Social Security: For You, or for Wall Street?

By Dan Cornwell, The Madison Institute

Social Insurance vs. an Investment Program

Social Security is a social insurance system, designed to assure a reliable foundation of income for workers and their families as protection against loss of income due to old age, disability, or death of the worker.

The current assault on Social Security comes from those who want to turn it into an investment program, focused on maximizing average benefits with considerable risk to the individual.

The Source of the Push Toward an Investment-Based System

The campaign for moving toward an investment-based system has come from the financial industry, which stands to reap huge profits if part of the $350 billion which now flows from workers' payroll taxes directly to beneficiaries can instead be diverted to financial markets and churned there for an average of 30 years. This would be a bonanza for Wall Street corporations and the advertising industry.

Some Background on the Current System

Social Security today is essentially a pay-as-you-go system. Revenues from the payroll tax are paid out almost immediately to beneficiaries.

Pay-in from Workers---->

Trust Fund Pay-as-you-go

-----> Pay-out to Beneficiaries

The trust fund acts like a checking account, designed to ensure a smooth cash flow. Income to the trust fund comes from payroll taxes, plus much smaller amounts from interest on the fund balance and taxation of Social Security benefits. Administrative cost is less than 1% of pay-out.

Progressivity

The payroll tax is regressive, but the benefit structure is progressive:

The Earned Income Credit (EIC) ameliorates regressivity of the tax for low-income workers with one or more children.

Pay-As-You-Go vs. Investment-Based Funding

In a pay-as-you-go system (approximated by Social Security today), money raised by a payroll tax on wages is paid out almost immediately to beneficiaries.

In investment-based systems, the money collected from workers is diverted into financial markets, where it is churned for an average of 30 years before the benefits are paid out.

The worker gets whatever the account is worth at the time of retirement, disability, or death.

Advantages of Pay-As-You-Go

1. Built-in inflation protection.

2. Predictability of benefits tied to the cost of living.

3. Stability of income to the system.

4. Low administrative cost.

No investment-based system can offer these qualities.

Don't Cut Cost-of-Living Adjustments (COLAs)

The following graph shows the effect on purchasing power of a 0.5% reduction in COLAs for someone who lives to age 95 after retiring at 65.

If it is felt to be necessary to cut benefits, a far better way is to reduce the initial benefit but then provide COLAs sufficient to maintain its purchasing power.

How Are We Doing?

Projected pay-in as a percentage of pay-out extended to 2075 is shown in the following graph:

If no adjustments are made, projected revenues will be sufficient to cover only about 70% of benefits beyond 2030. The creek is not running dry, but something needs to be done.

Although the rapid fall in the graph between 2000 and 2030 is an effect of the baby boom retirement, the fundamental long-term problem is the continued trend beyond 2050 (by which time most of the baby boom generation will have passed from the scene). Two factors cause this long-term trend:

· Increased life spans combined with a fixed retirement age mean a steady decline in the worker-to-retiree ratio.

· There continues to be a gradual shift of compensation for work from cash to forms (fringe benefits) not subject to the payroll tax. This erosion of the payroll tax base further lowers revenues.

Outline of a Pay-As-You-Go Solution

To counter long-term trends:

· Gradually increase the age at which full retirement benefits become available, then index it to average longevity. Replace incentives to retire early with opportunities to continue working.

· Avoid further erosion of the payroll tax base.

To improve equity:

· Make Social Security pension benefits subject to income taxation on the same basis as other government and private pension income.

· Extend mandatory Social Security coverage to all newly hired state and local government employees.

Effect of the Proposed Adjustments

The graph below shows the estimated effect of adopting the above proposals.

Longevity and the Normal Retirement Age

The Normal Retirement Age (NRA) is the earliest age at which full retirement benefits are available. It has been 65 since the beginning of Social Security. Under current law, it will rise gradually to 67 and then remain constant.

Keeping the NRA fixed while longevity is rising amounts to increasing benefits. Life expectancy at the retirement age will have increased from about 12 years in 1935 to 18 by 2050. Providing income to retirees for an average of 18 years as compared with 12 represents a 50% increase in the total benefit to a retiree.

Such increases are not sustainable. What the system can do, indefinitely, is to support a given fraction of the total population. This means gradually increasing the NRA to keep pace with longevity.

The graph below shows projected life expectancy at the current-law NRA (full columns, including the white caps). If the proposal offered here were adopted, the NRA would gradually rise to 69 in 2030 and then be indexed to life expectancy (black columns). Life expectancy at retirement would still be more than 15 years and would continue to rise after 2030.

Within a pay-as-you-go system, the alternative to raising the retirement age is increasing the payroll tax rate. Doing this leaves less discretion to the worker and shifts benefits toward younger retirees.

Direct Comparison With Compulsory Investment Plans

Most current proposals are hybrids with a pay-as-you-go part and a compulsory investment part. In these plans, the investment-based part has no guarantees. Only the pay-as-you-go part offers a predictable benefit tied to the cost of living.

Typical hybrid plans require mandatory contributions of about 1.5% of wages beyond the current payroll tax rate for building up the investment funds. Some recent proposals would use general income tax revenues (dubious budget "surpluses") as an alternative.

The pay-as-you-go plan proposed here would leave this money in the hands of individuals, who would still have the option to invest the additional amounts privately for earlier retirement or improved benefits, but would not be compelled to do so.

Conclusions

A public pay-as-you-go system can provide income insurance benefits which are tied to current wage levels and are practically immune from inflation. Benefits are secure and predictable. The simplicity of the system leads to remarkably low administrative costs. No investment-based system can match any of these advantages.

To be fair across generations, the system must operate with an approximately constant payroll tax rate and a stable ratio of workers to retirees. As life spans increase, people must expect to work longer.

References

Bipartisan Commission on Entitlement and Tax Reform, "Staff Report on Entitlement Reform Options" (Washington, DC, December, 1994).

1994-96 Advisory Council on Social Security, "Volume I: Findings and Recommendations; Volume II: Reports of the Technical Panels" (Washington, DC, January, 1997).

Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds, "1997 Annual Report" (Washington, DC, 1997).

C. E. Steuerle and J. M. Bakija, "Retooling Social Security for the 21st Century" (Urban Institute Press, Washington, DC 1994). This is an excellent background reference.