Social Security 101: The Program and the Problem

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Social Security 101The Program and the Problem
Social Security University August 26,
2002 Presented by Michael Tanner, Director of
Health and Welfare Studies Andrew G. Biggs,
Social Security Analyst The Cato Institute,
Washington, D.C. www.socialsecurity.org
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Some Main Issues
Solvency Can Social Security afford to pay what
it promises? How can we strengthen the
program? Rates of return Will Social Security be
a good deal for Americans? Will future
generations be as happy with Social Security as
past ones have been? Fairness Does Social
Security treat everyone equally? Can arbitrary
differences in benefits be fixed? Personal
Control Is Social Security flexible enough to
accommodate people of different ages, races,
marital statuses, and with different attitudes to
risk? Will people have a legal right to their
benefits?
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What is Social Security?

• The Social Security Act was passed in 1935 and
  the first benefits paid in 1940.
• A contributory social insurance program everyone
  pays in and everyone receives benefits.
• Financed by a 12.4 percent tax on wages up to
  85,000 (increases annually) the biggest tax
  most households pay.
• Provides retirement, survivors and disability
  benefits to eligible workers and their families.
• The largest government program in the world
  takes up almost one-quarter of the total federal
  budget.

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Social Security and the Budget
Social Security is already the biggest item in
the budget. Without change, it could eat up 29
percent of the budget by 2020, 34 percent by
2030, and 36 percent by 2075.
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Payments from the Old Age, Survivors, and
Disabilities Insurance (OASDI) program
Most Social Security benefits go to retirees, but
survivors and the disabled make up substantial
shares as well.
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How are benefits calculated?

• Determine workers average indexed monthly wage
  (AIME).
• Index each years past earnings for wage growth.
  (This effectively pays interest at the rate of
  wage growth, around 1 percent.) Years after age
  60 are not indexed.
• Select 35 highest earning years and add together.
  
• Divide the sum by 35 (to produce an annual
  average), then by 12 (to produce a monthly
  average).
• Run the monthly AIME amount through Social
  Securitys bend points.
• Bend points replace 90 percent of the first 592
  of workers average indexed monthly earnings,
  plus 32 percent of earnings between 592-3,567,
  plus 15 percent of earnings above 3,567. This
  produces a primary insurance amount (PIA).
• For a single individual, the PIA is their monthly
  benefit. It is also the basis for spousal,
  disability and survivors benefits.
• (For more information, see http//www.ssa.gov/OACT
  /COLA/BenForm.html)

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Social Security Revenues
Most of Social Securitys revenues come from
payroll taxes. A smaller amount is from taxes on
benefits, while the trust fund is credited with
interest each year.
Payroll Taxes 516 Billion General
Revenues1 13 Billion Interest on trust
fund2 73 Billion Total
602 Billion
1 Credited from income taxes on benefits. 2. No
actual cash changes hands. Interest to the trust
funds bonds is paid by issuing new bonds.
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How is Social Security Financed?

• Social Security is a pay-as-you-go system
  taxes collected from todays workers are used to
  pay benefits for todays retirees.
• For that reason, Social Securitys finances are
  very sensitive to the number of workers paying
  into the system and the number of retirees
  collecting benefits from it.
• The aging of the population means larger groups
  of retirees to be supported and smaller
  generations of new workers to support them.
• Demographics particularly birth rates and life
  expectancies are the key to Social Securitys
  financing problems.

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Social Securitys Pay-as-you-go Financing

• Conventional pension plan each generation
  provides for its own retirement by saving and
  investing its contributions over time.
• Social Security pay-as-you-go financing, taxes
  collected today pay benefits for todays
  retirees. Todays workers will be supported by
  workers in the future.
• Advantages
• can begin paying benefits quickly
• provides big windfalls to early retirees First
  retiree, Ida May Fuller of Ludlow, Vermont, paid
  24.75 in taxes lived to age 100 and collected
  22,889 in benefits
• simple to administer.
• Disadvantages
• pays very low rate of return to post-windfall
  generations
• very sensitive to the ratio of workers paying
  into the system to retirees collecting.

