ECON 101: Social Security, Personal Accounts, and National Saving

The Social Security system was instituted in 1935 as a way to provide benefits to retired workers age 65 and older and to reduce poverty among the elderly. While the system is generally credited with achieving its goal of keeping the elderly out of poverty, it has been plagued for decades by a series of financial problems.

 

The root of this financial instability lies in the design of the system. It is essentially an “unfunded” income transfer scheme where a predetermined package of benefits is paid to retirees and is financed by taxing the current income of working individuals. This approach is in contrast to a “funded” approach where an individual’s taxes would be invested and the proceeds of the investment would be used to provide for the individual’s subsequent retirement benefits.

 

In Social Security’s early years, the income transfer method worked because the ratio of workers to retired beneficiaries was high (16 to 1 in the early years), and people on average did not live much beyond age 65. Thus, tax revenue generally exceeded benefit payments. Technically, this excess was placed in a “trust fund” that invests in special Treasury securities, but in reality, the excess was borrowed by the government and spent on other programs.

 

Over the years, as life expectancy lengthened and fertility rates dropped, the ratio of workers to retirees fell to its current level of just over 3-to-1. Over the next few decades, it is projected to drop to less than 2-to-1. Moreover, the speed of this shift will be exacerbated by the retirement of the  baby boomers. As this occurs, tax receipts will become insufficient to cover benefit payments. It is important to note that the problem would occur even without the  baby boom, albeit somewhat more slowly. And the problem will exist even after the  baby boom passes.

 

Currently, the system has an excess cash flow. In fiscal year 2004, the system took in about $569 billion in taxes and paid out about $502 billion in benefits. The difference in tax revenue and benefit payments together with income taxes on Social Security benefits and interest on the government IOUs in the trust fund amounted to about $156 billion, which was credited to the trust fund. At the end of 2004, the trust fund accounts totaled more than $1.68 trillion.

 

To assess the future financial health of the system, the Social Security Administration (SSA) conducts a financial analysis each year for both a 10-year horizon and a 75-year horizon under three different sets of economic and actuarial assumptions. Figures for the “intermediate” set of assumptions are what one sees most often cited when the subject of the health of Social Security comes up. Currently, the system is in short-term balance. That is, estimated total revenue is expected to exceed expenditures over a 10-year horizon.

 

The long-term prospects are not as bright. Under the intermediate assumptions, it is estimated that total tax revenue (payroll tax plus income tax on benefits) will exceed benefit payments until 2017. After 2017, benefits costs will increasingly “eat into” credited interest until 2027 and thereafter erode the total assets of the trust fund. The trust fund will be exhausted in 2041, and the SSA will then be legally prevented from paying full benefits. It is estimated that the SSA will be able to pay only 74% of benefits in 2043, and these payments will decline to 68% by 2079.

 

The cumulative actuarial imbalance over the 75-year long-term horizon under the intermediate assumptions is estimated to be $4.0 trillion in present value terms and more than $10.4 trillion in the indefinite future. There are only two ways to address this imbalance within the current structure—raise revenue or cut benefits.

 

Correcting the imbalance in the current system would require a payroll tax increase of 1.82 percentage points—more than a 15%  increase—beginning today and extending through 2079 to return the system to a 75-year balance. Conversely, benefits could be cut by a corresponding amount. Moreover, there is no guarantee that such a “fix” would correct the imbalance beyond the 75-year horizon—on the contrary, there is every likelihood that it would not. Nothing short of a fundamental increase in birth rates, death rates, and/or immigration and labor force participation rates could provide something even remotely resembling a solution within the system’s current unfunded, pay-as-you-go structure. Hence, Social Security must be transformed, at least in part, into a “funded” system where real assets back the promised benefits. The best way to do this is with a personal account component as President Bush and others have proposed.

 

Another problem with the current system is the incredibly low rate of return that would be received by someone entering the system today. Estimates of rates of return for various income classes of individuals born in 1990 range from about 1% to 3%—well below rates of return on market securities. Social Security as an investment is simply not a good deal. Moreover, any tax increases or benefit cuts to address the actuarial imbalance will make the rate-of-return problem worse. A personal account component, properly structured to control risk, is the best (and perhaps only realistic) way to increase the long-run return on Social Security and to provide recipients with a suitable nest egg for retirement.

 

But perhaps the most important reason for creating personal accounts is their impact on national saving. Increasing national saving is absolutely necessary to finance investment that will underpin the productivity growth that we will need to provide for an aging population. In his March 15, 2005, testimony before the U.S. Senate, Chairman Alan Greenspan of the Federal Reserve Board said the following: