According to the best available projections, the Social Security system does not face any major financing problems. If left untouched it would continue to pay benefits for the next 35 years, while the baby boom generation retires. To keep the system sound indefinitely after that would require only minor changes, if any.
Nonetheless there is widespread public skepticism about the future of Social Security. This skepticism is based on a number of popular misconceptions that are examined in the last section of this paper. The paper also carefully examines the impact of the most important changes proposed by the various factions of the Social Security Advisory Council. These changes include:
Among this report's key findings and conclusions:
Increasing the basis for computing benefits from 35 to 38 years of earnings history for future retirees would disproportionately impact women, and especially low-income women.
Raising the retirement age, over time, from 67 to 70 will disproportionately harm African-American male retirees, whose life expectancy is considerably shorter than that of their white male counterparts. Low-income and blue-collar workers would also bear a disproportionate share of the burden.
Under the extensive Private Savings Account (PSA) privatization plan proposed by five of thirteen Council members, average benefits for future retirees would be less than under current law.
Reducing the Cost of Living Allowance for Social Security benefits, in accordance with the Boskin Commission's recommendations, would cause a significant increase in poverty among the elderly.
Although the Council unanimously opposed such a move, the Congress is currently considering a recommendation to reduce the Cost of Living Allowance (COLA) for Social Security benefits. Last month the Boskin Commission, a panel of economists appointed by the Senate Finance Committee, recommended a reduction in these COLAs on the basis of their claim that the Consumer Price Index overstates inflation by 1.1%.
Analysis of past data indicates that if such an adjustment had been implemented 10 years ago, an additional 600,000 elderly Americans would be living in poverty today. If Congress were to implement this reduction today, we would expect similar consequences over the next decade.
_________________________
The proposed changes examined in this report are not only regressive and inequitable, they are also unnecessary. The widespread belief that the retirement of the baby boomers will impose a burden on future generations is based on a number of misconceptions. For example, it is common to lump Social Security and Medicare together under the rubric of "entitlements for the elderly." The cost of medical care has indeed been growing at an unsustainable rate for decades. If it were to continue to grow at this rate, health-care spending would eventually consume most of our national income. This would be true even if there were no Medicare system at all, since the increased spending on Medicare is driven by the costs of the private health care system. This illustrates the need for health-care reform, but it has nothing to do with the Social Security system, which faces no such crisis.
A few of the non-regressive changes recommended by the Council - for example, bringing non-covered state and local employees into the system - would close 38% of the projected financing gap.* The rest could be covered with a payroll tax increase phased in at one-tenth of one-percent each year, split between employee and employer, for the years 2011-2032. This would amount to a total tax increase of 1.1 percentage points each for the employer and employee.
If such a tax increase were to prove necessary, the average worker's income would still be 30% higher in 2030, and 89% higher in 2070, after subtracting payroll taxes and adjusting for inflation. Clearly there is no problem of intergenerational equity here.
And all this assumes that the next 75 years will be the worst in American economic history. If future growth turns out to be more like the past and present, there would be hardly any financing gap at all.
In view of the prevailing public confusion over the Social Security system's actuarial soundness, and given the regressive nature of the changes proposed by various factions of the Council, it would be best to leave the system as is. Since the program is sound for at least the next 35 years, there is no pressing need for change. In such a situation it is clearly best to wait until a more honest and equitable policy debate can take place.
Every four years the Secretary of Health and Human Services is required to appoint an Advisory Council on Social Security to review the status of Social Security and other federal entitlement programs. The present Advisory Council was appointed in June of 1994. The Council was unable to agree upon a unified proposal but has instead divided into three factions, each putting forward its own plan.
Six members of the Council support the Maintenance of Benefits (MB) plan, which comes the closest to maintaining the present system. Five others have supported a partial privatization plan which would put an amount equal to almost half of the Social Security payroll tax into Personal Savings Accounts (PSA). These would be invested by individual employees in financial markets. A smaller-scale privatization supported by two Council members would create Individual Accounts (IA) funded by a 1.6% payroll tax increase.
Although there are some areas of common agreement, the factions are very much divided, most strongly over the question of privatization, which the MB group vehemently opposes. This report will not attempt to evaluate each plan in its entirety, but will instead focus on particular elements of the various plans.
As will be explained in some detail below, the Social Security system faces no threat to its solvency in the near or even intermediate future. Whatever changes, if any, that will be required to assure its long-term solvency are projected by the Trustees of the Social Security Trust Fund to be minor and easily manageable. In the face of much public and policy-making opinion that runs counter to these basic facts, it is reassuring that the Advisory Council has reaffirmed the basic soundness of the system.
The Council has also unanimously rejected the idea of reducing benefits by using a lower measure of inflation, instead of the Consumer Price Index, to calculate the Cost of Living Allowance for Social Security benefits. The Boskin Commission recommended this change in December. The Council's clearly stated consensus against this proposal, in spite of its sharp disagreement on other major issues, should carry considerable weight.
