Fixing Social Security For The Next Century

Fixing Social Security For The Next Century

December 31, 1996

Without fundamental reform, the financial foundation of Social Security as we know it will start to collapse within fifteen years. Projected retirement benefit payments will begin to outstrip the taxes currently dedicated to pay for them as early as the year 2012, according to the Social Security Board of Trustees. The gap widens over a 75-year long-range planning horizon. It amounts to a mounting string of deficits that average an annual 2.2 percent of the wages subject to payroll taxes.

The combination of unfavorable demographic trends, disappointing economic growth, and expanded program benefits over recent decades has done more than jeopardize the solvency of the Social Security program for Old Age, Survivors and Disability Insurance (OASDI). The same factors will make Social Security an increasingly bad deal for many workers. Unlike previous generations of workers, growing numbers of today's younger Americans and their children will not receive any windfall benefits or even high rates of return by participating in Social Security. Instead, they will pay over their working lifetimes greater amounts of payroll taxes than they can expect to receive as benefits. If benefit reductions or payroll tax hikes are imposed to help reduce or eliminate OASDI's long-term unfunded liabilities, the "money's worth" rate of return under Social Security will grow even more negative for future beneficiaries. Not surprisingly, younger people have unusually low levels of confidence that Social Security benefits "will be there" for them when they retire.

The Social Security system has a proud 60-year history of providing retirement income security and reducing poverty for several generations of older Americans. However, its pay-as-you-go financing structure cannot survive much longer in an aging society marked by low birth rates, increased life spans, and inadequate national savings rates. Periodic rounds of political controversy regarding Social Security's financial future have eroded its aura of permanence and stability. Two major "rescue packages" enacted by Congress in 1977 and 1983 included dramatic hikes in payroll taxes and a futile attempt to build up reserves in a "trust fund" for the future retirement claims of baby boomers. Today, there's little trust that the OASDI fund contains much more than a stack of paper IOUs that still must be repaid in the future through additional rounds of tax hikes or borrowing by the deficit-ridden federal government. The "surplus" revenues from higher payroll tax rates imposed over the last two decades certainly hampered job creation and economic growth, but they were not even "saved" to pay for future retiree benefits. Instead, they were consumed immediately on other spending projects in the bloated federal budget.

Critics of Social Security's financial structure also charge that its generous benefits discourage personal saving and encourage too much early retirement. Its formulas for paying benefits treat different classes of retirees unfairly, according to their income level, marital status, longevity, race, and age.

The old answers to Social Security's long-term funding problems have been political procrastination, followed by tax hikes. They won't work anymore. The combined rates for the employee and employer share of payroll taxes have already risen from 2 percent in 1949 to 9.9 percent in 1977, then to 10.8 percent in 1983, and finally to today's level of 12.4 percent. Additional rate hikes would operate as a tax on labor, reduce job growth and work incentives, further distort business decisions, and further worsen the poor money's worth rate of return on Social Security "contributions" for younger workers.

The urgent fiscal problems already facing the Medicare program's Hospital Insurance Trust Fund also will place greater pressure on the payroll tax revenue base that Medicare shares with OASDI. In any event, simply waiting to the last minute to deal with Social Security's rapidly escalating costs in the next century will leave the U.S. economy subject to an accelerating treadmill of higher and higher taxes on a relatively smaller and smaller work force.

The last decade's experiment in spreading out Social Security's financing burden by "pre-funding" liabilities (requiring the retirement program to take in more cash than it plans to pay out over the next few decades) has been tried and found wanting. When mythical "trust fund reserves" are held in the form of federal Treasury bonds, they can be diverted to pay for other government programs. That makes the official federal budget deficit look smaller and reduces political pressure to control spending. Sadly, such budgetary shell games pass up the gains potentially available from long-term investment in productive, private-sector assets. It simply increases the need to finance future retirement benefit obligations at a later date.

Fortunately, a number of public officials and political figures are starting to confront the truth about unstable Social Security promises. Last month, five members of the Social Security Advisory Council recommended fundamental transformation of the retirement program that would allow workers below the age of 55 to directly control the investment of their "employee" share of future payroll taxes (5 percent of covered payroll) through individual accounts. Their Personal Security Account (PSA) proposal also would begin to move Social Security from a pay-as-you-go, defined benefit program to a two-tiered, partially pre-funded retirement plan. Every full-time working American eventually would receive both a flat, guaranteed benefit and another benefit based on the amount of the worker's "contributions" and the latter's investment performance.

