Social Security: Long-Term Financing and Reform

Of the most important reform proposals, perhaps the most extreme would be to abolish Social Security altogether, leaving it up to individuals to decide how to provide for their retirement. (However, it should be recalled that Social Security is not simply an old age security program; privatization could leave widows, dependents, and disabled persons to their own devices.) Some reformers recognize that individuals generally underestimate the future costs of retirement, so some sort of mandatory minimum contribution levels should be maintained even if the program is privatized. Another variation would maintain basic coverage in a mandatory, government-run program, but would allow individual control over supplemental investments in privately run pension funds. Finally, some proposals would retain most features of the current system but would direct the trustees to invest a specified portion of the trust funds in private equities.

Some reformers advocate privatization simply as a matter of principle—for example, Milton Friedman has long argued that there is no justification for mandatory participation in a public system. Others emphasize that, as currently designed, Social Security has a strong redistributional element—both within and across generations. They typically use a money’s worth estimate to calculate a return on one’s contributions. Those with high earnings, and thus high contributions, receive low returns when they eventually collect benefits, while those with low earnings receive higher returns. Many beneficiaries never actually contribute; thus, contributions of others are redistributed to them. Returns also vary greatly by generation—early participants in Social Security received very good returns on their contributions, but returns for later generations are much lower. Thus, some reformers emphasize that reform should be geared toward ensuring better money’s worth outcomes for contributors, both within and across generations. It should be noted, however, that while some attention was paid to such equity concerns in the original Social Security Act, money’s worth was not a high priority in the beginning and most amendments since then have moved the program ever farther from this consideration.

Nevertheless, most reformers in recent years have pushed privatization to resolve the long-range financial imbalance of Social Security, with money’s worth calculations playing a smaller role. It is argued that under current arrangements, the trustees can hold only government bonds with relatively low interest rates. Allowing investments in the stock market and other private assets could increase returns on the trust fund. Such arguments were given a tremendous boost by the spectacular performance of U.S. stock markets from the mid-1980s through 2000. Many proponents argue that equity markets should earn real returns of about 7.5 percent per year—as they have averaged since the 1920s— probably more than double the real return on government debt. Over the long-range, seventy-five-year period, these higher returns could resolve Social Security’s financial problems.

However, opponents have raised several objections. First, there will be a costly transition period as the system becomes privatized, during which current workers must finance the cost of the existing Social Security system (paying taxes to finance the benefits going to current retirees), plus the costs of building up their own retirement funds. Thus, a fairly large, immediate tax increase will be required, and must remain in place for several decades until all those covered under the old system have died. Second, it is probably inconsistent to argue that real GDP growth will slow (to 1.3 percent per year, little over one-third its long-term average) without affecting growth of equity prices. Critics have shown that this implies either that the share of distribution of national income going to profits must grow to implausibly high levels (indeed, Dean Baker has calculated that wages must be negative by 2070), or that price-earnings ratios (already at all-time highs in 2000) must rise to truly astronomical levels (on Baker’s calculation, to 485-to-1 by 2070). On the other hand, privatizers believe that the influx of money into stocks would generate more investment, and thus higher economic growth. Third, privatization might place unacceptable levels of risk on workers. Even if the stock market were to grow at an average rate of over 7 percent per year, there could be relatively long periods of below-normal growth. In the past, equity prices have been fairly flat for decades at a time. Unlucky workers whose retirement happened to come after such a period could face deprivation during retirement. Furthermore, if workers are given individual control over their retirement accounts, they might do poorly even if the markets as a whole are doing well.

Fourth, numerous small retirement accounts can be very costly to administer and supervise. Current costs of administering Social Security are exceedingly small—well under 1 percent of revenues. Privatizers often point to the Chilean example as evidence that a private system can produce high returns for contributors; however, overhead costs in Chile are above 10 percent. While private fund managers were initially supportive of the move to privatize, they have become less enthusiastic as they have come to realize the logistics of managing many small accounts for lower income workers. Fifth, some critics have argued that because women typically have lower incomes, spend more time out of the labor force, and more often work part-time, most privatization reforms would adversely affect benefits paid to women. Others have noted that because African Americans and Hispanics typically have lower income and lower life expectancies, privatization reforms as well as raising the normal retirement age would have a disproportionately negative impact on those groups. Finally, critics note that privatization schemes do not, and probably cannot, offer the same kinds of coverage currently offered by Social Security. For example, private pension plans do not offer inflation indexing, as Social Security does. As discussed, Social Security also offers coverage for many individuals without significant work histories. If the program is privatized, a new social safety net would have to be created to cover individuals who could not purchase private insurance.

With the large turnaround of the U.S. federal government budget in the late 1990s (from chronic deficits to record surpluses), President Bill Clinton and many others proposed that budget surpluses could be set aside to resolve Social Security’s financial problems. Essentially, President Clinton would have increased the size of the trust fund by an amount equal to just under two-thirds of annual budget surpluses. The larger trust fund would then earn more interest and would have more Treasury securities to sell when program revenues fall below expenditures. However, as noted above, when the trust fund sells securities, the Treasury will have to cut other spending, raise taxes, or sell securities to the general public to cover the payments made to the trust fund. Furthermore, like most financial fixes, this reform will not necessarily increase future productive capacity. Indeed, it is not necessary for the federal government to run surpluses for it to credit the trust fund with more securities—the Treasury can add securities worth any amount to the trust fund at any time (in principle, it can add an amount equal to the entire Social Security shortfall today, thereby resolving any financial difficulties). Alternatively, the Treasury could simply agree to pay a higher interest rate on trust fund assets—paying whatever interest rate would eliminate the actuarial gap. Though somewhat ludicrous, these alternatives emphasize that accumulating a trust fund of Treasury securities really cannot resolve future annual deficits in the Social Security program.

Furthermore, as emphasized above, what really matters is the economy’s capacity to produce real goods and services in the future. Hence, if the amount that can be produced will not be sufficient to provide the level of consumption desired by all generations in the future, it will be necessary to either to boost production or to ration consumption. Extending the normal retirement age (which is essentially a benefit cut) will keep workers in the labor force longer, and will reduce the number of years they must be supported during retirement. Increasing taxes on future workers will leave them with lower purchasing power, ensuring that more of the nation’s output can go to retirees. Cutting future OASDI benefits will do the opposite—allocating more output toward workers and others with incomes that are not dependent on Social Security. Fortunately, given increases in worker productivity that reasonably can be expected to occur, plus increases in production facilities that are likely to take place as a result of public and private investment, it appears quite likely that future workers and future retirees will enjoy higher living standards than do their counterparts today—in spite of the aging of America.