The Council also recommended against subjecting benefits payments to any kind of means test. This is important because the universality of Social Security benefits is vital to its character as a system of social insurance. Means testing, which would make eligibility for Social Security benefits dependent on the level of income during retirement, would change the character of the system. It would constitute a very dangerous step toward converting Social Security to a welfare program, thus rendering it much more politically vulnerable to future cuts. The Council has also noted that means-testing of benefits discourages savings by reducing the benefits of those who save for their retirement.
However, there are a number of changes proposed by various factions of the Council that could undermine some of the most fundamental purposes and achievements of the Social Security system. This paper will evaluate the impact of such changes as proposed by the three plans. We will focus on three sets of changes which we consider to be the most important - and probably the most controversial - from the point of view of public policy. These include the following:
The current method of computing a retiree's benefits is based on the earnings record of the employee from age 22 through 61. The benefit is computed on the basis of the employee's 35 best years - i.e., those of highest earnings.
The majority of the Advisory Council proposes to add three years to this computation - benefits would therefore be computed on the basis of the employee's best 38 years. This would be phased in for new beneficiaries almost immediately, from 1997 to 1999. The effect would be to reduce the benefits of all new retirees from this point onward, since the three years added to the computation period would be, for almost all retirees, years of significantly lower earnings.
The impact of this change would hit women who retire on the basis of their own earnings much harder than men. This is because women, on average, spend more time outside of the labor force. Approximately 75% of men, but only 25% of women, have 35 or more years of covered earnings. As a result, most women retirees will have three years of zero earnings added to the computation of their benefits under the 38-year rule.
Table 1 shows the effect of this change on the benefits of various groups of retirees. A typical female worker who retires on the basis of her own work record, and who receives the average benefit for women, would be paid $621.30 per month under current rules. Under the proposed change she would lose 4.4% of her benefits, or $328.80 on an annual basis. This is a significant cut, and since the first year of benefits serves as the base for all future cost-of-living adjustments, it would be compounded throughout retirement. By comparison, the average male beneficiary would lose about 2.6% of his benefits.
Table 1: Benefit Cuts Due to Proposed Change in Computation Period
Monthly Benefit Monthly
Based on Benefit Based
35-year on 38-year
Computation Computation Change in Percent Change
Retiree Period Period Yearly Benefits in Benefits
Low Benefit $425.61 $392.01 -$403.20 -7.9%
Female
Average $621.30 $593.90 -$328.80 -4.4%
Benefit Female
Average $810.00 $788.86 -$253.68 -2.6%
Benefit Male
High Benefit $1,285.12 $1,269.22 -$190.80 -1.2%
(Maximum
Taxable
Earnings)
Source: SSA, Annual Statistical Supplement to the Social Security Bulletin, 1996; author's calculations.
In addition to reducing women's benefits more than men's, the proposed change would take a larger percentage of benefits from low-income than high-income retirees. The hardest hit would be women whose benefits under the current system are $425.61 or less. A female retiree at this benefit level would lose 7.9% of her benefits. This amounts to $403.20 on an annual basis, or nearly a month of benefits.
As shown in Table 1, retirees who earned the maximum taxable income ($62,700 in 1996) throughout their working lives would lose only 1.2% of benefits. The percentage loss suffered by low-benefit female retirees is thus more than six times that of the highest earnings group. The regressiveness of this change is compounded by the fact that poor and low-income retirees are overwhelmingly more dependent on Social Security income than those who are better off. As shown in Table 2, retirees in the bottom 20% of the income distribution depend on Social Security for about 81% of their income. By contrast, these benefits are only 23% of the income of senior citizens in the top quintile.
This means that many of those who will be hit the hardest by this cut are among those most dependent on Social Security. For example, the median income of an individual poor person 65 or older was $5,427 in 1994. Eighty-three percent of the income of this group, which numbers 2.4 million people, is from Social Security. A poor female retiree at this income level who is hit with the full effect of the proposed computational change would lose $358, or 6.6% of her annual income. Although current beneficiaries would not be affected, this would still inflict a terrible hardship upon the elderly poor who will retire a few years from now.
Table 2: Income from Social Security for Households Aged 65 or Older, 1994
Percent of Income from
Quintile Income Social Security
---------- ---------------- ---------------------
Bottom 20% $7,734 - $12,213 81.2%
Top 20% Above $31,179 22.7%
Source: Social Security Administration, Office of Research and Statistics, Income of the Population 55 or Older, 1994 (January 1996).
By contrast, employees who earned the maximum taxable income throughout their working lives would lose less than one quarter of one-percent of their income.
It is especially difficult to justify a cut that hits elderly women the hardest when their poverty rate is already so high. The official poverty rate for women aged 65 or older is 14.9%. It is 25.3% for elderly women who are not living with family members. This compares with a poverty rate of 12% for the general population. It is difficult to determine exactly how many women will be disproportionately affected by the proposed computational change. In 1995, there were about 1,277,600 women newly entitled to Social Security benefits. Of these, 683,500 (53.5%) were entitled on the basis of their own earnings records. The remainder received benefits as wives or widows, based on their husbands' earnings, and therefore would not be disproportionately impacted on the basis of their years spent outside the labor force.
