Social Security 101: The Program and the Problem

1
Social Security 101The Program and the Problem
Social Security University February 19,
2003 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
2
Challenges Facing Social Security

• Its going broke Social Security will begin
  running payroll tax deficits within 15 years. By
  2041, it will be legally and financially unable
  to pay full promised benefits, resulting in cuts
  of 25 percent or more.
• Its unfair Social Security often discriminates
  against working women divorcees African
  Americans and younger Americans.
• It hurts wealth creation asset ownership brings
  a host of economic and social benefits. Social
  Security discourages saving by the poor, reducing
  wealth accumulation and increasing economic
  inequality.
• Its risky workers have no legal right to their
  benefits, even after a lifetime of contributions.
  The lack of a legal obligation encourages the
  government to make promises it cannot keep, and
  to delay action on reform.

3
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. Not a
  welfare program.
• 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.

4
Social Security and the Budget
Social Security is already the biggest single
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.
5
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. Reform centers on the retirement
portion of Social Security.
6
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)

7
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.
8
Pay-as-you-go Financing

• Social Security is a pay-as-you-go system.
  Contributions from todays workers are not saved
  to pay their retirement benefits, but immediately
  used to pay benefits to todays retirees.
• A pay-as-you-go program can begin paying benefits
  quickly. (System started in 1935, first benefits
  paid in 1940).
• Pay-as-you-go financing provides big windfalls to
  early retirees, who only paid in for a few years.
  (First retiree, Ida May Fuller of Ludlow,
  Vermont, paid 24.75 in taxes lived to age 100
  and collected 22,889 in benefits.)

9
Downsides of Pay-as-you-go

• But a system that transfers money rather than
  investing it is very sensitive to the number of
  people paying in vs. the number of people
  collecting the ratio of workers to retirees.
• Demography is turning these ratios against Social
  Security.
• People are having smaller families, meaning fewer
  new workers paying into Social Security.
• Seniors are living longer, and collecting for
  more years.
• And the Baby Boom generation is about to retire

10
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.
11
And low birth rates mean fewer new workers to
support them
12
Worker-retiree ratio falling
When the ratio of workers to retirees falls, each
worker must bear a greater financial burden. As a
matter of simple math, this will raise the
required tax rate from around 6 percent in 1960,
to 10.5 percent today, to around 17 percent in
2030.
2030 2.1 to 1
Today 3.4 to 1
1960 5.1 to 1
13
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
  you see tomorrows!

14
and without reform, costs will reach 20 percent
of payroll.
Today, Social Security is running a surplus. But
deficits will begin in 2017 and grow ever-larger.
15
Social Securitys deficits grow with each passing
year
The date of trust fund exhaustion has moved back
several years, to 2041. But each year, Social
Securitys long-term deficit has grown by
trillions.
16
Social security will dominate government spending.
Many Democrats favor reform because they fear
that Social Security will squeeze out other
programs they care about. Social Security,
Medicare and other senior-related programs could
swallow the entire federal budget by mid-century.
17
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 the Social Security trust fund
is merely a debt the government owes to itself.
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! The fund cannot put off the
need for action. That is why non-partisan
analysts agree that Social Securitys financing
problems begin with payroll tax deficits in 2017,
not when the trust fund runs out in 2041.
18
Experts say Trust fund cant 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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Annual repayments to the fund will equal the size
of whole cabinet departments

• The question isnt whether well honor the trust
  funds bonds no reform legislation in existence
  would default on them but how well do it. The
  how is to raise taxes, cut spending or run a
  budget deficit.
• By 2018, Social Securitys cash flow deficit
  would equals Head Start and the Special
  Supplemental Nutrition Program for Women, Infants
  and Children (WIC).
• By 2021, the shortfall is equivalent to the
  Departments of Education, Interior, and 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 Departments of
  Veterans Affairs, Energy, Housing and Urban
  Development (HUD), 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.

20
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.

