money while working, then draws upon those funds to cover retirement or other expenses. Unlike pay-as-you-go financing, in which there is an ongoing intergenerational transfer of wealth, in a fully-funded approach each generation saves for its own retirement.
Is Social Security Pay-as-you-go or Fully-Funded?
According to the Social Security Administration, Social Security is a mixed or partially-funded system, with elements of both a pay-as-you-go and a fully-funded approach:
"Since 1983, the program has operated under a "partial reserve" method of funding. The intent is to have the system take in more than it pays out in order to build up the large reserve funds needed to help pay for the benefits of an increasing number of retired workers."
Most payroll taxes immediately pay benefits to current retirees, survivors, or the disabled. In 1998, of an estimated $435 billion that American workers paid in payroll taxes, about $380 billion was spent on benefits.
The government uses the money left over to supplement general tax revenue, and gives the Social Security Trust Fund special Treasury bonds in exchange. Since the Baby Boomers are at the height of their earning years, Social Security is running a surplus and the Trust Fund is growing.
In the future, the Baby Boomers will retire. Social Security will be deprived of Boomers' taxes and will instead have to pay them benefits. Beginning around 2017 Social Security's cash flow will turn negative; it will take in less money in taxes than it pays out in benefits.
To supplement payroll taxes, the bonds in the Trust Fund will be redeemed. This will pay benefits until around 2040, when the Trust Fund will run out. From 2040 onward, payroll taxes will bring in enough money to pay only 75 percent of promised benefits. To maintain full benefits new revenue would have to be found, either through tax increases, spending cuts or new borrowing.
This is a rough synopsis of the "official" view of Social Security. As we will see, there are reasons to take issue with this description, as well as with assurances of the program's stability for the near future. The true prognosis for Social Security's future is decidedly less rosy.
So, What is the Trust Fund, Really?
The American Association of Retired Persons (AARP) claims "even if we just sit back and watch the program, without any kind of change at all, Social Security will be able to pay promised benefits until the year 2029."
The Century Foundation says that, "without the Trust Funds' reserves, the moment when the government would need to find a solution to the gap between payroll tax revenues and obligations to retirees would be moved forward by 19 years, from 2032 to 2013."
Similarly, Social Security Commissioner Kenneth Apfel says that while "demographic changes raise serious long-range solvency issues, Social Security is not a program in crisis. The projected shortfall in the system, while serious, will not happen for almost three decades, by which time the program will be almost 100 years old."
The truth is, the Social Security Trust Fund will neither delay the need for tax increases by a day, nor reduce them by a penny.
This is for a very simple reason: Treasury bonds -- the assets in the Trust Fund -- are nothing more than written promises by the government that at a certain date it will raise revenue sufficient to repay the bond. As the Congressional Research Service has said:
Perhaps the biggest misconception is that the Social Security Trust Funds represent actual resources to be used for future benefit payments, rather than what is in reality a promise by the Government to take steps necessary to secure resources from the economy at that time.
The Trust Fund cannot delay the need for additional revenue, because the bonds in the Fund are themselves promises to provide additional revenue. And ultimately, the only "asset" underlying a government bond is the power to tax.
How much would these taxes be? The projected payroll tax shortfall in 2014 is only $4.2 billion, but grows rapidly as the Baby Boomers retire. Between 2014 and 2030, the Trust Fund will redeem a total $2.49 trillion (in 1999 dollars), an average of $131 billion per year.
The question defenders of the Trust Fund never answer is: where is the government going to get the money to repay those bonds? It's not sitting in Fort Knox, so it has to come from somewhere. The accompanying tables show 1998 Federal spending and revenue by category, along with Social Security's funding shortfall from 2014 to 2031.
Covering the shortfall by raising taxes would require income taxes to increase by 17 percent or payroll taxes by 25 percent. Alternately, we could trim Social Security benefits -- if you consider a one-third reduction a "trim." Or we could reduce other government spending. That is, if cutting National Defense by half or eliminating all funding for energy, agriculture, natural resources, commerce and housing, transportation, and education is your cup of tea.
Of course, we could always borrow, bringing back the days of massive budget deficits. This is what the Trust Fund will bring us, and all of it before Social Security is scheduled to become insolvent.
Both President Clinton and Congressional Republicans state their opposition to increasing taxes to save Social Security. But relying on the Trust Fund burdens the public with $2.5 trillion of additional taxes without notifying them of that fact. In effect, Washington will be telling the public, "We're not raising your taxes to pay for Social Security; we're raising your taxes to pay for the bonds which will pay for Social Security." Given the size of the tax increases that would be necessary, this is a distinction likely be lost on the public.
If the Trust Fund were the backstop against tax increases its defenders claim, then an instant solution to Social Security's problems would be to issue more bonds to the Fund. But as A. Haeworth Robertson, former chief actuary of Social Security stated, "With or without a trust fund, the same amount has to be taken out of the taxpayers' hands."