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Low birth rates mean fewer new workers
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Increasing life expectancies mean more retirees
to support
Future retirees will live years longer than
todays 65-year-olds, and collect thousands more
in benefits.
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In the future, fewer workers will support more
retirees.
As a matter of simple math, when the ratio of
workers to retirees falls, each worker must bear
a greater financial burden.
2030 2.1 to 1
Today 3.4 to 1
1960 5.1 to 1
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Social Security taxes are already high

• The Social Security payroll tax is 12.4 percent
  of wages. Thats
• An eighth of the average workers total wages
• The biggest tax the average household will pay.
• Thats enough to pay
• Six months rent on a 700 per month apartment,
  or
• A full year of student loan payments at 350 per
  month, or
• A keg of Budweiser every weekend (plus chips!).
• And if todays payroll tax seems high, wait til
  it rises to 18 percent or more!

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and without reform, theyll only go higher by
2030, costs will top 17 percent of payroll.
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But wont the trust fund help pay benefits?
Technically, the government bonds in Social
Securitys trust fund will help pay full benefits
until 2041
But why do we say technically? The Social
Security trust fund is full of government IOUs.
And the only way to turn those IOUs into cash is
to raise taxes, cut spending, or borrow.
Those are the same choices wed face if there
were no trust fund at all!
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Unified Household Budgeting
If a woman lends her boyfriend 500, she holds an
IOU for 500 while he gets 500 cash. But if
they get married, they dont have a thousand
dollars they have zero. His debt cancels out
her asset. If hes gone and spent the 500, then
theyre even worse off! Like it or not, Social
Security is married to the rest of the budget
there is no true trust fund or lock box to keep
the cash separate. Politicians treat the fund as
if its an asset to everyone but a debt to no
one. In truth, its a wash.
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Experts Say Social Security trust fund not a net
asset the government can use to pay benefits.
The Congressional Budget Office Although there
is no money in the Treasury to pay for future
obligations, the obligations to people eligible
for Social Security benefits are real. And most
important, those obligations are a direct result
of federal law, not a consequence of whatever may
or may not be credited to the Trust Funds. In
particular, the size of the balances in the
Social Security Trust Funds be it 2 trillion,
10 trillion, or zero does not affect the
obligations that the federal government has to
the programs beneficiaries. Nor does it affect
the governments ability to pay those benefits.
(CBO Director Dan L. Crippen and Deputy Director
Barry B. Anderson, testimony before the House
Ways and Means Committee, Feb. 23, 1999)
Rep. Robert Matsui and Sen. Bob Graham Trust
Fund reserves are growing at the pace of a
billion dollars a week. But these billions wont
be available to the next generations of Americas
retirees. As quickly as the surpluses amass, they
are being siphoned off to help finance the
deficit. Bluntly put, the federal government is
spending more than 1 billion a week of the
Social Security surplus as though it were general
revenues. All that the Trust Fund gets for these
expenditures are chits from the U.S. Treasury.
(The Washington Times, September 12, 1990)
Social Securitys Public Trustees While the
bonds held by the trust funds are assets from the
vantage point of the Social Security and Medicare
programs, from the viewpoint of the unified
budget they are liabilities of the U.S. Treasury.
No one doubts the U.S. Government will honor the
bonds. But since the U.S. Treasury is the
ultimate payer of the programs benefits and the
trust fund assets are also debts of the U.S.
Treasury, neither the interest paid on the bonds,
nor their redemption, provides any net new income
to the U.S. Treasury. When annual revenues from
earmarked taxes for Social Security and Medicare
begin to fall short of annual expenditures, such
shortfalls inevitably must be made up by
increased taxation, increased borrowing (i.e.,
the sale of more U.S. Treasury bonds to the
public) and/or a reduction in other government
expenditures. This fact is the basis for the view
that trust fund assets have no "real" economic
value. From a unified budget viewpoint, the trust
fund surpluses are a budget accounting device and
make no meaningful contribution to funding future
Social Security or Medicare expenditures. They
simply reflect the fact that in the past, surplus
Social Security and Medicare revenues have been
used by the U.S. Treasury to fund other
government programs or to reduce outstanding
Federal debt. (John Palmer and Thomas Saving,
Social Security Public Trustees, 2002)
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The trust fund both a debt and an asset
The trust fund is an asset to Social Security but
an equal and opposite debt to the rest of the
government. From the point of view of the
government as a whole and to the taxpayer the
trust fund makes no difference. The question
isnt whether well honor the trust funds bonds
no reform legislation in existence wouldnt
repay them but how well do it. That is why
people argue that Social Securitys problems
begin in 2017, when the program starts running
payroll tax deficits, not in 2041 when the trust
fund runs out. The how is to raise taxes, cut
spending or run a budget deficit (which is
nothing more than a tax increase on future
generations).
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Annual repayments to the fund will equal the size
of whole cabinet departments

