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Home > Library > Stable Times > Volume 3, Issue 1
The quarterly publication of the Stable Value Investment Association
First Quarter 1999 • Volume 3 Issue 1
Social Security:
Getting at the Issues of Underfunding & Options for Reform
By Ann Combs, Principal, Washington Resource Group, William M. Mercer, Inc.
The Problem
The demographic trends are irrefutable. The population is aging. Life
expectancies have increased and fertility rates have dropped. The number
of people over the age of 65 is expected to double over the next 40 years,
increasing from 13 to 20 percent of the total population. The number of
active workers supporting each Social Security beneficiary was 5:1 in 1960,
3.3 today, and is projected to drop to 2.0 by 2030. These facts are driving
the pending insolvency of Social Security.
Social Security is essentially a pay-as-you go, inter-generational transfer
program that uses active workers' taxes to pay current retirees' benefits.
To date, Social Security has largely accomplished the objective of providing
a floor of financial support in retirement for millions of Americans. However,
due to a steady expansion of benefits and an increasing number of beneficiaries,
the cost of the system has increased substantially over the years. The program's
long-term deficit is projected to be 2.19 percent of taxable payroll. The
current unfunded liability for Social Security is estimated to be as much
as $9 trillion.
While the cost of the system has grown, real rates of return individuals
receive on their "contributions" have dropped dramatically. Workers
retiring in 1960, on average, received a 15 percent real rate of return
on the taxes they and their employers paid. Those retiring in 1980 earned
eight percent. The average return for workers turning age 65 today is approximately
four percent. In the future, even without taking into account any changes
necessary to bring the system into balance, retirees can expect to receive
only a one to two percent return. If taxes are increased and benefits are
adjusted to restore long-term balance, returns will fall below one percent.
This drop has contributed to an erosion of confidence in the current system,
particularly among younger Americans.
According to the most recent projections, in 2013 the Social Security system
will begin paying out more in benefits each year than it collects in taxes.
At that point, the federal government will have to begin making interest
payments on the special issue Treasury bonds held by the trust funds. In
2021, interest payments will be insufficient to meet benefit obligations
and the trust funds will have to begin cashing in the bonds themselves.
Beginning in 2032, an unreformed Social Security system will be able to
pay only 75 percent of currently promised benefits. The critical date from
a fiscal perspective, however, is 2013, the year the federal government
will have to increase taxes, cut spending and/or borrow in order to meet
its obligations to pay the accumulated interest on the Treasury bonds and,
ultimately, to pay the face value of the bonds themselves.
The Options
Social Security plays an important role in the lives of all Americans.
But in order for it to continue, it must be reformed. Social Security must
be redesigned to recognize the demographic, economic and social changes
in our society since the program was put in place. A new, strengthened system
could continue to provide essential retirement, survivors and disability
benefits, but it also could contribute to capital formation, improve savings,
and reinforce individuals' responsibility to plan for and contribute to
their own retirement. The current system is simply not sustainable without
harm to the economy and future generations of workers and retirees. It's
not a question of whether to reform the system. It's a question of how and
when to do it.
There are really only three ways to restore solvency to the Social Security
system: increase revenues; adjust benefits; or improve the rate of return
realized by the investment of accumulated assets. The magnitude of the problem
effectively requires the adoption of some combination of at least two of
the three options.
Revenue enhancement
If the problem were to be addressed solely through increases in the
payroll tax rate, an immediate 2.2 percentage point increase in the current
12.4 percent tax would be necessary to bring the system into long range
actuarial balance. To keep the system balanced in perpetuity, however, would
require an increase of nearly five percentage points. Seventy-five percent
of the population already pays more in payroll taxes than it does in income
taxes. Payroll taxes are regressive and have a negative impact on cash wages
and jobs. Higher payroll taxes, whether in the form of a higher rate or
an increase in the amount of wages subject to tax, would reduce the rate
of return individuals receive on their contributions and undermine support
for the system.
Benefit adjustments
To solve the problem solely through adjustments in benefit levels would
require a 25 percent across-the-board reduction if current retirees were
included. If those in or near retirement are held harmless, younger workers
would face benefit reductions of 30 to 35 percent. Benefit cuts sufficient
to restore solvency, without some mechanism to replace them such as individual
accounts, would reduce rates of return individuals receive on their contributions
and could erode support for the system. While there are appropriate adjustments
that can be made to the benefit structure, it is probably not feasible,
or desirable, to restore solvency to the current system solely through benefit
reductions. Possible benefit adjustments include increases in the normal
retirement age and possibly the earliest eligibility age, changes in the
benefit formula, modifications to the Consumer Price Index so that it accurately
reflects inflation, and means-testing of benefits.
Increases in life expectancy and improvements in health status have been
quite dramatic since Social Security was put in place and may justify an
increase in the normal retirement age. However, increases in the normal
retirement age will have a negative impact on many employers due to increased
costs for employer-provided retirement, health and disability plans that
will flow from delayed retirement or delayed receipt of Social Security
benefits.