A large fraction of this 683,500 are dually entitled - i.e., on the basis of their own and their husband's earnings, and receive benefits based on the latter. Even if we assume that half of these women are dually entitled - a likely overestimate - this still leaves 341,750 women each year who would be disproportionately affected by the cut.
The number of low income women in the hardest hit category is also quite large. Although $425.61 is a relatively low benefit amount, the proportion of female new retirees who would fall below this amount (adjusted for inflation) when the proposed change takes effect, and therefore suffer a 7.9% benefit cut, is substantial. About 32% of women who retired in 1995 fell within this category. Even if half of these are dually entitled - again, a likely overstatement - this would still leave 109,360 women per year in the hardest hit group.
The Charter for the 1994 Advisory Council on Social Security mandates that it address "general Social Security program issues such as the relative equity/adequacy provided for persons at various income levels, in various family situations, and various age cohorts, taking into account such factors as the increased labor force participation of women, lower marriage rates, increased likelihood of divorce, and higher poverty rates of aged women." Members of the Council who support this computational change have failed to take into account its effect on poor elderly women. Furthermore, the number of women affected by these changes is likely to increase in the future, for exactly the reasons spelled out in the Charter: the higher labor force participation and divorce rates of successive cohorts of retirees. Each year more women will be retiring on the basis of their own earnings, rather than the earnings of their spouses.
The PSA and IA plans propose to increase the retirement age - the age at which people become eligible for full benefits - over time, to 70, and to speed up the implementation of the increase to 67 that has already been enacted into law.
Increasing the retirement age is an extremely regressive way to trim the outlays of the Social Security system. It also hits African-Americans much harder than whites. The main reason for both of these differential impacts is straightforward: African-Americans, and lower-income workers generally, have a considerably lower life expectancy as compared to the general population. Each year that the retirement age is raised a much larger bite is taken out of these groups' retirement.
This effect is most pronounced for African-American men. The life expectancy of an African-American man who is currently 40 years old is about 70.6 years, compared with 76.1 years for white men. A typical 40 year-old Black male worker can thus expect about 5.6 years of benefits if he retires at 65, about half of the 11.1 years his white counterpart will enjoy.
This means that the first two years that have already been added to the retirement age reduce a Black male's expected lifetime benefits by 36%, or twice the reduction suffered by the white male worker (18%). These changes, enacted in 1983 and phased in beginning with retirees who reach age 62 in the year 2000, raised the age of eligibility for full retirement age to 67.
The effect of this change is shown in Tables 3a and 3b. Table 3a shows what would have been expected to happen over the next 64 years if the retirement age had been left at 65. Since life expectancy is projected to increase, the expected retirement years of a 40 year old Black male would slowly begin to catch up with the white male worker - although even by 2061 it would only reach a ratio of 62%.
Table 3a: Expected Years of Retirement for 40-Year Old Males With the Retirement Age Fixed at 65 (by Race)
Year* Black White
----- ----- ------
1977 4.2 8.6
1983 5.3 9.7
2000 5.6 11.1
2013 7.2 12.8
2037 8.4 14.1
2061 9.6 15.4
Table 3b: Expected Years of Retirement for 40 Year-Old Males With Increases in the Retirement Age Under Current Law (by Race)
Expected Retirement
Retirement Span Under Retirment Age
Age (Under
Year* Current Law) Black White
----- ------------ ----- -----
1977 65 4.2 8.6
1983 66 4.3 8.7
2000 67 3.6 9.1
2013 67 5.2 10.8
2037 67 6.4 12.1
2061 67 7.6 13.4
*This is the year that a 40 year-old worker would be affected by the change in the retirement age. For example, workers who turned 40 in 1977 comprise the last cohort eligible for full benefits at age 65. Workers who turned 40 in 1983 will face a retirement age of 66; those who will turn 40 in 2000 will be eligible for full benefits at age 67.
Table 3b shows the change in expected retirement years due to current law, which raises the retirement age to 67. The drop from 5.6 to 3.6 years, as noted above, is a drastic cut for African-American men. If no further changes were made, they would slowly recover these losses and increase their expected retirement span to 7.6 years over the next six decades.
Table 3c shows what would happen to the expected retirement spans of Black and white males if the PSA or IA plan were implemented. A Black male worker who is 24 years old today, and therefore reaches 40 in 2013, would be in the first cohort to face a retirement age of 68. He would lose about 19.2% of his expected retirement years as a result of this increase. A white male would lose about 9.3%.
By the time the retirement age is raised to 70, the loss for Black males as compared to current law would be 39.5%, and 22.4% for white males. This is a very large cut for both groups. As can be seen in the table, even with the projected increases in life expectancy over the next 64 years, a 40 year old Black man in 2061 would expect only 4.6 retirement years, as compared to 4.2 years for his counterpart of the late 1970s. The proposed increases in the retirement age would thus severely impede progress toward a decent retirement span, both in absolute terms and relative to whites, for African-American males over nearly an entire century.
Table 3c: Expected Years of Retirement for 40 Year-Old Males Given Increases in the Retirement Age as Proposed in the PSA and IA Plans (by Race)
Expected Retirement Percentage Cuts in Retirement
Retirement Span Under Retirement Span Due to PSA and IA Proposed
Age under Age Increases in Retirement Age
PSA and IA
Year* Plans Black White Black White
---- ---------- ----- ----- ----- -----
1977 65 years 4.2 8.6 - -
1983 66 years 4.3 8.7 - -
2000 67 years 3.6 9.1 - -
2013 68 years 4.2 9.8 -19.2% -9.3%
2037 69 years 4.4 10.1 -31.2% -16.5%
2061 70 years 4.6 10.4 -39.5% -22.4%
*This is the year that a 40 year-old worker would be affected by the change in the retirement age. For example, workers who turned 40 in 1977 comprise the last cohort eligible for full benefits at age 65. Workers who turned 40 in 1983 will face a retirement age of 66; those who will turn 40 in 2013 will be eligible for full benefits at age 68.
These differences would of course be less pronounced if we were to look at, for example, life expectancies for those who survive to age 65. We consider life expectancy at age 40 here because by this age the typical worker has already paid taxes into the system for almost half of his or her working life. As noted above, the typical African-American male worker in this situation can already expect to receive less than half the retirement years for these taxes than a white male worker. The fact that raising the retirement age will widen this gap should raise serious doubts about the fairness of such a proposal.
It cannot be overemphasized that these differential impacts would apply not only to racial groups, but to income groups as well. Although the U.S. government does not collect mortality statistics by class - e.g. by income, education, or occupation - there is considerable evidence that most of the racial differences in U.S. mortality data are attributable to class differences. For example, the difference in life expectancy between low and high income groups of 25 year old males was found to be about 23%, even greater than the 16.2% white-black differential. We would therefore expect similarly severe and disproportionate effects on low-income and blue-collar workers from raising the retirement age.
Both the PSA and IA plans accelerate the rate at which the 67 year retirement age is phased in. This will add to the regressive and racially disproportionate effects of the benefit cuts described above, as will the PSA's additional proposal to raise the early retirement age from 62 to 65.
It should be noted that although this analysis is presented in terms of workers retiring at the age of eligibility for full benefits, the fact that most people choose early retirement between ages 62 and 64 does not change the results. Benefits under early retirement are reduced: e.g., a worker who retires at 62 will receive 80% of the benefits he would have received if he retired at 65. This reduction, which remains in effect for the rest of the beneficiary's retirement, is calculated so that on average, the retiree will receive the same amount of benefits over the rest of his life.
Early retirement benefits at age 62 will thus be reduced to 75% of full benefits when the retirement age increases to 66, 70% for 67, with similar reductions as the age increases to 70. As these changes are phased in, they will also have a very significant regressive impact on the income distribution of the elderly. This is true because any across-the-board cuts hurt lower income households more than upper income ones, since the former are dependent on Social Security for a much greater percentage of their income.
The most controversial of the proposed changes are those put forward by the PSA and IA factions that would involve a shift from the collective social insurance of the present program to a system based on individual savings. This "privatization" of Social Security would only be partial: the PSA plan would put five percentage points (or 48% of the current Social Security payroll tax) into individual accounts, and the IA plan would allocate only 1.6% of payroll for these purposes. Both plans would retain at least some of the current system of social insurance: the IA plan would add its individual accounts to the present structure, with some benefit reductions, while the PSA plan would retain a minimum $410 monthly benefit as a safety net beneath the personal accounts. Furthermore, the system itself would remain publicly administered (under the IA plan), and the savings under both plans would be mandated by the government.
Nonetheless this proposed shift to government-mandated individual savings, invested in private stocks and bonds, would be the most drastic change in the history of the Social Security system.
Proponents of these changes have offered two basic rationales for the shift away from social insurance. At the practical level, there is the promise of a higher return, on average, from private securities than from the government bonds in which the Trustees of the Social Security trust fund are now required to invest the fund's accumulated surplus. On a more theoretical plane, proponents have argued that these changes will help raise the national savings rate. We will examine each of these rationales in turn.
Rates of Return
The most significant flaw in the evaluation of the PSA and IA plans by their proponents concerns their estimation of the rate of return on funds invested in the stock market. They assume a 7% annual real rate of return on stocks. This rate of return is based on the historical rate of return on equities over the past 60 years.
The problem is that this assumption is inconsistent with the Council's projected rate of growth of the economy, which are based on the Trustees' intermediate projections. There is a huge difference between the 3.5% average annual growth in real GDP in the past, and the 1.47% growth projected for the next 73 years. The returns on equities cannot be the same under these vastly different conditions.
To understand why this is not possible, consider the components of this rate of return: dividend payments and the capital gains that accrue from the appreciation of stock prices. Both depend on the rate of growth of profits. As profits grow, a corporation can afford to pay a higher dividend per share. Growing profits are also the source of increases in the price of the stock: investors may anticipate higher dividend rates or an increase in the value of the corporation due to reinvestment of profits. Thus, regardless of the individual firm's allocation of profits between dividends and retained earnings, appreciation of the price of its stock depends on the growth of profits. For some period of time, investors may overvalue or undervalue stocks relative to their present and expected future earnings, but no one believes that such a process can continue indefinitely.