• By 2018, the cash flow deficit in Social Security
  would equals the size of Head Start and the
  Special Supplemental Nutrition Program for Women,
  Infants and Children (WIC).
• By 2021, the cash shortfall is equivalent to the
  Department of Education, the Department of the
  Interior, the Department of Commerce and the
  Environmental Protection Agency, in addition to
  those listed above.
• By 2035, Social Securitys cash needs equal all
  of the above, plus NASA, the Department of
  Veterans Affairs, the Department of Energy, the
  Department of Housing and Urban Development
  (HUD), the Department of Justice and the National
  Science Foundation.
• And this is all before the trust fund runs out.
  In the end, the federal budget would consist of
  little more than a pension plan with an army.

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We cant borrow our way out

• Some people think we can borrow to get Social
  Security over the hump of Baby Boomer
  retirements.
• But Social Securitys problems continue and grow
  larger even after the Boomers are gone.
• Borrowing doesnt reduce Social Securitys
  deficits, it is just a stealth tax increase on
  our children and grandchildren. Thats what
  Social Security reform is supposed to avoid.
• If we borrowed to cover Social Securitys
  deficits, the debt would exceed 7 trillion (in
  todays dollars) by 2040, 14 trillion by 2050,
  and over 47 trillion by 2075. This would be
  larger than the national debt at the end of World
  War II (as a percent of GDP) and would cripple
  the US economy

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Ok, so what are our choices?
There is no easy solutionbut some solutions are
a lot easier than others. Doing nothing is not an
option. Without action, benefits will eventually
be cut by over 25 percent. If you dont have a
reform plan, youre for benefit cuts, because
thats what the law prescribes. We could raise
taxes, but weve been there and done that. Do we
really want an 18 percent tax rate just to pay
for one program? We could raise the retirement
age, but its already going up.
We could lift the cap, applying payroll taxes
to all of a workers wages, but that would be the
biggest tax increase in history and it still
wouldnt fix the problem permanently.
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The long-term solution prefunding.
Many analysts favor moving Social Security from
pay-as-you-go financing to a funded
basis. Funding means that instead of transferring
todays payroll taxes directly to todays
retirees, those taxes would be saved and invested
for the future in real capital assets. When
needed, those assets could be redeemed to pay
benefitswithout raising taxes. Funding can be
done centrally by the government, or individually
through personal accounts.
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Why prefunding?
One reason to prefund Social Security is to
smooth burdens across generations if one
generation pays a bit more, the burden is reduced
for future generations. A bigger reason is that
prefunding pays a much higher return than Social
Securitys pay-as-you-go financing up to four
times higher, in fact. Higher returns, compounded
over decades, mean a more efficient system
higher benefits at a lower cost than
pay-as-you-go financing.
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So whats the catch?
Over the long term, a funded system can pay
higher benefits at lower cost than the current
pay-as-you-go program. But to get to funded
system, we have to put up the funds. Thats true
whether we fund Social Security through personal
accounts, collective government investment, or by
retiring existing public debt. When someone
talks about the cost of personal accounts,
theyre really referring to the amount we would
put aside today to help pay benefits tomorrow. Is
that really a cost? Optimum solution use some
existing government spending to cover the
transition. Personal accounts are no more
expensive than any other means of pre-funding
Social Security. And theyre a lot cheaper than
raising taxes down the road.
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How much cheaper?
Illustration in 2042 Social Security will run a
payroll tax deficit of 366 billion (in todays
dollars). We could raise taxes in 2042 to
almost 18 percent to meet that 366 billion
deficit, and continue raising taxes as Social
Securitys deficits increase. Or, we could put
aside money today. If we invested only in
government bonds earning 3 after inflation, wed
have to save less than one-third as much today --
109 billion. If we invested in stocks and bonds
earning 5 after inflation, wed need to put
aside only 49 billion today. Thats the power of
higher rates of return. We can pay a little
today, or force our kids and grandkids to pay a
LOT tomorrow. Which is the more responsible
choice?
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Other reasons for reformSocial Security and the
Modern Family

