FACING FACTS The Truth about Entitlements and the Budget A Fax Alert from The Concord Coalition Volume II ( Number 3 April 15, 1996) THE NEW DEBATE OVER SOCIAL SECURITY REFORM: PART I A rapidly growing number of voices are advocating that we somehow transition from today's pay-as-you-go Social Security system to a funded system. Plans are under development at half a dozen think tanks, from the libertarian Cato Institute to the "New Democrat" Progressive Policy Institute. In March, the Senate Subcommittee on Social Security held hearings on "privatization." In May, the Social Security Advisory Council is expected to announce the most radical reform plan ever proposed by an official body in the history of Social Security. Endorsed by five of the Council's thirteen members, it would shift roughly half of the FICA tax into a new system of individually owned and privately invested "Personal Security Accounts." Meanwhile, opinion surveys show low and falling levels of public trust in Social Security as it now stands. Three-quarters of all Americans doubt that Social Security will be able to fulfill its promises to new retirees within twenty years and about two-thirds agree that Social Security "is in need of major reform now." Why is this happening? And why now? The first in a series on Social Security, this alert looks at the concerns that are swiftly radicalizing the reform debate. The End of the Chain Letter In the first place, there is the growing realization that the current Social Security system will become an insupportable burden on tomorrow's work force. According to the most plausible 1995 Trustee estimates (the "intermediate" and "high-cost" projections), the cost of OASDI as a percent of taxable payroll is slated to rise by 6 to 9 percentage points over the next thirty-five years or by about 50 to 80 percent over today's level. This is not the first time we have faced such large projected imbalances in Social Security. But unlike the mid-1970s and early 1980s, when it took an acute near-term financing crisis to precipitate reform, Americans are in a more sober mood. They are less likely to assume that we can "grow our way" out of the long-term projections. They are also more aware of other dependency burdens such as the exploding cost of health benefits that will put a crushing extra pressure on future living standards. According to a study by Facing Facts editor Neil Howe, the rising cost of just three benefit programs Social Security, Medicare, and Medicaid for seniors will, under SSA's official intermediate scenario, erase all growth in real after-tax worker incomes over the next forty-five years. Under SSA's (more prudent) high-cost scenario, real after-tax incomes would suffer a catastrophic decline of 59 percent. Second, there is mounting concern that the current system if it doesn't crush future workers will betray future retirees. As Craig Karpel puts it in his book, The Retirement Myth, there is only one thing that Baby Boomers fear more than the prospect that the federal budget will never be balanced, and that is the prospect that it will someday be balanced. To keep Social Security outlays from exceeding earmarked tax revenues in 2030, we would, in that year, have to enact a roughly one-quarter to one-third across-the-board benefit cut. Under half of the private-sector labor force participates in an employer pension plan. In 1993, according to a Merrill Lynch analysis of Census Bureau data, half of all U.S. families had less than $1,000 in net financial assets. Even among adults in their late fifties, the age at which workers are staring directly at retirement, median savings are still shy of $10,000. Most Americans are simply not prepared for large future cuts in Social Security benefits; indeed, most are probably not prepared for the cuts that Congress already legislated in 1983 and that are due to affect everyone born after 1937. This leads to a third concern about Social Security. There is now a growing consensus that America needs to raise its private savings rate. According to one recent poll, more than two-thirds of Americans agree strongly that "government should provide more incentives to save for retirement"; among adults in their forties, the share is four-fifths. Yet economists widely believe that Social Security's pay-as-you-go benefit structure (entirely aside from its impact on the federal budget) discourages thrift. Nor is this just a U.S. worry. As a superb World Bank study, Averting the Old Age Crisis, points out, reformers around the world are turning away from unfunded retirement systems precisely because of their tendency to undermine private savings. Finally, there is the widespread disappointment about Social Security's declining rate of return on contributions. Today, for the first time in the history of Social Security, large categories of newly retiring workers are due to get back less than the market value of prior contributions, even when that value is computed at the lowest plausible discount rate. Everybody is beginning to understand that in future years these "market losers" will comprise a growing share of all beneficiaries. Average-earning single males born in 1930 (the cohort that turned 65 in 1995) will suffer an average net lifetime loss of $5,000 on their and their employer's contributions. For average-earning single males born in 1945, the net loss will be $36,000; for high-earning single males born that year, the loss will be $135,000. This is bad news for a program predicated on the chain-letter notion that everyone can be a winner. Many critics used to think that Social Security's windfall paybacks were a good argument for reform: Why not cut benefits and still leave everyone a winner? That argument fell on deaf ears. Ironically, the opposite argument may now turn out to be more persuasive: Why not rethink a system that cannot possibly offer the same long-term rate of return as genuine economic savings? The Benefits of Funding The Concord Coalition has long called for Social Security reforms, including a progressive means-test and a hike in retirement ages, which, together, would restore the system to long-term cash balance. These benefit cuts would prevent the future payroll tax burden from growing and would also boost national savings by reducing the federal deficit. However, future benefit cuts (or hikes in FICA taxes) cannot alter Social Security's built-in bias against thrift. They would also do nothing to redress (and might even worsen) the cascading pattern of generational inequity that is inherent to any pay-as-you-go system. It is these issues that are leading many to advocate a more radical solution: transforming Social Security into a funded system of personally owned and privately invested defined contribution accounts. Such a reform is not necessarily "privatization"; in fact, it is compatible with any degree of government paternalism. It is also different from simply moving toward a more funded system, which, to some extent, nearly everyone supports. Indeed, most Americans believe (mistakenly) that Social Security's cash surpluses are now being saved in order to partially prefund the Baby Boom's retirement. Properly designed, any funded system offers two obvious benefits: higher national savings and vastly improved rates of return. While the long-term rate of return in a pay-as-you-go system is limited to population plus productivity growth, the rate of return in a funded system is equal to the marginal product of capital, which (even when adjusted for risk) is typically much higher. A system of personally owned accounts could have other benefits as well. Most economists believe that the FICA is a tax and that taxes distort labor markets. By reducing (or eliminating) this tax, a system of personally owned retirement accounts could increase labor supply and improve economic efficiency. By requiring people to save and by giving them a convenient and tax-free means of doing so such a system would also institutionalize the habit of thrift, and this might create an accelerator effect that further boosts national savings. Then there is the issue of ownership. Ironically, Social Security was originally set up because people trusted the government more than financial markets. Today, most Americans under fifty feel just the opposite. They know that future Congresses will necessarily renege on unsustainable pay-as-you-go benefit promises but that no politician can take away personally owned assets invested in the real economy. ...And the Drawbacks It is often said that a system of personally owned retirement accounts would shift unacceptable risks to individuals in other words, that such a system amounts to totally "privatized" retirement. But a system of personally owned accounts need not allow people to recklessly undersave during their working years; contributions could be made mandatory and restrictions placed on the use of account balances. Nor need it put low-income (or simply unlucky) workers at greater risk of poverty and hardship in old age; the government can subsidize savings contributions and provide a guaranteed floor of old-age income protection. But there is one drawback that no plan can avoid: the huge transition cost. Since moving to a funded system means that society must begin to save at a higher rate, society will necessarily have to consume at a lower rate at least until the productivity advantages of higher savings kick in. Or to put the problem in layman's terms, current workers will somehow have to pay for two retirements: their own (which now must be prefunded) and that of current beneficiaries (who will naturally continue to depend on Social Security). In a future alert, we'll explain how to distinguish the responsible from the irresponsible plans. Stay tuned.
FACING FACTS AUTHORS: Neil Howe and Richard Jackson CONCORD COALITION EXECUTIVE DIRECTOR: Martha Phillips