Social Security Still Ill

May 12th, 2009 - 1 Comment

[This entry has been modified to include the new data released by the SSA. Changes are noted in strikethrough text. As expected, the date at which Social Security funds is projected to be exhausted has moved up to 2037 (four years earlier than before, but not as bad as the 2029 exhaustion date projected in the 1997 Trustees Report).  An earlier date than last year’s projection was expected because: (1)  The 5.8 percent cost-of-living adjustment to benefits this past January was higher than expected due to high oil prices in 2008, and (2) the unemployment rate is higher, which means that less payroll tax money is coming in (compared to what they expected in their report a year ago).]

The following is a primer on Social Security, its ailments, and options for fixing it by Ron Gebhardtsbauer, faculty-in-charge of Smeal’s Actuarial Science Program. Prior to joining Smeal, Gebhardtsbauer was senior benefits adviser for the U.S. Senate Finance Committee. He also served as senior pension fellow for the American Academy of Actuaries.

Members of Congress frequently call Social Security the most successful program of the federal government. It provides income to 50 million Americans and helps stabilize the economy.  It helped reduce poverty rates among the elderly from 35 percent in the late 1950s to 10 percent (which is also the poverty rate for Americans of working age).  Some negatives might be that it encourages people to leave the work force while they are still able to work, and it has been accused of breaking down the multi-generational American family (although the elderly and their adult children both like their independence).  My folks like their Social Security income the best, because it increases each year by the CPI.  They also like it better than their assets, because it comes in the form of an income, while they are afraid to touch their assets (which just fell 50 percent due to the stock market crash).  In summary, they don’t worry about their Social Security benefit decreasing or stopping, no matter how long they live and no matter how bad the markets are.

Social Security is huge. The Social Security Administration (SSA) will collect $700 billion in taxes this year and pay out $625 $672 billion in benefits (1/3 of which goes to survivors and disabled workers).  Their administrative expenses are less than 1 percent of benefits ($5.8 $6.1 billion), even though the benefit calculations are complex and the disability program is very difficult to administer.   This is much, much cheaper than any insurance company or mutual fund. 

Unfortunately, Social Security has financial problems due to our living longer, and not having as many children.  SSA actuaries project that their assets could be exhausted around 2041 2037.  Their taxes at that time will pay just 78 76 percent of benefits.  Even worse are the budget consequences.  Social Security tax income is currently $75 billion last year was $64 billion more than outgo, but this “annual surplus” is decreasing rapidly as the baby boomers retire.   By 2017 2016, outgo will exceed income, so we will have to increase our Income Taxes (and/or debt) to pay SSA its money back (since we borrowed and spent the surpluses).  In fact, we need to reform Social Security before 2017 2016. 

Social Security reform is needed soon.  Proposals rarely touch workers over age 55, so the longer we wait, the fewer baby boomers that can be a part of the solution, and thus, the greater the burden placed on younger people.  A 1983 reform increased the retirement age for full benefits from 65 to age 67, but delayed it for 17 years.  Actuaries frequently suggest raising retirement ages as the logical reform since we are living longer and are healthier at older ages, but people need time to plan for that change.  Another reason to reform now, is that some Americans don’t believe Social Security will be there when they retire.

Can we fix it?  It’s actually not that difficult to fix Social Security.  Eight common options (such as raising the retirement age, reducing benefits, or increasing taxes) are provided by the American Academy of Actuaries (www.actuary.org) Social Security Game.  A reporter reviewing the Web site wrote in the Philadelphia Inquirer that he solved Social Security’s problems over breakfast.  The problem is not that it can’t be fixed, just that people can’t agree on how to fix it.  Republicans are more likely to cut benefits and Democrats are more likely to increase taxes.  The changes do not have to be drastic.  The necessary tax increase would be less than the Capital Gains tax cut earlier this decade, and the increase in retirement age could be so gradual that it wouldn’t affect current workers much.  

The House of Representatives could pass a Democratic version, but they will likely need to get some fiscally conservative Democrats or Republicans on board in the Senate.  That won’t be easy.  It would require compromise legislation, which means everyone will have a difficult time voting for it.  Members of Congress hate voting for something that will irritate their constituents.

A bipartisan proposal is needed anyway, because Social Security needs universal acceptance in order to continue as “the most successful government program.”  It won’t be good if one faction is against the reform, as they will want to change it the next time they are in power. 

Possible Reforms

Thus, whatever passes will probably have some tax increases and some benefit cuts.  As an actuary, I believe we must raise the retirement age.  It doesn’t make sense for government programs to encourage people to retire when they are healthy—to be retired longer than they worked—but that’s what will happen if we don’t increase the retirement age.  Why should everyone pay larger taxes to let healthy intelligent people in their 60s retire, when there are so many more important needs to be met, like education and health care for everyone?  Indexation is the buzz word today.  Benefits are indexed to the CPI and initial benefits are indexed to average wage growth.   The indexation actually helps keep the system in balance, because past Congresses would enact bigger increases right before elections.  We could similarly index the Retirement Age to longevity.  That would keep the system from going out of balance if/when we live longer.  The retirement age would increase very gradually (one month every two years)—much slower than the fast increases in the retirement age that people barely noticed this past decade (from 65 to 66). It wouldn’t reach age 68 until around 2050.  Of course, Congress would have to deal with an unhappy labor movement, which fights for workers with physically demanding jobs.  It’s easy for actuaries with nice desk jobs to suggest others work longer or retrain.

Cutting Benefits:  Another prominent idea is “price indexation,” which would reduce future increases in the initial retirement benefit.  Currently, the initial benefit increases at the same rate as average wages, so that Social Security benefits will continue to replace about the same amount of wages for current and future generations of retirees.  For example, average wage earners retiring at age 66 have about 40 percent of their wages replaced by Social Security.  However, under price indexation, this 40 percent would gradually decrease, and in about 60 years the replacement rate would be half of that or 20 percent.  This proposal actually reduces benefits more than raising the retirement age, but people don’t realize it.   That’s because cutting benefits is not as transparent as raising the retirement age, which is another reason actuaries prefer raising the retirement age.  It sends a signal to workers that they need to work longer and retire later, if they want to continue the same standard of living as past generations.

Some proponents of price indexation have modified it so that it doesn’t touch workers in the bottom 1/3 of the income scale.  They call it “progressive price indexation” so you can be forgiven if you think it improves benefits—it doesn’t, but it sure sounds good.  Unfortunately, they would still continue the cuts forever.  The result is that eventually, