Understanding Social Security Reform

Edward J. Steffes
2005

The Basics of Social Security

Social Security is not an investment plan like an IRA or 401(k), in which you own the assets in your personal account.  It is an insurance program, whose formal title is Old Age Survivors and Disability Insurance (OASDI).  Benefits are paid out to three groups: the elderly and their dependents (69% of benefits), the survivors of deceased workers (14%), and disabled workers and their dependents (17%).  Your Social Security taxes are paid into one big pool, and benefits are paid out from that pool according to various eligibility requirements and formulas.  Think of it as one big piggybank.

Employers and employees each pay a 6.2% tax on up to $90,000 of an employee's earnings [with some increase since this essay was written].  If you are self-employed, you have to pay both the employer and employee share.  The abbreviation FICA on your pay stub stands for the Federal Insurance Contribution Act.  Employers and employees pay an additional 1.45% each to support Medicare, for a total of 7.65% each.

Social Security benefits are determined by complex formulas that Congress can change.  Your benefits are affected by how much you paid in Social Security taxes, but you do not just get back what you paid in, plus interest.  For one thing, your benefits depend on how old you are relative to the age at which you become eligible for full benefits.  For example, if you were born between 1943 and 1954, you are eligible for full benefits at 66, with permanently reduced benefits if you retire before 66 and permanently enhanced benefits if you delay payments until after 66.  The age of eligibility is a little younger for workers born before 1943, and a little older for workers born after 1954.  Another complication is marital status.  Spouses have the option of basing their benefit on their own earnings record and contributions, or taking a half benefit based on the earnings and contributions of their spouse (or ex-spouse if they were married for at least ten years).  Widows can inherit their spouse's benefit.  (These provisions increase the benefits for one-breadwinner families, while doing little or nothing for households with two earners or no earners.)  Another complexity is the indexing of benefits for inflation, which will be discussed in more detail later.

How important is Social Security income to retired people?  On the average, it provides about two-fifths of all income for people over 65, making it the largest single source of their income.  But that average hides enormous variation.  Some retirees live almost entirely on Social Security, while others have excellent private pensions or personal retirement plans.  However, in recent years employers have been phasing out traditional defined-benefit pension plans, so that retirement is increasingly financed with employer and employee contributions to 401(k)s and similar arrangements.  These offer less security than defined-benefit pensions, and leave workers more dependent on their own frugality and the vagaries of financial markets.  Social Security remains an important part of the retirement picture for most people.

The solvency problem

Much of the Social Security debate revolves around the question of whether there is a "crisis" requiring drastic action, or whether there is a more manageable problem requiring only modest reforms.

Certain demographic facts are generally agreed on.  The ratio of workers to beneficiaries is dropping; that is, the number of people paying into Social Security is dropping relative to the number of people taking out.  There are now about 3.3 workers for every recipient, but that is expected to drop to 2.1 by 2031.  One big reason for this is the impending retirement of the large baby-boom generation (the first of them will reach 65 in 2011).  A second reason is the general increase in longevity, so that people spend more of their lives in the retirement years.  When Social Security began in 1935, a person already 65 could expect to live 12.5 more years; now it's 17.5 years.

On the other hand, certain mitigating factors soften the demographic impact.  Although a large generation is a potential burden on the system when they retire, they also pay more into the system while they are working.  This is especially true of the baby-boom generation, since the women of that generation have had such a high rate of employment.  In theory, the system can generate a surplus when a large generation is in their working years and save it for the years when the same generation is retired.  Another mitigating factor is the trend toward smaller families.  The population is coming to include a higher proportion of elderly, but a smaller proportion of children, so the overall burden of dependency hasn't increased too dramatically.

The 1983 fix

Congress has been aware of a potential problem in Social Security for some time.  The Social Security Amendments of 1983 enacted a number of recommendations that came out of a commission chaired by Alan Greenspan.  The revisions raised Social Security taxes and started taxing benefits for middle- and upper-income retirees.  They also started phasing in higher ages of eligibility for full benefits, in the range of 66-67 instead of the traditional 65.

The result is that the Social Security system is now taking in more money than it is paying out, and is expected to do so until 2017.  The aim was to build up a surplus during this period, which could then be used to pay benefits farther into the future, after inflow no longer exceeded outflow.  As of this writing, the Social Security Administration projects that the surplus should be sufficient to pay benefits until 2041. 

In order to achieve an even longer period of solvency, additional adjustments would be needed.  Congress has a wide range of options for either increasing revenue or reducing expenditures.  The options with the largest potential impact include taxing wages above the current $90,000 threshold, raising the Social Security tax rate, changing the benefit formula, or reducing cost-of-living adjustments for recipients.

The (mis)trust fund

Part of the reason why commentators don't agree if there is a Social Security crisis is that they cannot agree on whether the surplus supposedly generated by the 1983 reforms really exists.  Supposedly there is money in the piggybank to pay benefits until 2041.  But is there?