21
The solution a funded system

• A funded system invests contributions from
  todays workers to pay their future benefits.
• A funded systems return equals the return on
  economic capital. (Only part of this return goes
  to stock-holders the rest flows to the
  government as taxes.)
• The return to capital averaged 8.5 percent after
  inflation from 1960 to 1996. Social Securitys
  pay-as-you-go return (labor force growth plus
  wage growth) averaged just 2.7 percent during
  that period.
• A funded system can pay the same benefits at just
  one-quarter the cost of a pay-as-you-go program,
  reducing the need for tax increases or benefit
  cuts.
• Funding can be done centrally by the government
  or individually through personal accounts.

22
Return to Capital and Paygo Return
23
Why does a capital-based system work?

• In economics, capital means the tools,
  factories and machines that are used produce
  goods and services.
• When there is more capital in the economy,
  workers become more productive, increasing
  economic output.
• With increased economic output we can support
  growing populations of seniors without raising
  taxes on workers.
• The details are complex but the principle is
  simple A funded Social Security system aims to
  strengthen the economy through increased saving
  and investing. A larger economic pie means bigger
  slices for everyone.

24
So whats the catch?

• A funded system pays higher benefits at lower
  cost than the current unfunded program. But to
  get to funded system, we have to put up the
  funds.
• Funding means higher costs in the short term.
  Thats true whether we fund through personal
  accounts, government investment of the trust
  fund, or by retiring existing public debt.
  Personal accounts are no more expensive than
  any other means of pre-funding Social Security.
• Moreover, transition costs bring transition
  benefits reduced burdens on workers, higher
  benefits for retirees, a stronger economy and
  higher wages.
• Fund transition with existing government
  spending. Cut corporate welfare, reduce pork,
  slow the growth of other programs. This money
  would be used more productively as private
  capital, and would channel the gains to something
  important Social Security.

25
Should the government invest?
Government investment of the trust fund in stocks
was supported by the Clinton administration and
by many opponents of personal accounts. But the
public is opposed In the latest Cato
Institute/Zogby International poll, likely voters
supported personal accounts over government
investment by 62 to 24 percent. Raids could
continue the current trust fund has been
raided to pay for other programs, and a central
fund of stocks could be too. Personal accounts
are tougher to raid, a stronger lock
box. Political risks Many fear that federal
ownership of American companies opens to the door
to political control over the economy, and could
bias investment decisions to help or harm
particular firms.
26
Greenspan and Gore Oppose Government Investment
of the Trust Fund
I think it's very dangerous... I don't know of
any way that you can essentially insulate
government decision-makers from having access to
what will amount to very large investments in
American private industry... I know there are
those who believe it can be insulated from the
political process, they go a long way to try to
do that. I have been around long enough to
realize that that is just not credible and not
possible. Somewhere along the line, that breach
will be broken. Alan Greenspan, Senate Banking
Committee, July 21, 1998 The magnitude of the
governments stock ownership would be such that
it would at least raise the question of whether
or not we had begun to change the fundamental
nature of our economy. Upon reflection, it seemed
to me that those problems were quite serious.
Al Gore, New York Times, May 25, 2000
27
How would personal accounts be set up?

• Workers could invest part or all of their payroll
  taxes in accounts holding diversified stock and
  bond mutual funds. Higher returns on market
  investments would increase expected benefits for
  the worker.
• Workers choosing accounts would give up part of
  their traditional benefits, reducing pressure on
  the current systems finances.
• 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.

28
Greenspan Supports Personal Accounts

• "I do think that the notion of moving some funds
  into private accounts is the appropriate thing to
  do. And I think we're going to be moving in that
  direction inexorably because of the way the
  economy is developing that is, more out of
  defined benefit into defined contribution, with,
  presumably, some form of safety net for
  individuals who turn out to have not had the best
  of experiences."
• Senate Budget Committee, January 2001
• My own preference is strongly in the direction
  of moving towards a privately financed system
  because I believe that's the quickest way to get
  to full actuarially sound funding and get
  programs which will work In my judgment,
  restoring Social Security to solvency can be
  most effectively be done in the context of
  gradually moving toward a private system.
• Senate Budget Committee, January 1998

29
Insolvency isnt the only problem

• Social Securitys benefit structure can
• Discriminate against working women and two-earner
  couples
• Deny benefits to many divorced individuals
• Disadvantage minorities and low-wage workers with
  shorter life expectancies, increasing inequality
  of wealth over generations
• Discriminate against younger workers, who will
  receive low returns
• Deny workers a legal right to their benefits.
• Personal accounts can help address these problems

30
Social 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.
• As a result, 63 percent of working women 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.
• The dual entitlement rule is one of the most
  regressive aspects of Social Security. According
  to the SSA, a high-income single earner couple
  receives higher returns from Social Security than
  a low-income single worker or dual-earner family.

