Boomer burden
The debate is joined over reforming Social Security
As the debate over Social Security reform heats up, you're likely to be blitzed with all manner of headache-inducing charges and claims, plans, and numbers. The early skirmishes have already begun. President Bush argues that "the crisis is now" for Social Security and that the 70-year-old retirement benefits system desperately needs privately owned investment accounts and perhaps other unspecified changes to remain viable. The president's reasoning is simple. There were 42 covered workers for each Social Security beneficiary when the program began in 1935. Now there are just over three workers per beneficiary and falling. In coming decades, all those retired and longer-living baby boomers will be taking money from the system far faster than generation X-ers and Y-ers can replenish it.
Yet there are many in Washington who think the president is disingenuously alarmist. "This is a completely manufactured crisis," says economist Mark Weisbrot of the Center for Economic and Policy Research, echoing a view held by many Democrats and their allies. "We shouldn't do anything for a while," he says. "It's dangerous to make benefit cuts and other dramatic changes based on false information."
In the middle of the heated debate are many analysts, like Robert Bixby, executive director of the pro-balanced-budget Concord Coalition. Bixby says the White House is "correct in fostering a sense of urgency" and thinks private accounts, in which individuals would invest a small portion of the payroll taxes they now pay into the system in the stock and bond markets, could be part of the solution. The calculus: that higher expected returns in the market would mean less is needed in contributions to keep paying benefits. But he also worries about borrowing $1 trillion to $2 trillion to support Social Security as private accounts are being phased in. And there's also the question of higher administrative costs if individuals churn their accounts.
But don't despair. To help keep your Excedrin moments to a minimum, here's a guide to the major approaches to reform:
Doing nothing--at least for now. The go-slow crowd argues that for the next four or five decades, the Social Security Administration expects to be able to pay 100 percent of promised benefits to retirees, although in 13 years or so it will need to start cashing in the federal bonds that have accumulated in its trust funds to do that. In recent decades the trust funds have taken in far more in payroll taxes than they paid out in benefits. That surplus is then lent to the regular federal budget to help pay for things like defense and education, in effect masking the true size of the annual deficit. But starting in 2018, payroll taxes are expected to fall short of what is needed to fully pay benefits, and the trust funds will need to be tapped. How are those IOU s going to be paid? By raising taxes, cutting spending, or borrowing more than $5 trillion (in today's dollars) in the coming decades. Without that infusion, payments will need to be cut to 73 percent of scheduled benefits in 2042, dropping to 68 percent by 2078.
But Weisbrot and others point out that the SSA has repeatedly underestimated the trust fund's life span because of its overly cautious economic forecasts. Back in 1997, the agency said 2029 was the year the money would start running out. And that point may be delayed further if the economy outperforms the agency's projections, such as its current forecast that worker productivity gains will decline to a 1.6 percent annual rate by 2012, about half the pace of the past decade. Robert Gordon of Northwestern University thinks a combination of technology and cost cutting will allow long-term productivity gains of 2.5 percent.
Now, rising productivity should fuel higher wages, meaning more money available to fund Social Security. Yet since initial retirement benefits are tied to wages, faster economic growth will also raise future benefits. Social Security could be made solvent through 2078 if current payroll taxes were increased from 12.4 percent to 14.3 percent or benefits cut by 13 percent, according to the agency. Wait until 2042 and payroll taxes would have to be abruptly bumped up to 16.9 percent or benefits cut by 27 percent. "That's ridiculous," says economist Arnold Kling, author of the popular EconLog blog. "I am 50 years old. If you are going to reduce my benefits when I reach 68, tell me now. Don't wait until I am 68."
Even AARP, which has launched a highly visible advertising campaign against private investment accounts, says that while drastic changes are unnecessary, it is better to tweak the system "sooner rather than later to strengthen the program for future generations."
