The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

Social Security: Apocalypse Soon?

 

 

                    Will you still need me, will you still feed me,
                                        When I'm sixty-four?

                                                                             Beatles

            Social Security always has stirred intense passions.  Although billed as old age "insurance" when signed into law in 1935, it never has been run as such.  Instead of salting payments away in individual accounts to be repaid at retirement, the program has been financed on a pay-as-you-go basis.  Payments from current workers immediately are recycled as benefit checks to retirees.

             Moreover, benefits received have never been based on payments in any meaningful way.  Congress has used the system to generate massive redistributions of income across generations and across income classes.  Despite the official rhetoric, Social Security has been administered as a type of welfare program in which current workers (rich and poor alike) redistribute dollars to current retirees and their spouses (rich and poor alike).

              Is that bad?  Not necessarily.  The program successfully has shored up the incomes enjoyed by elderly citizens and has enjoyed enormous popular support.  Not that many years ago, the elderly were a generally impoverished lot with average standards of living well below those of their younger counterparts.   Now, thanks largely to Social Security, income levels of most elderly citizens have reached or surpassed national averages.

            Despite its success, the system has come under increasing fire.  Social Security, along with its associated Medicare program, is the largest item in the federal budget -- far surpassing the runner-up lines for national defense and interest on the national debt.  As Congress struggles to balance the budget, escalating costs in Social Security have squeezed other federal programs into oblivion.  Can we afford it?

The issues:

1.         The shrinking trust fund.

            The early years were a piece of cake.  In 1940 there were 159 workers paying into the system for each beneficiary drawing payments out.  Tax rates were low and financing non-controversial.  This allowed Congress to legislate benefits to early recipients that far exceeded the value of their contributions plus interest.  Ida Fuller, the first American to draw a Social Security check, ultimately received $20,940.85 from a system to which she had contributed a mere $22. 

            Later recipients enjoyed similar largesse.  However, as the number of retirees grew, problems began to mount.  By 1960, the number of workers per beneficiary had plunged to five.  It currently stands at about four and, by 2030 when the final baby boomers will hit the nursing homes in full force, we expect the number to fall almost to two workers per beneficiary.

            As the number of workers per beneficiary falls, a pay-as-you-go Social Security System becomes increasingly untenable.  Early retirees reaped exorbitant rates of return from the Social Security System, far greater than what they could have obtained themselves with their contributions earning a reasonable rate of return. Of course if past recipients received more than the value of their contributions plus a reasonable return, someone eventually must receive less.  In effect, the overly generous payments to past recipients have created a legacy debt that eventually must be paid by either current or future workers.1 That means that negative rates of return are likely for current or future workers.  It was relatively easy for past retirees to live off of the contributions of the huge baby-boom generation.  The boomers will find living off their less numerous children far more difficult.

            Realizing the dilemma, Congress phased in several tax increases to build a trust fund and return the system to a sound actuarial footing.  Even though these increases have created a large and growing trust fund, it's not enough.  Now that the baby boomers have begun to retire, the annual surpluses already have turned to deficits.  In 2010 the Social Security Administration paid out more in benefits than it received in revenues.  By about 2040, the trust fund will be empty and system will be bankrupt. The funding shortfall currently projected over the next 75 years is $3.7 trillion.2

            Or so goes the rhetoric.  But it's all a ruse, a red herring.  There is no real trust fund to deplete.  Oh, it does exist on paper; but the trust fund is only an accounting artifice, an illusion.  By law, all trust fund monies are invested in special non-marketable government bonds.  In effect, the current Social Security surpluses are given back to the Treasury Department each year for bonds -- interest-bearing IOU's with no tangible assets or collateral to back them.  In other words, the current surpluses are not being squirreled away in a protected account somewhere; they simply are loaned back to a Congress that, in turn, spends the monies to finance ongoing government operations.

            When the annual surpluses become deficits down the road, the trust fund will begin cashing in its bonds and ask Congress to fork over the needed dollars.  But where will Congress get the dollars?  It has no storeroom of tangible assets to tap into; no real reserve exists.  With no tangible asset -- only government IOU's -- the fund is an illusion.  When the trust fund tries to redeem its bonds, Congress either must raise taxes or borrow the needed funds.  Of course, Congress could always renege and not pay the promised benefits.  But as the number of retirees and their political clout grows, this becomes less and less likely.

            We can build a bigger trust fund, but it would not solve the problem. It does not matter if we have a $10 trillion trust fund or a $10 trust fund.  As soon as annual outlays begin to exceed annual tax receipts, Congress either must raise taxes, cut benefits, or borrow the additional monies.  The size of the trust fund is irrelevant.  The "expert" wringing his/her hands over the vanishing trust fund is an "expert" to ignore.

2.         Economic Growth

            The claims of retirees ultimately are claims on the output being produced by current workers.  If retirees claim an increasing share of the pie, current workers necessarily must inherit a smaller share.  No conceivable financial arrangement can alter that fact.  Fundamentally, the problem is that of economic growth.  If productivity rises and economic growth is robust, disaster will be averted.  With a rapidly rising GDP, "baby busters" could enjoy a higher absolute standard of living despite consuming a smaller share of output.  The best way to "fix" Social Security is to generate more economic growth.

            How?  Most macroeconomists insist increased saving is the key. The more we save, the more resources we can plow into new technology and productivity-enhancing investments.  More savings translates into more productive capacity for future generations; more capital per worker.  In general, countries with the highest savings rates have the highest standards of living.  A recent estimate by economists at the respected Brookings Institution pegs the needed increase in national savings at an extra five percent of GDP per year.  That amount of new savings should generate enough new growth to finance the projected increase in spending on the elderly.

            Unfortunately we are not moving forward; we are backpedaling.  Savings rates have fallen well below historical levels and show no sign of recovery. As expected, productivity growth has suffered a similar fate.  Although the causes are still hotly debated, it appears that the Social Security System itself may have been part of the problem.  Guaranteeing elderly citizens a minimum standard of living has reduced the needs of workers to save for retirement.  More importantly, the system has reallocated massive amounts of dollars from middle-aged workers, whose savings rates are relatively high, to retirees, whose savings rates are very low.  Ironically, Social Security has undermined the very behavior needed to insure its long-run success.  Rats.

            Can we reverse the trend?   Some politicians expected the tax cuts and Individual Retirement Accounts of the 1980's to unleash new torrents of private saving.  They were wrong.  Attempts to prompt more private savings by tweaking the tax code have been a resounding flop. But all is not lost.  Government savings can substitute for private savings.  When the Treasury Department borrows to cover the federal deficits it absorbs funds that might otherwise be invested in new technology and capital.  Smaller deficits or even, gasp, federal surpluses could reverse this drain and pump more dollars back into investment markets.

            Naturally, politicians disagree on the proper approach.  Some advocate deep cuts in government spending.  The resources no longer needed to support government spending could be released for private investment.  Others counter that public, not private spending is needed to enhance productivity and growth.  Government-funded education is needed to generate new ideas and to equip workers with the skills needed in a technological world.  Government-funded highways, bridges, and ports are needed to provide the infrastructure on which growth must be based.  In this scenario, Congress should raise taxes and plow the monies back into education, research, and public investments.

The proposals:

            Politicians, economists, and government advisory committees have jumped into the middle of this fray with abandon.   Experts agree that the current system is unsustainable, but disagree on the appropriate fix.  Two basic types of proposals have been put forth:  (1) making reforms within the current system structure and (2) shifting toward a privatized system with mandated personal accounts.

Proposal #1:   Reforms within the current structure

            Advocates of this approach oppose any radical change of the system.  They opt to cover the legacy debt and return the system to long-run balance through various combinations of cuts in benefits and higher taxes. They note that the projected 75-year shortfall, while large in absolute terms, amounts to less than one percent of projected GDP over the same period.  The extra tax revenue needed to close the gap is far smaller than the amount of tax revenue lost by the 2001 and 2003 tax cuts passed by Congress at the behest of President Bush.3

            In its 2010 report, President Obama's bipartisan National Commission on Fiscal Responsibility and Reform (often referred to as the Simpson-Bowles Commission) concluded that, with a few "minor" changes, the system could regain fiscal balance.4  The proposed changes were:

1.         Increase the retirement age.  Today’s workers can expect far more years of robust health and productivity than could their grandparents.  When Social Security began, average life expectancy in the U.S. was a mere 62 years (life expectancy for men was even lower); barely half expected ever to live long enough to receive a single retirement check.But by 2009 average life expectancy at birth had edged past 78 -- an increase of 16 years.  To bring down costs, the normal retirement age could be increased and eventually be indexed to changes in life expectancies. 

2.         Make all wages subject to the Social Security tax.  Under current law, social security taxes are imposed only on the first $113,700 of annual wages or salary.6  Wages and salaries above that are not subject to the social security tax.  While relatively few workers earn more than this cap, those that do often earn millions more.  About 15% of total wages in the U.S, escape the social security tax.  Gradually removing the cap and making all wages taxable could raise substantial sums of revenue and close as  much as 70% of the projected revenue shortfall.7

3.         Revise the cost-of-living calculations.  Social Security benefits increase automatically each year to keep up with changes in the overall cost of living. However, economists agree that the current statistcial methods overestimate the true amount of price inflation that occurs.  Using a more accurate method of measuring inflation would decrease the annual cost-of-living adjustments and save many billions of dollars in the long run.  

4.         Reduce the relative benefits to the wealthiest retirees and increase them to low-income retirees. Retirees with low incomes collect benefits for fewer years since they typically die much sooner than those with high incomes.  Shifting annual benefits toward those at the bottom would save money and also would help even out lifetime benefits received.  

Proposal #2:   Personal Accounts

            Personal account proposals represent a more radical approach that makes more fundamental changes in Social Security.  These proposals divide Social Security taxes into two pieces.  One part of the taxes paid would go into the current system and would continue to fund a smaller, fixed safety-net pension.  A second part would go into personal accounts controlled by each individual.  Registered investment firms offering a smorgasbord of portfolio options for their individual clients would manage these personal accounts.   Because this would move some Social Security funds out of the federal government and into private hands, many brokerage firms and mutual funds have been salivating in anticipation.

            Upon retirement, employees would receive the smaller safety-net benefit given to all, plus an annuity based upon the success of their personal account.  Those whose accounts earn high rates of return will receive more than those whose accounts are less successful.  In effect, this would move the Social Security System away from a defined benefit plan in which benefits are guaranteed, toward a defined contribution plan in which contributions are fixed, but the benefits vary with the return on pension investments. The proposal reduces the role of the federal government to running the safety-net fund and allows individuals the freedom to invest the other monies as they see fit.  In this respect,  personal accounts are a step toward privatization of Social Security.

            By themselves, personal accounts can neither repay the system's legacy debt nor change the system's long-run fiscal imbalance.  They simply move dollars from a government-run Social Security account to a privately-run account.  However, under current law, the Social Security Trust Fund is invested entirely in government bonds and earns only paltry rates of return.  Personal account advocates claim that individual accounts can be invested more aggressively in corporate stocks and similar financial instruments that historically have earned higher rates of return.  If so, we could we could cut Social Security benefits and use the higher returns on personal accounts to offset the loss. 

            As an example, suppose that by investing in corporate stocks Jorge could earn $100 more in a personal account than the Social Security Trust Fund would earn on its government bonds.  If so, we could cut Jorge's Social Security benefits by $100 without lowering his retirement income.  In other words, every additional dollar that individuals could earn in a personal account is a dollar that could be cut from Social Security benefits.  If the additional earnings in personal accounts are large enough, benefits could be cut enough to return the system to long-run fiscal balance.

            While some have rallied behind the privatization that personal accounts promise, others recoil in horror.  Defined contribution plans like personal accounts shift investment risks to employees.  What if the accounts do not generate the high rates of return that proponents predict?  What if financial markets take a dive just as a worker is ready to retire and needs to cash in his/her personal account?  Will employees -- especially unskilled, uneducated employees -- be able to make intelligent investment decisions?  Or will unscrupulous money managers take many to the cleaners? 

            Transition issues are even more problematic.  Workers in my generation have already paid for our parents' retirements.  In this scenario our children will be paying for their own retirements via personal accounts.  Who will foot the nearly $2 trillion bill to finance ours?  The legacy debt built in the past would remain unpaid. Unless we are ready to add another $2 trillion to the national debt, large tax increases would be needed to raise the necessary monies.

Where are we now?

            The plans and their many variants are complex and controversial; none are easily explained through commercial sound bites to the electorate.  More importantly, neither aims directly at increasing economic growth -- the only sure-fire solution.  We cannot pay Social Security benefits to larger number of retirees without a larger pool of resources and output.  Growth is the key.  Growth requires more saving, more investment, more productivity growth.  And, that means sacrifice.  Ouch, what an ugly word.  But, it's a necessary word.  We cannot save more unless we are willing to consume less.  Proposals that ignore the need to sacrifice are both dishonest and useless.

            Conservatives push a combination of benefit cuts and personal accounts.  The benefit cuts are designed to bring expenditures into line with projected revenues and move the system toward solvency.  They tout the personal accounts as a way to "soften the blow." If personal accounts perform as well as their proponents hope, the increased returns will offset some or all of the lost benefits.  Many opponents prefer the minor tinkering approach.  They reply that personal accounts will create unacceptable risks for many workers.  Indeed, recent returns earned by savers have fallen far below what would have been forecast a decade earlier.  Many also fear that personal accounts are a first step toward attempts to dismantle the entire Social Security System. 

             Many who do favor personal accounts argue that they should be added on top of the current system rather than than replacing it.  For example, current Social Security tax rates would remain the same, but those who want to do so could pay an additional sum each month that would be used to create a personal account.  Keeping the current tax rates would help us repay the legacy debt hanging over the system and, adding personal accounts on top of the system might encourage the extra savings needed to boost long-run economic growth.8

             Although almost all proposals address only the retirement part of the Social Security System, most experts agree that the financial problems facing Medicare are even more thorny. Whatever the solution, the stakes are high. If we expect to avoid intergenerational warfare, we must do what we can to ensure that baby-buster incomes will be high enough to afford the tab they will be asked to pay.

______________________________________

Notes:

 

1.         The legacy debt term was coined by economists Peter Diamond and Peter Orszag.  See Diamond, Peter A. and Orszag, Peter R., "Saving Social Security," Journal of Economic Perspectives, Spring 2005, volume 19, number 2, pp. 11-32.

2.         These are the Social Security Administration's intermediate estimates.  See Hines, James R. and Taylor, Timothy, Shortfalls in the Long Run: Predictions about the Social Security Trust Fund," Journal of Economic Perspectives, Spring 2005, volume 19, number 2, pp. 6-7.

3.         Diamond and Orszag, op. cit.., pp. 7 and 25.

4.         Orsag, Peter, "Safersocial Security", New York Times, November 14, 2010.

5.         The Economist, June 27, 2009, page 10.

6.         The $113,700 was the cap on maximum taxable earnings for 2013.  The cap is adjusted annually based the national wage index.

7.         Currently both workers and employers pay a 6.2% tax on earnings up to the cap.  To close this much of the revenue gap, the cap would have to be removed for both groups.

8.         Sweden moved to a similar system in the 1990's.  See "Social Security Smorgasbord? Lessons from Sweden's Individual Pension Accounts," by R. Kent Weaver, Brookings Policy Brief #140, 2005.

 

_______________________

 

Testing Yourself

 

To test your understanding of the major concepts in this reading, try answering the following:

 

1.     Explain why people are worried about the long-run health of our Social Security System.

2.     Explain the origin of the system's legacy debt and how this affects the rate of return likely to be earned by future generations on monies paid into Social Security.

3.     Explain why generating more economic growth is the best way to solve the Social Security problem and how the Social Security System itself might have lowered growth rates.

4.    Discuss and explain the types of minor tinkering changes that might return the Social Security to long-run balance.

5.    Explain how proponents of private social security accounts expect to bring long-run fiscal balance to the Social Security System.

6.    Explain the disadvantages of allowing individuals to put Social Security tax dollars into personal or private accounts they can manage as they wish.

7.    Distinguish between defined benefit and defined contribution retirement plans.

 


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Last modified 05/22/13