Even the other two factions on the 13-member panel recommended some form of investment of "surplus" Social Security payroll tax revenues in private sector assets. More notably, several promising Social Security reform initiatives will be introduced on Capitol Hill this year. The most intriguing one, sponsored by Rep. Mark Sanford (R-SC), would move all younger working Americans and future generations into a retirement system based solely on mandated contributions to private-sector-based investment accounts. The Sanford bill would also allow, but not require, older Americans to redirect their future payroll tax payments into such accounts.

A revolution in federal retirement policy thinking is underway. This year's round of opening debate will set the stage for a major overhaul of Social Security within the next five years. Reformers will draw upon the remarkable track records of several international experiments with privatized investment of old-age retirement funds (especially the Chilean model launched in 1981). They also will point to the superior investment performance demonstrated in recent years by such private sector vehicles as mutual funds and 401(k) retirement plans.

Opponents of major restructuring of Social Security raise a number of objections and concerns. They contend that the long-term financial problems for the old-age retirement program are manageable through a combination of "modest" hikes in payroll tax rates, trims in projected benefit increases, and perhaps investment of a portion of Social Security trust fund "reserves" in private-sector assets under the guidance of a handful of government-selected investment fund managers. Defenders of the status quo wish to preserve Social Security's intergenerational transfer of funds for retirement purposes, as well as its complex cross-subsidies that redistribute income. Under present law, young breadwinners must pay higher payroll taxes and save less in order to finance the spending decisions of current retirees. High-earner workers, dual-earner couples, and workers who do not reach retirement age all receive lower rates of return in order to fund increased retirement benefits for low-earner workers, more "traditional" one-earner couples, and the oldest retirees, respectively.

Opponents of greater reliance on individual-based, private-sector investment accounts to finance future retirement needs about the risks of private market volatility and untimely drops in asset prices, as well as the greater inequality in retirement benefits that decentralized investment decisions may create. They argue that unsophisticated workers will make inappropriate investment decisions and that private fund managers might impose "excessive" administrative costs on them.

Most of all, critics of a private-sector-oriented overhaul of Social Security claim that moving from a pay-as-you-go, defined benefit program to a pre-funded, defined contribution retirement plan that relies on individual investment accounts faces unaffordable transition costs.

A firm rebuttal must clear away many of the myths and illusions concerning Social Security and chart a credible road map for lasting reform. It should emphasize that a combination of spending reductions and higher yielding private investment alternatives offer the best way to dig out from under the approximately $11 trillion in unfunded debt of the current Social Security system. Reform advocates should note that private market risks are not any greater than the political risks facing previously promised Social Security benefits. The private-sector risks are offset by the higher expected payoff from individually owned retirement accounts. They also can be addressed by prudent portfolio management. Risk-averse worriers must be reminded that scary scenarios based on stock market crashes and massive defaults on private bonds would also drastically reduce the federal government's projected income streams. Mere taxing authority alone cannot collect the revenue needed for Social Security benefit payments in the absence of real economic growth, expanding employment levels, and healthy business profits.

As long as public officials help maintain a competitive market in money management, encourage efforts to educate individual investors more effectively, and structure a modest set of back-up, safety net guarantees for workers who fall through the cracks of a private-investment-oriented retirement system, the potential benefits of Social Security overhaul will far outweigh the largely hypothetical costs cited by its critics.

By liberating Social Security funds from political manipulation, we can turn burdensome tax obligations into productive investment opportunities, convert shaky political promises into vested property rights, let individual Americans become owners of their retirement savings instead of tenants living off other workers' taxes, stimulate private sector growth instead of public sector sloth, and take the insecurity out of Social Security. Increased reliance on the much greater efficiency of private markets will allow people to create greater wealth for themselves than the federal government can give them. True Social Security reform will enhance intergenerational equity, put an end to mounting unfunded liabilities, increase private saving, improve productivity, and offer more workers a direct stake in the future of our economy.

We can save and be independent, or be taxed and remain dependent.