Social Security Reform Hidden Behind Myths

by Dan Cornwell,
from the Wisconsin State Journal, Madison, WI, February 15, 1998.

The chief impediment to effective reform of the Social Security system is the constant repetition of myths. Let's examine them:

Myth One: The baby boom is the problem.

The population surge known as the baby boom helped us to delay facing the real problem, and this delay has made matters worse. However, the fundamental problem is the insistence on trying to finance retirement at a fixed age (65 or 67) despite steadily increasing longevity.

When Social Security began, life expectancy at the retirement age was about 12 years. By the middle of the next century it will be 18 years. If benefits have to be paid out for an average of 18 years instead of 12, there will be a shortfall.

This shortfall has nothing to do with the baby boom. It should be obvious that the only long-range solution will be to index the retirement age to life expectancy.

For example, the age could be set to provide an average of about four months in retirement for each year in the working period (the period between age 20 and the retirement age). This would mean retirement at an age when the average remaining life expectancy would still be over 15 years.

The good news is that making only this one change in the system would solve most of the problem without any tax increase.

Myth Two: Since returns on stocks are likely, over time, to be higher than interest on Treasury bonds, we could improve future benefits by diverting part of payroll tax payments to investment accounts.

The comparison of interest rates on Treasury bonds with returns on stocks is irrelevant. Benefits under Social Security do not depend on investment income.

The appropriate comparison is between a pay-as-you-go system and an investment-based system. With pay-as-you-go, income to the system comes from a tax on current wages and benefits are tied to current wage levels.

This is the ideal funding arrangement for a national income insurance system. It allows benefits to track current wages, which is exactly what benefits from a national income insurance system should do.

In the current system, the first-year benefit is indexed to the national average wage. In subsequent years, increases follow the Consumer Price Index rather than the national average wage, but the effect is similar.

The trust fund in a pay-as-you-go system is like a checking account. Its main purpose is to smooth out fluctuations in cash flow.

The balance is typically equal to about one year's benefit payments. The trust fund earns interest, but that generally amounts to less than 10 percent of total income to the system. Even with current Social Security surpluses, the system is close to pay-as-you-go.

The alternative to pay-as-you-go is an investment-based system, in which funds paid into an account accumulate for about 30 years before being paid out to the beneficiary.

Because of the effect of compounding over such long periods, the final benefit level is extremely sensitive to the rate of return on investments. As a consequence, benefits are hard to predict and have no direct relationship to the cost of living.

Myth 3: Adopting an investment-based plan is an alternative to raising the payroll tax rate or raising the retirement age.

Two investment-based plans were proposed by the Social Security Advisory Council last January, the Individual Accounts (IA) Plan and the Personal Security Accounts (PAS) Plan. Both would increase the payroll tax rate by about 1.5 percent. Both would raise the retirement age relative to that under current law and then index it to life expectancy.

Myth 4: With the same dollar inputs, an investment-based plan would provide better benefits than would a pay-as-you-go system.

If the same tax rate increase and the same retirement age increase prescribed by the IA and PAS plans were adopted without any investment provisions, the current pay-as-you-go system could continue benefits at current-law levels indefinitely, with full cost-of-living adjustments (COLAs).

Claims that benefits would be higher for an investment-based system than for pay-as-you-go do not stand up under careful analysis. Average benefits for most workers would, in fact, be comparable or lower. Beyond this, benefits would be subject to much risk and would not be tied to the cost of living.

Myth Five: Current COLAs exceed increases in the cost of living. Continuing them is a luxury the system can't afford.

COLAs as currently calculated are designed to keep up with price inflation but not with improvements in the standard of living. They may have exceeded the rate of inflation, but they have not kept up with improvements in the standard of living.

The purpose of an income insurance system should be to provide benefits which track the cost of living at each year's standard of living. A pay-as-you-go system is uniquely suited to doing exactly this.

Payroll tax revenues track wages. The total of all wages approximates what the nation actually spends in a year to purchase its standard of living.

Thus, COLAs are sustained by rising wages with no increase in the tax rate.

Much more can be said on these issues. But let's begin by getting the facts straight.

Cornwell is professor emeritus at UW-Madison. Since retiring from the chemistry department, he has studied several public policy issues.