This is not to say that the Trust Funds are being mismanaged, that money is being "stolen" from the funds, as some accuse. A Federal Trust Fund is different from an ordinary one, but a citizen would need to examine the fine print of the budget to figure that out. Ordinary people, upon realizing that the only assets underlying the Trust Fund are currently residing in their bank accounts, feel a sense of betrayal.
The True Return on Taxes "Invested" in Social Security
A standard approach in articles on Social Security reform is to contrast the return from stocks with that of the bonds issued to the Social Security Trust Fund, then show that over time an individual can earn much more in the market than with Social Security.
A writer to the New York Times recently made a similar point: "if the Government paid more reasonable interest rates for its access to the Social Security reserves, the whole idea of having to go to the stock market would evaporate."
But these comparisons are misleading. Whatever the interest rate on the bonds, the difference between what Social Security collects in taxes and what it pays in benefits will be met using general revenue. Therefore, we need to look closer.
An important first step is to differentiate betweenthe rate of return for individuals and the rate of return for the system as a whole. The chart at right shows the inflation-adjusted rate of return for different categories of beneficiaries retiring in different years. Clearly, those who retired early in Social Security's history received a higher rate of return. Part of the reason is simple: Social Security was founded midway through their working lives, so they received full benefits without paying a full lifetime's taxes.
In addition, different beneficiaries receive different rates of return. Single men, for instance, receive a lower rate of return, because they tend to have shorter life spans than women or married men. One-earner couples receive a higher rate of return because the non-working spouse receives benefits without having to pay taxes.
While important, individual rates of return do not help nearly as much as knowing the structural rate of return for the system as a whole. If the system produces a high rate of return then benefits for everyone can improve, even if some individuals still get a better deal than others.
For that reason, we will define Social Security's rate of return as the annual change in funds available per beneficiary. Three factors determine Social Security's annual rate of return:
*Growth of the labor force
*Growth of productivity
*Growth of the beneficiary population
Growth in the labor force increases the number of workers paying taxes. Growth in productivity increases workers' wages. Both of these factors increase the total pool of money available to pay benefits. Growth in the beneficiary population determines among how many people the pool of money will be divided.
If the labor force and productivity grow faster than the beneficiary population, the amount of money available to each beneficiary will increase. But if the beneficiary population grows too quickly, then there will be less money available per person.
The good news is that these three factors are predictable far in advance. Unlike the stock market, which goes up or down on a daily basis, we can have a fair idea of what the return will be from Social Security decades in advance. The bad news: if they combine to produce a low rate of return, there is little that can be done to change it.
Conclusion
Social Security's ability to continue as a self-financing program for the long term depends on these three factors: growth of the labor force, growth of productivity (which determines growth of workers' wages), and growth of the retiree population.
Looking at the Trust Fund is worse than useless. The bonds in the Trust Fund represent how much payroll tax money has been borrowed for other uses, but they cannot forestall the need for increased revenue in the near future.
Now that we have a general understanding of how Social Security is financed, we can look at how the factors that make for the program's success or failure have changed over time.
3. UNDERLYING PROBLEMS WITH SOCIAL SECURITY
Social Security produces a good rate of return only under certain advantageous economic and demographic conditions. The labor force and the productivity of the economy, which determine the tax base, must grow faster than the population of retirees and other beneficiaries, which forms the benefit base. In the early years of Social Security, these conditions were satisfied. The labor force grew quickly and the economy prospered, while the retiree population increased relatively slowly.
But the factors that made Social Security successful and popular in its early years have turned against it. Social Security is ill-equipped for an environment in which these conditions no longer hold true.
The Baby Boom and Bust
Following World War II, servicemen long separated from their spouses made up for lost time in building families. The "Baby Boom," in which birth rates jumped from 2.2 births per woman in 1940 to 3.6 per woman in 1960, created a demographic wave of new children.
Financing the health and education of the young Baby Boomers was a challenge. But as the Boomers reached working age, the labor force grew by over 2 percent per year and payroll tax revenue increased. As a result, the return from Social Security increased.
Following the Baby Boom, however, birthrates did not simply return to their previous levels. They actually fell as far below normal as they rose above it during the Boom. By the early 1970s, the birth rate had fallen below its 1940 level. It has never recovered since. This created what has been called the "Birth Dearth," the opposite of the Baby Boom.
While the labor force grew by over 2 percent annually in the late 1960s and early 1970s, present growth is only around 1 percent. By the year 2020, growth will be only around 0.1 percent. This means that almost no net additional workers will be paying taxes into Social Security.
As the Baby Boomers begin to retire in the early 21st century, they will stop contributing to Social Security and start collecting benefits. Meanwhile, low birthrates mean there will be fewer workers to take their place, and fewer workers means fewer contributors to the system.