The long-run return on equities is thus linked to the rate of growth of profits, which, in turn, grow in line with the economy. It is of course possible for profits to grow faster than the economy, which would mean that the capital share of income increases relative to that of labor. But the Trustees assume no such shift in the share of income from labor to capital over the next 75 years, and there is no reason to assume otherwise. Therefore, in the long run the value of stocks can be expected to grow at about the same rate as the economy.
The average dividend rate per share is currently 2.87% for stocks. The Trustees' projected rate of economic growth over the next 75 years is about 1.47%. Adding these two together gives a projected return on equities of 4.34%. A projected return significantly higher than this - e.g., 7% - is simply inconsistent with the rest of the Trustees' projections about the economy.
To illustrate this inconsistency, Figure 1 shows what would have to happen for stocks to provide a 7% rate of return over the next 75 years. Again, this is based on the assumptions about economic growth that the Council has adopted. The price of stocks, relative to their earnings, would have to expand astronomically. This price to earnings ratio, as it is known, would have to rise to 79:1 by 2035 and 216:1 by 2055. In other words, with dividend payouts directly constrained by the rate of growth of profits, the only way to get a 7% return is for stock prices to rise at an increasing rate until they bear no relation whatsoever to the assets they represent.
Figure 1: Price to Earnings Ratios Implied by a 7% Annual Real Return on Equities
Source: Baker (1996).
Of course, no one can say that speculative bubbles, driven by buying that is divorced from potential future earnings, will not occur. Indeed, some analysts would consider today's near record price to earnings ratio of 20:1 as a prime example of such a bubble. But the ratios required under the Council's assumptions are clearly impossible, and any speculative bubble would burst long before it reached such levels.
There is a world of difference between a projected 7% rate of return and the 4.34% that is logically consistent with the Council's assumptions. If $1000 is invested at 7% for a working lifetime (say, 40 years), it will grow to $16,445. At 4.34% it will grow to $5,675.
Not much remains of the practical argument for shifting to a system of private accounts once we adopt a rate of return that is consistent with projected economic growth. Returns to retirees would be further reduced by the costs of management, oversight, insurance, and brokerage fees. These would probably be in the range of 1.5% to 2.5% a year, depending on the size of the account.
Baker (1996) has estimated the retirement benefits that could be paid out from a PSA plan, based on these costs and rates of return. Even under the best of circumstances, these do not compare favorably with Social Security benefits as presently structured. The Trustees project a life expectancy of about 19 years for people reaching age 65 in the year 2040, and the current system pays benefits of about 57% of final wages for low income workers and 31% for high income workers. (As noted above, the structure of benefit payments in the current system is progressive.) The accumulated assets under the PSA plan could support a low income worker at about 16% of final wages, and a high income worker at 19% of final wages for this period of time. Even when the minimum benefit is added to these payouts, they fall well below the benefits of the present system.
But the worst part of the proposed privatization is that these returns are only averages for all retirees. Some will do better, and some will inevitably fare much worse. Some of this will be due to bad choices, whereas others will just have bad luck. Returns fluctuate widely from year to year, and from decade to decade. From 1968-78, for example, the stock market lost 44.9% of its value in real terms. Workers who have to retire during this kind of a downturn will certainly have a lot less to show for their Personal Savings Accounts than those who retire near the peak of a bull market.
In sum, the partial privatization of the PSA plan would jettison most of the security that the present system achieves and replace it with a much riskier program that promises, on average, lower benefits. At the same time it would create a two-tier system that would further separate the interests of retirees at various income levels. The poorer retirees would be disproportionately more dependent on the remains of the present system as embodied in the minimum benefit. The minimum benefit is supposed to be indexed to the growth of average wages, and then adjusted for inflation after retirement. However, unlike the present system in which all retirees have an interest in maintaining the Cost of Living Allowance, the minimum benefit would be most important to low-income retirees. The safety net provided by Social Security would therefore be much more politically vulnerable to further dismantling than in the present system.
Privatization and Savings
The second argument for the partial privatization of Social Security is more theoretical, although it has been widely popularized. This is the argument that privatization can increase national savings.
Since there is a lot of confusion surrounding this issue, it is important to state what should be obvious at the outset: the movement of funds from government bonds to private securities does not increase national savings. This is true regardless of how it is accomplished: whether the Trustees move a portion of the system's assets to private securities (as is under consideration in the MB plan) or whether this shift is accomplished through tens of millions of personal accounts. At present, the trust fund is buying about $60 billion of Treasury securities each year. If these funds are shifted to private securities, the Treasury will have to borrow this sum from other sources. The amount of national savings would remain unchanged.
The PSA plan also increases payroll taxes in order to finance the transition to individualized accounts. This would be necessary because the current system is "pay-as-you-go"- i.e., the benefits paid out each year are funded by current payroll taxes, as opposed to being funded from assets accumulated from the retirees' (and employers') contributions, as in a private pension plan. In order to make the transition to "partial advance funding," a tax increase is necessary, since the system must continue to pay full benefits to current retirees out of current contributions while the assets of the Personal Savings Accounts are accumulating.
By definition, national savings equals the sum of private and public savings. Therefore, as a matter of accounting, any tax increase will automatically increase national savings. Since the PSA plan includes a payroll tax increase, it increases national savings. However, this is purely the result of the tax increase, and not of the change in the structure of the Social Security system.
To understand this, consider what would happen if the present Social Security system were transformed into a program based completely on Personal Savings Accounts. During the transition to this system, very large tax increases would be needed in order to maintain current benefits while the personal accounts were accumulating funds. At the end of the transition period - say 40 or 50 years - the new system of individualized accounts would have accumulated enormous assets. At this point, if the payroll tax were returned to its pre-transition level, the national savings rate would return to its pre-transition level. The Social Security system would then be fully funded, instead of "pay-as-you-go." But annual national savings would not be any higher, and the funds accumulated in the personal accounts would simply be the result of the increased payroll taxes collected during the transition.
Economists do not fully understand either the causes or the extent of the decline in the national savings rate. The connection between America's low savings rates and the growth slowdown of the last two decades is unclear: it may just as well be that the lower savings rates are the result of slower growth, rather than the other way around. In view of these uncertainties and the absence of consensus, the case for attempting to restructure the Social Security system in order to increase national savings is very weak. In any case it is clear that partial privatization of the system will not by itself contribute to any increase in national savings.
The present Advisory Council is the first since 1979 to emphasize questions of long-term financing. Although the Council has noted that the Social Security system does not face any immediate threat to its solvency, its focus on long-term financing implies that there is a serious problem in this area. This is certainly the public perception regarding the Social Security system - polling data show that most young people do not believe that Social Security will provide them with anything in their retirement years. The Council explicitly acknowledges these widespread beliefs as the impetus for their attempt to increase, through their proposed changes, the return that today's younger generations will get from their Social Security taxes when they retire.
The idea that the retirement of the baby boom generation will severely strain the Social Security system, or reduce the living standards of future generations, is so commonly accepted that it has become the backdrop for all discussion of Social Security. However, it is not true. In what follows we attempt to clarify some of the most prominent misconceptions and confusion surrounding the issue.
The Social Security Trust Fund
Contrary to popular belief, the retirement of the baby boom generation has already been taken care of. If the Social Security system were left exactly as it is today, with no changes in either taxes or benefits, payments to beneficiaries would continue uninterrupted for the next 35 years. This is a relatively long time horizon, and the reason for this financial solvency is that the Trustees of the system's trust fund are required each year to evaluate the actuarial balance of the fund over the next 75 years. In 1983 the payroll tax and retirement age were increased in order to bring the system into actuarial balance, taking into account the vast increase in the number of beneficiaries that would ensue as the baby boom generation begins to retire in 2008.
As a result of this planning, the trust fund has accumulated assets of well over $500 billion, and this sum is projected to grow to more than $3 trillion (in current dollars), before it begins to decline in 2021.
It has become common for policy analysts who wish to argue that the system is in serious trouble to dismiss these assets as irrelevant. The argument is as follows: the federal government is borrowing (and spending) the trust fund's annual surplus each year. Therefore the government will have to cut spending, raise taxes, or increase the federal budget deficit when the baby boomers begin to retire. In other words, when the Social Security trust fund stops loaning money to the government, and then starts redeeming its bonds, the Treasury will have to make up this difference elsewhere. It follows that the fund's accumulated assets - often dismissed by these analysts as "mere pieces of paper" or "IOU's from one part of the government to another"- cannot avert the fiscal crisis brought on by the swelling of retirement cohorts.
This argument has a ring of plausibility to it, but on closer inspection it turns out to have nothing to do with the solvency of the Social Security system. Someone who believes that the rest of the government is spending too much money can certainly argue that it should be cut back (or taxes raised). She might even argue that these measures should be taken before the Social Security trust fund's annual surplus begins to shrink, if she thinks the government should not increase its borrowing from other sources. But this is an argument about the rest of federal spending, not Social Security spending. The trust fund is collecting enough taxes now to pay for the future retirement of the baby boom generation. It is investing its savings in government bonds. These bonds are just as real as the ones owned by private institutions or individuals. To deny this is to say that the government's obligation to pay back what it borrowed from financial institutions or individual investors is somehow different from its obligation to pay back what it borrowed from 141 million employees who pay Social Security taxes.
It must also be emphasized that the assumptions under which the system can claim to be solvent for the next 35 years are relatively pessimistic. The Trustees of the Social Security Trust Fund produce three sets of estimates for the operations of the system: a low-cost, an intermediate, and a high-cost scenario. The intermediate projections are considered to be the most likely outcome, and these are therefore the ones employed by the Advisory Council, as well as most policy analysts.