• Social Securitys benefit structure is stuck in
  the past it assumes that husbands will earn the
  wages while wives will remain at home, and it
  punishes couples who do not accord with this
  1930s norm.
• Dual entitlement rule A spouse is entitled to
  her own benefits or benefits equal to one-half of
  the higher earning spouse but not both.
• Working women pay an eighth of their wages as
  taxes, yet 63 percent receive no additional
  benefits for the taxes they pay. They could have
  received just as much by not working and simply
  accepting the spousal benefit.
• Social Security rewards single-earner families
  over dual-earner families, even though
  single-earner families often have higher incomes.

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Identical Earnings Can Mean Very Different
Benefits

• Tom and Beth Green (age 35)
• Tom earns twice the average wage, while Beth
  doesnt work outside the home.
• Tom retires in 2032.
• The Greens Social Security benefit
• 2098 for retirement, plus
• 1049 p/m spousal benefit 3147 p/m total.
• If Tom dies, Beth receives 2098 p/m in widows
  benefit, 66 of the Greens initial benefit

• Mike and Sue Smith (age 35)
• Mike and Sue both work and each earns the average
  wage.
• Mike and Sue retire in 2032.
• The Smiths Social Security benefit
• 1447 p/m for Mike plus 1447 p/m for Sue, equals
  2894 combined.
• Thats 253 less per month than the Greens
• If Mike dies, Sue receives 1447 p/m in widows
  benefit, 50 of the Smiths initial benefit.
  Thats just 69 of Beth Greens benefit, even
  though Sue paid into the system while Beth did
  not.

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Social Security and Divorce

• Spousal and survivor benefits are extended only
  to ex-spouses married 10 years or more. Marriages
  ending in divorce have a median length of just 7
  years, and fully one-third of all marriages end
  prior to the 10 years needed for benefit
  eligibility. An example
• George and Rita Ball obtain a divorce after 10
  years and 1 month of marriage. Rita is entitled
  to full spousal and survivors benefits based on
  her ex-husbands earnings.
• John and Judy Hill end their marriage after 9
  years and 11 months. Judy is entitled to no
  benefits based on her husbands earnings. If she
  did not work outside the home, she may have no
  entitlement to any benefits or protections.
• Personal accounts would be split 50-50 between
  divorcing spouses. These assets, left to compound
  until retirement, could significantly increase
  the benefits of women who might otherwise
  retirement into poverty.

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African Americans can be disadvantaged by Social
Security
Social Security benefits last as long as you
live, so the most benefits go to those who live
the longest. High-income Americans tend to live
longer than African Americans, who have lower
incomes on average. As a result, African
Americans receive nearly 21,000 less from Social
Security over their lifetimes than whites with
identical incomes and family profiles. Identical
people, but very different results. Nearly half
of all marriages among African Americans are
disrupted by divorce in less than 10 years,
making them ineligible for spousal benefits. A
greater number of African American women do not
remarry after divorce. African Americans do rely
disproportionately on Social Securitys
disability protections, but adding personal
accounts for retirement can make the system more
progressive and fair.
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As Social Securitys finances decline, so does
the rate of return it pays

• Early retirees got great deal paid in for a few
  years, collected the rest of their lives. Later
  retirees dont do nearly so well.
• Over long term, Social Securitys pay-as-you-go
  funding pays a rate of return labor force
  growth rate wage growth rate. Over the next 75
  years, thats roughly 1.4 percent annually after
  inflation.
• Real capital assets pay higher returns.
  Guaranteed government bonds, projected to earn 3
  percent, would increase benefits by over 50
  percent. Assets such as corporate bonds and
  stocks could produce higher returns.
• Basing Social Security funding on real capital
  assets means higher benefits at lower cost.
  Better protections, lower poverty, more dignity
  and independence in retirement.