Recently the system has been taking in more money in taxes than it pays out in benefits.  The difference is going into special accounts called the Social Security Trust Funds. (There are actually two of them, one for retirement and survivor payments, and another for disability payments; I'll refer to it as a single fund, as a convenience.)  Considering how important the trust fund is to the future of the country, it's remarkable that even the financial experts can't agree on what it's worth.  As Money magazine put it: "To understand [the debate], you need to come to terms with the beast known as the Social Security trust fund--a leviathan-size stash that, depending on whom you ask, is either a preposterous myth or as solid as the U.S. Treasury" (4/05, 152).

The Social Security Administration's website makes it sound very straightforward: "The Social Security trust funds hold money not needed in the current year to pay benefits and administrative costs and, by law, invest it in special Treasury bonds that are guaranteed by the U.S. Government.  A market rate of interest is paid to the trust funds on the bonds they hold, and when those bonds reach maturity or are needed to pay benefits, the Treasury redeems them."

The AARP assures us that all is well: "Question: Is Social Security in 'crisis' right now?  Answer: Despite what you may hear, no.  It is universally agreed that even if no changes are made to the current system, Social Security will be able to pay 100% of the money guaranteed to beneficiaries until at least the year 2041."

"Universally agreed"?  Maybe not.  Critics of the existing system, including President Bush, have disparaged the trust fund as just a "file cabinet full of IOUs," suggesting that the alleged surplus is largely illusory. 

Analogy: A college savings fund

To understand how the same trust fund can be evaluated very differently by different observers, consider an analogy.  You want to save for your child's college education, and so you use a special piggybank.  Here are some options:

The disappearing surplus

What exactly is in the Social Security piggybank?  The trust fund holds IOUs from the Treasury.  Some observers regard these as just as sound as the treasury bonds held by private citizens, which is very sound indeed.  Others see a problem with these special bonds, because the government has the power not to honor IOUs it writes to itself.  When the time comes to redeem them, Congress can change the rules to alleviate the fiscal stress on the treasury. 

From this perspective, it makes a difference what the rest of the government is doing with the surplus that it has borrowed from the Social Security system.  If it were investing it for future growth, or at least using it to pay down the national debt, then prospects for paying future benefits would be brighter.  Instead, the Bush administration has simply been spending it.  So instead of an actual surplus, such as we had briefly under the Clinton administration, there is an overall deficit despite the increased revenue from Social Security, and the national debt is rising again.  The IOUs held by SSA represent the government's good intentions to find the money somewhere when benefits start to exceed revenue after 2017 or so.  At that point the government will have to do exactly what it would have had to do if there had been no trust fund: either increase revenues by taxing or borrowing, or cut benefits.  Since taxing is politically difficult, and excessive borrowing could hurt the economy by raising interest rates, the incentive to cut benefits might be strong.

Up to a point then, President Bush is right to disparage the Social Security trust fund as just a bunch of IOUs.  What he hasn't admitted is that his own taxing and spending policies have contributed to the problem by making it impossible to generate real budget surpluses.  Ironically, the temporary surplus created by Social Security reform before he took office gave Bush an excuse to cut taxes, by claiming that the surplus should be returned to "the people."  (One wonders if "the people" would have wanted it if they had understood that much of it was needed for future Social Security payments.)  And the people who produced the surplus by paying increased Social Security taxes were not always the same people who benefited when the surplus was returned through cuts in income and estate taxes.  Social Security taxes apply only to the first $90,000 in income, while the biggest beneficiaries of tax cuts were wealthy people subject to taxes on dividends, capital gains, and large estates.  Making these tax cuts permanent will cost the government trillions of dollars in revenue that could have been used to fix Social Security.

Supporters of the tax cuts argue that they provided needed economic stimulus.  If consumers spend more as a result, that can generate new jobs and tax revenue, offsetting at least partly the revenue lost by the reduction in tax rates.  Nevertheless, the fact remains that the government needed to generate actual surpluses in order to save for future Social Security outlays, and in fact failed to do so.

Optimists and pessimists

To summarize, the Social Security situation can be interpreted in at least two very different ways.  The more optimistic view sees no crisis because the Social Security trust fund is sound.  It holds Treasury bonds, one of the world's most secure financial assets, which the Treasury must honor someday regardless of what it does with the money in the meantime.  The system is solvent until 2041, and all that we need to do is make modest changes in taxes or benefits to extend its solvency beyond that.

The more pessimistic view does see a problem with how the government is using the money it owes to the Social Security trust fund.  By spending that money instead of investing it outside the government or using it to pay down the national debt, the government is putting itself in the position of having to raise the money again by taxing or borrowing.  If that becomes too difficult, Congress will be strongly tempted to ease the burden on the Treasury by cutting benefits, in order to slow down the rate at which the IOUs in the trust fund are redeemed.  The government can evade its responsibilities without actually defaulting on any bonds, since the party to which it owes the money is part of the government itself, subject to Congressional control.  The system cannot be considered solvent, even to 2041, unless the trust fund is placed off-limits to government spending (remember Al Gore's "lock box"?)  Allan Sloan of Newsweek recommends not only that we stop letting the Treasury use the trust fund to finance deficit spending, but also that we invest the money in a wider range of financial assets to earn a larger financial return.