The intermediate projections show growth slowing from its current rate of 2.2% to 1.4% by 2030, while unemployment averages 6.0% throughout most of the period. Growth slows even further to 1.2% by 2070. Figure 2 compares these growth projections with the actual performance of the economy over the last thirty-five years. As can be seen in the figure, the projected growth rate from now until 2030 is less than half the growth rate of the last 35 years. For 2031- 2070 it is even smaller. Yet even under the assumption that the next 35 years will be the worst such period in U.S. economic history, the Social Security trust fund will remain solvent. Critics have often confused the issue by conflating the operations of Social Security with those of Medicare, lumping both together under the rubric of "entitlements for the elderly." There is indeed a serious problem with Medicare costs, although it is not primarily the result of demographic changes. The problem is that health care costs in the private sector have been rising at an unsustainable level for decades. This crisis of the private health care system spills over to Medicare because the government has to pay private health care providers for medical services to the elderly. All this makes a strong case for health care reform, but it has nothing to do with Social Security.
Figure 2: Rate of Growth of Real GDP Historical and Projected (OASDI Trustees' Projections)
From 1960-1995 the average rate of growth of real GDP was 3.27%. The Trustees of the OASDI (Old-Age and Survivors Insurance and Disability Insurance) Trust Funds have projected that average GDP growth will slow to 1.67% over the next 35 years. Their long-range projections are even more pessimistic, averaging 1.30% from 2031 to 2070. Source: OASDI Board of Trustees, 1996 Annual Report.
Demographics and Intergenerational Equity
The idea that "demographics is destiny" - or as some of the most prominent critics of Social Security like to say, that we are facing a "demographic time bomb" - is difficult to shake, irrespective of the facts. Much of its widespread appeal is undoubtedly due to the fact that most people are aware of the expansion in the birth rate that took place from 1946-64, and know that these "baby boomers" are nearing retirement age. With a few carefully chosen statistics, for example that the number of workers for every retiree will shrink from 3.3 today to 2.0 in 2040, it is easy to create the impression that these retirements will impose a crushing burden on future generations.
One simple way to keep this issue in its proper perspective is to realize that our society has already borne the "burden" of this demographic explosion once before, when the baby boomers were children. Richard Leone has aptly posed the question in a way that ought to put the demographic doomsaying to rest: If we were able to feed, clothe, house, and school this cohort when they were growing up, why shouldn't we be able to take care of their retirement when they are old? After all, the care of boomers as children was managed with a per capita income that was just a fraction of what we will have in the 21st century. The economy prospered as never before and we managed a savings rate that was considerably higher than it was today. And all this was accomplished with a smaller percentage of people working than we will have when the baby boomers are retired.
This simple common sense - that the baby boomers can't be more of a demographic problem in retirement, for a much richer country, than they were as dependent children - is confirmed by an honest look at the numbers. The first column of Table 4 shows the growth of average wages according to the Trustees' projections. Even at these relatively slow rates of growth, the average wage in 2030 is still 36.2% higher than today, after adjusting for inflation. By 2070 the increase is 99.7% - i.e., real wages will have doubled.
Table 4: Projected Average Real Wages (Constant 1996 Dollars)
Projected Real Wages with the
Social Security Trustees' CPI Adjusted According to the
Year Projected Average Real Wage Boskin Commission's Recommendations
---- --------------------------- -----------------------------------
1996 $25,639 $25,639
2010 $28,832 $33,635
2030 $34,913 $50,822
2050 $42,272 $76,564
2070 $51,195 $115,689
Source: OASDI Board of Trustees, 1996 Annual Report; author's calculations.
These improvements are diminished only slightly - to 30.1% and 89.3% respectively, if we subtract the payroll taxes necessary to restore actuarial balance, without any benefit cuts whatsoever (see below). It is clear that there is no problem of intergenerational equity here.
Unfortunately, much of the public is convinced of the opposite: that the living standards of future generations must be sharply reduced if we are to finance the retirement of an aging population without changing the structure of Social Security. Underlying this belief is a generalized awareness that incomes have been stagnating for some time now, and that there is no indication of an upswing. Many people therefore assume that future benefits will have to be financed from taxes on income that is roughly the same as current income.
However, these ideas are based on a confusion between the concepts of average and median. Average (or mean) family income, for example, is simply the total amount of income received by all families divided by the number of families. The median, however, represents the midpoint of the distribution: half of all families are at or below the median. It is the median - the majority - of families that are referred to when it is stated that "family income has declined." But the median income can fall while the average rises with the growth of the economy. And that is exactly what has been happening.
For example, the real income of the majority of American families declined from 1979 to 1994. But average family income increased by 9.7%. In other words, the economy grew, and so did the income of the better-off families. This made the average go up, even while the majority of families faced declining incomes and living standards.
While it is also true that the economy has been growing more slowly over the last two decades than previously, the real problem is distribution. The majority of Americans are sharing very little in the fruits of economic growth. In fact, just about all of the gains from this growth over the last decade went to the top 5% of families. Since the early 1970s, the top 1% of households have more than doubled their income, while the income of 80% of households has stagnated.