Increased Life Spans
Not only are the Baby Boomers moving toward retirement, but thanks to improved nutrition and healthcare they will spend more years enjoying their retirements than any previous generation of Americans. This is good news for them. It is not so good news for Social Security.
In 1940, only 53.9 percent of males survived to collect benefits. By 1990, over 72 percent of males lived to collect Social Security.
In 1940, people who lived to 65 survived for an average of 12.7 additional years. By 1990, life expectancy at age 65 was 2.5 years longer than in 1940.
The benefit-years liability -- the product of the percentage of the population living to age 65 and life expectancy beyond that age -- nearly doubled between 1940 and 1990, and will continue to increase in the future.
As a result, the money Social Security takes in through payroll taxes must be divided up among a larger pool of beneficiaries. All other things being equal, this means less money available per person.
Lower Productivity Growth
Economist Paul Krugman says that "productivity isn't everything, but in the long run it is almost everything." What he means is that a country cannot reliably raise its standard of living other than by raising the level of output per worker. Employees can work longer hours or more people can enter the labor force, but only for so long. Productivity growth is and will continue to be the linchpin to increased national wealth.
Increased productivity is central to Social Security's rate of return. If productivity increases, wages also increase. If wages increase, workers pay more payroll taxes without having to increase tax rates. Increased payroll tax receipts make for a higher rate of return from Social Security, with more money available for each beneficiary. The U.S. has seen both sides of this equation.
The early post-war period was one of boundless optimism. In the 1960s, real wages per worker subject to payroll taxes rose by an average annual rate of 2.2 percent, and in 1967 Fortune magazine predicted that per capita income would rise by 150 percent by the year 2000.
Quickly, the optimists were proved wrong. In the 1970s, as productivity growth declined, wage growth slipped to 0.5 percent annually. It recovered to only 0.7 percent in the 1980s and 90s, less than one third that of the 1960s. For many lower income workers, wages actually dropped.
Slow productivity growth is serious business: had growth in the last quarter of this century been as high as in the first 75 years, current American living standards would be 25 percent higher than they are today.
High productivity makes it easier to overcome changes in the worker-to-retiree ration. If productivity growth slows, the effects of demographic changes are only exacerbated.
Economists debate the reasons for the slowdown in productivity and wage growth. Part may be that today's economy is based more upon services than upon manufacturing, and productivity increases are harder won in service industries than in manufacturing. As economists joke, we can produce millions more widgets than in days past, but a string quartet needs just as many workers as it did three hundred years ago.
A second reason for slower wage growth may be that a greater share of workers' total compensation is taken up by non-wage benefits, particularly health care. Even to the degree that total compensation is growing, wages subject to Social Security taxes may remain stagnant.
Whatever the reason for the slowdown in growth of productivity and wages, decreased wage growth plays a central role in the nation's ability to provide benefits for future retirees.
The Future Return from Social Security
Declines in labor force and productivity growth combined with increases in the retiree population mean that the future return from Social Security will be far lower than at present. Many individuals may not even get back all the money they put in, much less earn interest.
Social Security is a defined benefit plan, in which a worker is promised a given level of benefits, without regard to the return on the money he has paid in. If the return is insufficient to pay promised benefits, the plan's provider must make up the shortfall. In this case, the provider is the American public. If taxpayers make up the difference, there must be large tax increases or cuts in other programs. If the public chooses not to make up that shortfall, Social Security benefits must be drastically cut.
Since there is little that can be done in the short term to change these conditions, efforts must be concentrated on readying Social Security to weather the coming storm.
5. SOCIAL SECURITY AND QUALITY OF LIFE
Return on investment, security, skepticism about government and a desire for increased personal control all affect public views of the Social Security debate, often in confused, intertwining ways. To some degree, these variables are interrelated. In other ways, they are at odds. The goal is to balance these values in ways that achieve the optimal quality of life.
The selling point behind many reform proposals will no doubt be that they keep Social Security solvent. But we should be asking different questions:
*Does it raise Social Security's return on investment or does it simply pump more money into the system? Will workers have to pay more in while getting less out? In other words, is it reform or is it merely a bailout?
*Does it put Social Security on a sound footing to provide benefits for the future? Or is it a quick fix that will need to be revisited in years to come?
*Does it require blind faith in government, or will workers have real guarantees that their payroll taxes are being invested wisely?
*Does it depend upon optimistic economy and demographic assumptions, or is it built to weather whatever storms the future may bring?
*Does it give workers more control over their retirement planning, or does it maintain Social Security as a one-size-fits-all program?
Social Security is a commitment that covers one's entire adult life, beginning upon entering the labor force and lasting through old age. Reformers should look first to the values, beliefs and opinions that people hold regarding Social Security. No reform of a program as central to the public's quality of life as Social Security can succeed if it does not rest on a foundation of widely held values.
http://www.conginst.org/socialsecurity/issues/index.html
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