The Bush plan

President Bush would seem to be in the ranks of the pessimists, since he disparages the existing Social Security system and suggests that the government may not be able to pay up when the "IOUs in a file cabinet" come due.  But unlike other pessimists, he doesn't acknowledge the role of his own fiscal policies in perpetuating and aggravating the problem.  Instead, he uses the weaknesses of the present system as a reason to argue for personal accounts.

As of this writing, President Bush's proposal is not a specific piece of legislation but a collection of ideas from his Social Security commission, known as "Plan 2."  Under this plan, 4% of the total 12.6% Social Security tax could be placed in a personal account designated for the benefit of the worker contributing to it, something like a 401(k) plan.  Individuals would have some investment choices and some potential for a higher return than the trust fund gets now.  Those who choose to set up personal accounts would get a lower guaranteed monthly benefit, but they would supplement that benefit by taking the balance of their personal account and converting it to a monthly annuity.  The President likes to call this a "better deal" (perhaps a reference to FDR's "New Deal"), and he likes to claim that individuals can earn a higher return than the government does.  He emphasizes the benefits of personal investing, especially for young workers who have time to build up these personal accounts and ride out some of the ups and downs of the market.  He creates the impression that retirees will end up with higher benefits under this plan.

Criticisms

Critics have called attention to a number of problems with this scheme.  Personal accounts with a variety of investment options would also have a variety of returns.  Retirement benefits would be less predictable, and there would be winners and losers.  When workers came to convert their account to a lifetime annuity upon retirement, the size of the annuity would depend on where the markets stood at that time.

A second problem is the large administrative cost of managing millions of small accounts, costs that would presumably be paid out of investment returns.  If we want the money in the Social Security system to earn a better return, it is administratively more cost-effective to let the Social Security Administration invest it in a variety of securities, like state pension funds do.  (But first we have to stop spending the money!)  Personal accounts are not inherently more successful than group accounts; they are just more costly to administer.  They can actually be less successful if the individual owner invests foolishly.

An even bigger problem is the transition cost to go from an insurance system to a hybrid system supplementing insurance with personal investment.  Under the current system, the dollars paid by today's workers are used to pay the benefits of the retirees who need those dollars first, whether they are current retirees or baby-boomers retiring soon.  The money diverted to personal accounts would not be available to pay anyone's benefits for many years, since it's earmarked for the worker who owns the account.  The initial effect would be to make the solvency problem worse by taking money out of the system.  When this transition cost is added to the obligations the system already has, cuts in benefits become almost inevitable.  Such cuts would probably be across-the-board, applying whether or not a worker chose to create a personal account.

The Bush plan does call for benefit cuts, but in a very subtle form.  They would involve the way benefits are indexed to adjust to changes in the economy.  As it stands now, starting benefits for new retirees are indexed for wage changes in the economy.  Then once retirees start receiving benefits, they are indexed for changes in the cost of living.  The first form of indexing is the one at issue here.  Historically, real wages (adjusted for inflation) have risen due to economic growth and higher productivity, allowing workers to raise their standards of living.  By indexing Social Security benefits to wages, we have insured that the elderly shared in higher living standards.  If we hadn't done that since the 1930s, we would have locked the elderly into a 1930s standard of living, so that over time they fell farther and farther behind the rest of the population.  Workers would then experience a more dramatic decline in living standards when they retired.  The Bush plan calls for continuing this indexing only for the poorest 30%, but letting benefits erode relative to wages for the upper 70%. 

If the change in indexing is taken into account, the plan isn't as good a deal as it seems, even for the younger workers to whom it is supposed to appeal most.  Young workers have more to gain from personal accounts, since they have time to harvest long-term gains from the stock market.  But they also have more to lose from the change in indexing, since the gap between retirement benefits and wages would widen over their lifetimes.  An analysis by Jason Furman of NYU didn't find any age group that did as well under Bush's plan as they would under the present benefit formula.

Other proposals

Democrats generally oppose personal accounts and prefer to work within the existing social insurance approach.  They are divided into optimists and pessimists as those positions were described above.  In general, optimists call for only modest changes in taxes or benefits, while pessimists want to address the larger problem of Social Security revenues being used to finance the federal deficit.

Even Republicans have been backing away from the President's plan.  Some support an approach proposed by Senator Robert Bennett of Utah.  This calls for changes in the indexing rules but no personal accounts, so it is really just a subtle benefit cut.  A bill proposed by House Republicans goes the opposite way, calling for personal accounts but no benefit cuts.  The personal accounts are set up a little differently, inside the trust fund instead of outside it, but it's hard to see how that would help.  The bill doesn't appear to address the solvency problem at all, so it seems to be just an effort to get personal accounts into the legislative debate.