This problem must be resolved outside of the Social Security system, but it adds another reason to be cautious about making regressive changes in the structure of benefits. And more importantly for the purpose of analyzing the effect of proposed changes, it is essential to distinguish the effects of the increasing income inequality within generations from any demographic or other changes that affect the distribution of income between generations. The economy is growing fast enough to provide each successive generation with a significantly higher standard of living, even after providing for the retirement of a growing and longer-lived elderly population. If the majority of people do not experience rising living standards, this is not a problem of intergenerational equity nor of demographics - it is a problem of income distribution.
Social Security Benefits and the CPI
Since the Boskin Commission's argument that the CPI overstates inflation is currently under serious consideration, it is worth looking at how their recommended adjustment would affect projected wage growth. The second column of Table 4 (p. 17) shows the growth of real wages under the assumption that the Boskin Commission's estimate is correct, i.e., that the CPI overstates inflation by 1.1% annually. This overstatement of inflation implies that real wages are growing much faster than previously thought. Under these conditions, average real wages in 2030 would be $50,822 or just about double today's. By 2070, this would rise to $115,689, again after adjusting for inflation. There are three things worth noting about the implications of the Boskin Commission's findings. First, if the Boskin Commission is wrong, and inflation is not significantly overstated, then reducing the cost-of-living allowance would constitute a real and unjustified cut in benefits. It would also seriously damage what the Advisory Council recognizes as one of Social Security's most important contributions: the protection of benefit payments from inflation.
Second, even if the Boskin Commission's estimates are true, it would not make sense to cut benefits. If inflation is really overstated by 1.1 percentage points, then not only will future generations be much better off than previously thought, but past generations were also much poorer. This is because the economy must have been growing much faster than previously estimated. If the economy has been growing much faster than we thought it was, we must have started from a much lower point, say, 35 years ago. If we accept the Boskin Commission's estimates, then most of the country was living at or near the poverty level in 1960. From the standpoint of intergenerational equity, it makes very little sense to cut the benefits of generations who were, on average, quite poor, only to increase the future income of generations that will be enormously well off, even by today's standards.
Third, and perhaps most importantly in view of the proposed cuts in benefits, a cut in the Cost of Living Allowance (COLA) for Social Security benefits along the lines of the Boskin Commission's recommendations would cause a significant increase in poverty among the elderly. Table 5 shows what would have happened if this adjustment had been made in 1985.
As can be seen from the table, this reduction in benefits would have pushed more than 600,000 senior citizens into poverty. The poverty rate among the elderly would have reached 12.5% today, instead of its actual rate of 10.7%.
These figures highlight the precarious situation of many of the elderly poor, who are heavily dependent on Social Security to keep them above the poverty line. In 1994 Social Security benefits kept more than 15 million senior citizens from falling into poverty. Although the effects of the cuts currently proposed by various members of the Council would not affect current beneficiaries, the sensitivity of the elderly poverty rate to what appear to be small changes in the benefit structure provides another reason for caution in implementing such changes. This is especially true in light of the regressive nature of the proposed cuts. And finally, since the Boskin Commission's recommendations are still under serious consideration, there is a real danger that both the cost-of-living cut and the cuts proposed by different factions of the Advisory Council may be implemented, with combined effects that would push millions of senior citizens into poverty in the ensuing decades.
Table 5: Projected Impact of Boskin Commission's Recommended COLA Reduction on Poverty Rates for Americans Aged 65 and Older
Elderly Population in 1995 34,300,000 Number of Elderly in Poverty in 3,681,000 1995 Number in Poverty in 1995 if COLA Were Adjusted in 1985 4,281,000 Increase in Number of Elderly in Poverty 600,000 1995 Poverty Rate Among the 10.7% Elderly 1995 Poverty Rate if COLA Were Adjusted in 1985 12.5% Source: Census Bureau Data.
his report assesses the impact of the two major benefit cuts proposed by various factions of the Advisory Council - adding three years to the computation of benefits and raising the retirement age. Both are highly regressive, with the computational change especially hurting low-income female retirees, and the increased retirement age disproportionately impacting African-American and low-income men. In addition, the proposed plans for partial privatization were found to provide lower retirement benefits, on average, while introducing enormous risks and insecurity that the present system has been able to avoid over the past 60 years.
These proposals are not only inequitable; they are unnecessary. Implementing three non-regressive proposals of the MB plan would, according to the Trustees' and the Advisory Council's projections, eliminate 38% of the gap in financing that needs to be closed over the next 75 years. The remaining gap could be closed by increasing the payroll tax one-tenth of one percent each year, split between employer and employee, for the years 2011-2032. At the end of this twenty-two year period, the tax increase would total 1.1 percentage points for the employer and the same for the employee. As noted above, the average worker would still have 30% more real income in 2030 and 89% more income in 2070, after subtracting the additional payroll taxes and adjusting for inflation.
All of this is based on the Trustees' projections that the economic growth over the next 75 years will be the slowest on record. If the economy were to continue grow at its present moderate pace, for example, there would barely be any gap in financing to close at all.
These are compelling reasons not to tinker with the most successful social program in American history. An additional reason has been described in some detail in this report: the massive public confusion over the actual state of the system's financial health, which extends to many political leaders and oft-quoted advocates of change. All this makes a strong case for leaving the Social System as it is, at least until a more honest and equitable policy debate can take place.
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