31
Identical Earnings Can Mean Very Different
Benefits

• Tom and Beth Green (age 35)
• Tom earns twice the average wage, Beth doesnt
  work outside the home.
• The Greens monthly benefit
• 2098 for retirement, plus 1049 spousal benefit
  3147 total.
• If Tom dies, Beth receives 2098 monthly 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.
• The Smiths monthly benefit
• 1447 for Mike plus 1447 for Sue, equals 2894
  total.
• Thats 253 less per month than the Greens, who
  have the same household income.
• If Mike dies, Sue receives 1447 in widows
  benefit, 50 of the Smiths initial benefit. Sue
  receives just 69 of Beth Greens benefit, even
  though Sue paid into the system while Beth did
  not.

Source Urban Institute
32
Personal Accounts and Marriage

• Under a system of personal accounts
• Both husband and wife would have personal
  accounts of their own.
• Any work performed would increase the account
  balance and raise benefits at retirement.
• Single workers and dual-earner couples would no
  longer be discriminated against.

33
Social Security and Divorce

• To qualify for spousal and survivor benefits a
  marriage must last 10 years. But 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.
• George and Rita Ball are divorced after 10 years
  and 1 day 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.
• The Urban Institute says Social Security grants
  people who signed divorce papers after being
  married nine years and eleven months hundreds of
  thousands of dollars less than those who waited
  another month to divorce.

34
Personal Accounts and Divorce

• Under a system of personal accounts
• Couples who divorce would split their account
  assets accumulated during their marriage 50-50.
• There would be no time requirement. Even spouses
  divorcing prior to 10 years would receive
  benefits based on their spouses personal
  accounts.
• Example A woman marries at age 25 to average
  earner and divorces just prior to 10 years. Her
  share of account assets, if left to accumulate
  until retirement, could result in lump sums
  ranging from 10,000 to 40,000, increasing her
  monthly income by 55 to 215. (Based on reform
  proposals from Presidents Commission.)

35
African Americans and Social Security
Shorter Life Expectancies One-third of black
males will not live to collect retirement
benefits others collect for fewer years. As a
result, African Americans receive nearly 21,000
less from Social Security over their lifetimes
than whites with identical incomes and family
profiles. This neutralizes much of Social
Securitys progressivity. Lower Incomes 75
percent of African Americans receive most of
their retirement income from Social Security 37
percent receive all of it (thats double the
percentage for whites). Since Social Security
cant be passed on, inequality of wealth is
increased. Spousal Benefits In 1998, only 36
percent of black females were married (versus 58
percent of whites), meaning that most black women
will be ineligible for spousal benefits.
Divorce Nearly half of all marriages among
African Americans are disrupted by divorce in
less than 10 years, contributing to ineligibility
for spousal benefits. A greater number of African
American women do not remarry after
divorce. Disability African Americans do rely
disproportionately on Social Securitys
disability protections, but personal accounts can
make the retirement program more progressive and
fair. (Many personal account plans also make the
disability program more progressive.)
36
Personal accounts and African Americans

• Personal account plans increase Social Securitys
  progressivity versus the current system, often
  substantially so.
• Workers who die prior to retirement would have an
  inheritance to pass on, in addition to Social
  Securitys traditional survivors benefits.
• Bequests important to African Americans The
  median U.S. household owned 17,400 worth of
  financial assets in 1998, including retirement
  accounts. For African American it was only
  3,060.
• Personal accounts would allow spouses, children
  and the community to retain wealth,
  disproportionately benefiting African Americans
  and reducing wealth inequality.