The formula for determining Social Security benefits could be modified in
a way that protects the most vulnerable members of society. This could be
accomplished by reducing benefits and adopting a more generous minimum guaranteed
benefit. Such changes to Social Security's benefit formula can be viewed
as a form of "means testing" because middle- and higher-income
individuals would have less of their pre-retirement income replaced by Social
Security. This approach contrasts with proposals to means test Social Security
benefits based on other assets held in retirement. Asset-based means testing
is popular with the public but would be difficult to administer, could lead
to sheltering of assets and income, create a disincentive to save, and could
undermine support for the Social Security system among middle- and higher-income
individuals.
Increasing the rate of return
Problems posed by proposals to increase revenue and/or reduce benefits
have spurred interest in proposals to improve the rate of return on assets
held by the Social Security trust funds. However, moving to a more funded
system and investing Social Security assets in the private markets where
they would earn a higher real rate of return than is credited to the special
issue Treasury bonds held by the trust funds raises a host of complicated
issues that must be thought through very carefully.
Centralized investment
One approach would maintain the defined benefit plan nature of the current
Social Security system and have the government invest the trust fund assets
through a newly-created governmental agency. Supporters of this approach
argue that sufficient firewalls can be constructed to minimize government
influence over the investments. Critics of this approach, however, raise
a number of concerns. Investments of large amounts of capital by a central
fund could result in undue asset concentration in certain market segments,
leading to share price distortion. The government would own substantial
portions of private companies, raising significant corporate governance
concerns. It would create the potential for social investing - basing investment
decisions on criteria other than financial risk and return. This approach
could improve the financial status of the trust funds but would not create
new savings in the economy. In essence, it would swap current trust fund
investments in debt for investments in equity. The markets would respond
with shifts in the relative cost of debt and equity. Other investors would
then increase the amount of debt they hold and decrease their equity holdings.
Thus, in a macroeconomic sense, the overall economy would be no better off.
Individual accounts
An alternative to investing the Social Security trust funds in the private
capital markets is to redesign the Social Security system so that it is
made up of two components: 1) a defined benefit plan that continues to provide
a guaranteed annuity based on work history and which invests any assets
it holds in special issue Treasury bonds; and 2) a defined contribution
component that consists of individual accounts owned and invested by the
individual participant.
Properly structured individual accounts have the potential to create new
savings and improve the overall economy, raising standards of living for
active workers and retirees. Individual accounts would give all Americans
participating in the Social Security system the opportunity to accumulate
wealth that could be passed on to their heirs. Individual accounts should
not, however, be a substitute for employer-sponsored retirement plans, IRAs,
or other forms of savings. Individuals will need to continue to supplement
their Social Security benefits with personal savings.
The creation of individual accounts also raises many issues with respect
to the funding, administration and governance of such accounts. Depending
on how they are structured, individual accounts could have similar consequences
for the capital markets, including the potential for undue market concentration,
share price distortion, and non-economic factors influencing investment
decisions. However, unlike the centralized investment approach, individual
accounts can be designed in a manner that minimizes these concerns. Individual
accounts also raise a host of administrative issues. Approximately 147 million
Americans participate in Social Security, including young, seasonal, part-time,
and itinerant workers. Many of these workers would have very small account
balances. Who should be responsible for collecting, allocating, and investing
the contributions? Who would administer the accounts? How should fees be
structured? How much investment discretion should be allowed? What is the
proper form of benefit payment; full or partial annuitization or lump sums?
Much work remains to be done in designing effective individual accounts.
Individual accounts that are funded by reallocating a portion of the current
payroll tax also create transition problems. Current payroll taxes are used
to pay current retirees' benefits. Reallocating a portion of these taxes
to create funded accounts for active workers makes it more difficult to
meet our obligations to current retirees. Because those in or near retirement
will continue to receive their promised benefits, younger workers will face
larger reductions in the defined benefit component of their Social Security
benefits than would otherwise be the case if a portion of their payroll
taxes were not reallocated to individual accounts. By taking advantage of
the higher rates of return available in private markets in the individual
accounts, however, individuals should be able to more than offset the benefit
reductions in the defined benefit component of the system.
The Outlook
There is a great deal of bipartisan interest in enacting Social Security
reform legislation this year. The President, anxious to move forward on
developing a legacy, made Social Security reform the centerpiece of his
State of the Union address. Republicans want to show that they can govern
effectively. The window of opportunity, however, is relatively brief. Most
experts agree that once campaigning for the 2000 presidential election begins
in earnest, the candidates' and the parties' positions will harden - making
compromise difficult, if not impossible. Reform is possible, but the conditions
are very fragile. It also is unclear how substantial any reforms will be.
Will Congress adopt fundamental reform to put the system on solid footing
for the next 75 years, or will more limited steps be taken to extend the
solvency of the trust fund for a shorter period of time? Prospects are likely
to rise and fall over the coming months.
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