Add private investment accounts and trim benefits. A variety of plans floating around would seek to partially privatize Social Security. The one that many analysts think most reflects the thinking of the White House is the so-called Model 2 plan developed in 2001 by the president's Commission to Strengthen Social Security. The plan would allow workers to invest up to 4 percent of their taxable earnings (with a cap of $1,000 or so annually) in private accounts. Future initial benefits would be based on changes in inflation rather than wages, which presumably would be lower as wages have, in the past, typically risen faster than prices. Under the Model 2 plan, the system would be in balance by 2050, the Congressional Budget Office concluded.
By investing in a fairly conservative half-bond, half-stock portfolio earning a 5.2 percent real return, adjusted by the CBO for risk, a middle-class worker born in 1970 and retiring in 2035 would end up with $13,600 in annual retirement benefits vs. $17,700 under the current system. On the face of it, the current system seems like a better deal. But remember, the only way Social Security can pay that $17,700 is by taking hundreds of billions each year from the regular budget to pay off all those trust-fund IOU s. And that $13,600 from the Model 2 plan would still be more than retirees currently get.
What's more, Social Security is more than just a pension plan--it also provides generous benefits to nonworking spouses as well as financial support to widows and the disabled.
Either way, of course, no one would want to depend on either system for the bulk of retirement income. The low figures should prompt any sensible person to set aside as much as possible in 401(k) and other retirement accounts. And if some form of privatization occurs, investors will have to look at their total retirement savings portfolios to make sure they have the right asset mix; Social Security should be considered part of the fixed-income portion of your retirement money. If you elect to put some of it into the stock market, then you may well increase your overall exposure to equities beyond what you had intended.
The CBO also projects that the economy could be about half a percent larger by 2025--and about 3 percent to 4 percent larger by 2080--than it is under current Social Security law because of higher private investment levels.
The most commonly highlighted downside is the $1 trillion-plus transition cost needed to fill the shortfall once money is diverted from Social Security to private accounts. But many see this as a political, rather than a budget, problem since the government is simply recognizing a future debt and putting it on the books now. A stickier issue concerns just how much those private accounts can be expected to earn and whether individuals will make appropriate investment choices. Most privatization advocates use similar numbers as does the president's commission, an inflation-adjusted return of 3.3 percent for bonds and 6.8 percent for stocks, which is how these asset classes performed during the 20th century. But Jeremy Siegel, author of Stocks for the Long Run and a finance professor at the Wharton School, predicts that future equity returns may be nearly a percentage point lower.
Begin cutting benefits and raising taxes now. Call this the Pain Proposal. Peter Diamond of the Massachusetts Institute of Technology and Peter Orszag of the Brookings Institution propose increasing combined employer-employee payroll taxes from 12.4 percent to 15 percent over the next 75 years as well as instituting a 3 to 4 percent payroll tax on earnings above the current taxable maximum of $90,000. They would also calculate the cost of increased life expectancy to Social Security and offset that cost through gradual benefit reductions. The CBO projects that scheduled benefits would be cut from their present level by 2 percent in 2025, 12 percent in 2050, and 23 percent in 2105. On the plus side, those new taxes and benefits cuts would mean the system would stay in balance without subjecting workers to the vagaries of the financial markets.
To some, the biggest problem with this proposal is that it penalizes younger workers. "If your only goal is the solvency of the existing system, it is possible to raise taxes and/or cut benefits enough to do that--but then you are going to make Social Security an even worse deal for younger workers," says Michael Tanner of the Cato Institute. Already, a single middle-class male worker born in 2000 will earn an annual real return on his contributions of only 0.86 percent (not counting spousal or disability benefits). For workers who earn the maximum amount taxed, the real annual return is minus 0.72 percent. The CBO also calculates that the higher tax burden from the plan means the economy will not grow as large in the future.
And while the Diamond-Orszag plan avoids stock market risk, it exposes workers to political risk. Perhaps future taxpayers will be unwilling to pay higher shares of their income for retired baby boomers. And who knows what antics lawmakers will be up to in the future? These are the same spendthrifts, after all, who have been looting the trust fund and promising workers retirement benefits far beyond what the system can currently afford.
This story appears in the January 17, 2005 print edition of U.S. News & World Report.