37
Younger Americans Disadvantaged
Non partisan analysis shows the popular Social
Security program that paid high benefits with low
tax rates no longer exists. Most younger
Americans will receive lower returns than if they
had invested in risk-free government bonds. Low
returns mean lower retirement incomes, less
security, greater poverty in retirement.
Real annual return
Source Dean R. Leimer, Cohort-Specific Measures
of Lifetime Net Social Security Transfers,
Social Security Administration.
38
Social Securitys Return

• Calculating Social Securitys rate of return for
  individuals is complex. But calculating the
  systems overall return is relatively easy.
• Social Securitys return the rate of growth of
  the labor force the rate of growth of wages.
  More workers, earning higher wages, means more
  money to distribute to retirees.
• From 1960 to 1996, Social Securitys
  pay-as-you-go return averaged roughly 2.7 percent
  after inflation. (Early retirees earned higher
  returns, because they paid taxes only for a few
  years.)
• Over the next 75 years, Social Securitys return
  will be only around 1.4 percent. Thats not
  nearly enough to pay the benefits it has promised.

39
Real Rates of Return Falling for All Retirees
(Assumes No Change in Law, Retirement at Age 65)
40
Personal Accounts and Younger Americans
Young Americans are the strongest supporters of
personal accounts 75 percent support in July
2002 Zogby poll. Even reform opponents polls
have found support 69 percent of Americans under
35 supported plan to require investment in
personal accounts. (2030 Center, 1999 poll note
that most account plans are optional.) Reform
would pay young Americans higher benefits at
lower cost than the current program. Example The
SSA found that a low-wage worker retiring in 2052
could expect benefits 26 percent higher under one
of the Presidents Commissions personal account
plans than under the current program, even if
both plans received the exact same amount of
funding. An average-wage worker could expect 16
percent higher benefits.
41
Property Rights

• Individuals have no legal right to their
  benefits.
• Workers pay a tax based on their wages and
  retirees receive a benefit based on their wages.
  However, there is no direct link between taxes
  paid and benefits received, and the tax and
  benefit formulas can (and have) been changed at
  any time.
• For example, the 1977 and 1983 reforms increased
  taxes and made large cuts in future benefits.
  What does this say about the government
  guarantee of benefits?
• The lack of property rights gives flexibility
  to the government but denies security to workers
  and retirees.
• It also encourages politicians to make promises
  today that they may not be able to keep tomorrow.

42
The Supreme Court on Property Rights
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)
43
The SSA on Property Rights
There has been a temptation throughout the
programs history for some people to suppose that
their FICA payroll taxes entitle them to a
benefit in a legal, contractual sense. That is to
say, if a person makes FICA contributions over a
number of years, Congress cannot, according to
this reasoning, change the rules in such a way
that deprives a contributor of a promised future
benefit. However, Congress clearly had no such
limitation in mind when crafting the law. Like
all federal entitlement programs, Congress can
change the rules regarding eligibility--and it
has done so many times over the years. The rules
can be made more generous, or they can be made
more restrictive. Benefits which are granted at
one time can be withdrawn, as for example with
student benefits, which were substantially
scaled-back in the 1983 Amendments. Source
www.ssa.gov/history/nestor.html (emphasis added).
44
Personal Accounts and Property Rights
Unlike the current program, personal accounts
would give workers a true legal property right to
their contributions and benefits. Social Security
would no longer be a political football. Workers
and retirees would not have to worry that
politicians would cut their benefits. As
property, personal account assets could be passed
on to a spouse, children or a charity. Unlike the
current system, contributions to personal
accounts couldnt be raided to pay for other
programs. Personal accounts are the ultimate
lockbox.
45
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.

46
Social Security reform should

• Increase economic growth Smaller numbers of
  workers will support larger populations of
  retirees. By raising national saving, Social
  Security reform can boost worker productivity and
  increase economic growth .
• Increase personal control Reform should give
  workers true legal ownership of their retirement
  savings, prevent the government from raiding
  Social Security, 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 to
  divorced workers, who are often denied benefits
  and to 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.

47
Where to from here?
There is no easy solution but 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.
Every year that passes increases the cost of
reform by hundreds of billions of dollars. We
must act soon!
Every congressman and every American needs to
learn about Social Security, the problems it
faces and the solutions that have been proposed.