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Real Rates of Return Falling for All Retirees
(Assumes No Change in Law, Retirement at Age 65)
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Property Rights
The Supreme Court has ruled that individuals have
no legal right to their benefits. This may give
flexibility to the government, but it denies
security to workers and retirees. It also
encourages politicians to make promises today
that they may not be able to keep tomorrow.
To engraft upon the Social Security system a
concept of accrued property rights would
deprive it of the flexibility and boldness in
adjustment to ever changing conditions that it
demands. Flemming v. Nestor (1960)
The proceeds of both employer and employee taxes
are to be paid into the treasury like any other
internal revenue generally, and are not earmarked
in any way. Helvering v. Davis (1937)
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Criteria for Reform To be successful, Social
Security reform should

• Increase economic growth In the future, smaller
  numbers of workers will support larger
  populations of retirees. Social Security reform
  can help make each worker more productive by
  raising national saving, thereby increasing
  worker productivity and boosting economic growth.
  
• Increase personal control Reform should give
  workers true legal ownership of their retirement
  savings, prevent the government from raiding
  Social Security for other purposes, and give all
  Americans the opportunity to build wealth and
  pass it on.
• Increase fairness The current system can be
  unfair to African Americans, who often do not
  survive to retirement age to working women, who
  often do not receive spousal benefits and the
  young, who must pay high taxes into a system that
  will be insolvent by the time they retire. Reform
  should correct these flaws so all Social Security
  participants feel they are treated fairly.

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Time is money Why we must act soon
Social Security is currently running surpluses,
but in 2017 those will turn to deficits. These
deficits grow very big, very fast 97 billion in
2021, 186 billion in 2025, 332 billion in 2035
(in 2002). If we wait to act we will have so
much trouble just covering the programs deficits
that prefunding may become too expensive.
The only alternatives then would be tax increases
or benefit cuts, which everyone wants to avoid.
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How would personal accounts be set up?

• Every plan is different, but
• Workers could invest part or all of their payroll
  taxes in accounts holding stock and bond mutual
  funds.
• In return, they would give up part of their
  traditional benefits.
• Only diversified funds would be allowed. Workers
  could not invest in single stocks like Enron or
  WorldCom. Choices would likely be limited at
  first to keep costs low.
• At retirement, workers could purchase an annuity
  or take gradual withdrawals of their money.
• If the worker died before the account was
  exhausted, the remainder would pass onto his
  spouse, children or a chosen charity.

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What is a Benefit Cut?

• Many critics charge that reform plans would cut
  benefits. But versus what?
• For instance, a low-wage worker retiring in 2042
  is promised a benefit of 896 per month (in
  todays dollars).
• Under one of the Presidents Commissions plans,
  that same worker would receive 806 from the
  traditional system, a cut of 90.
• But this ignores that
• Under law, the insolvent Social Security system
  can actually afford to pay that worker just 655
  per month, plus
• The personal account would add 180 per month,
  raising total Social Security benefits to 986
  per month.
• Thats 90 more than the current system even
  promises, and 331 more than it can actually pay.

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Are accounts investing in stocks too risky?
Just the opposite. A single male worker retiring
today can expect a 1.74 percent real return from
Social Security. Married couples can expect
around 2.5 percent. If he had a personal account
invested only in the SP 500, hed have received
around a 6 percent real return even after the
market decline. The stock market has never lost
money over 20 years or more, and today is no
exception. Workers wanting absolute safety could
invest in risk-free government bonds. Theyd
still receive higher benefits than the current
system, plus theyd have a true legal right to
their savings. If workers retiring today would
get higher benefits with personal accounts, who
wouldnt?
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Even after crash, personal account invested in
stocks would still pay more.
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Personal accounts are

• Flexible Your money works for you, whether
  youre working or staying at home.
• Equitable Resolve many of the inequities
  concerning divorce, dual-earner families, widows
  benefits, African Americans.
• Empowering Low earners could create wealth
  without paying higher taxes, and could pass that
  wealth on to their heirs.
• Voluntary Personal accounts would be voluntary
  its your money, its your choice. No one would
  be required to invest in the stock market.
• Most of all, theyre yours you would own the
  account, you could control it, and no politician
  could raid it to pay for other programs. When you
  die, you could pass it on to your heirs.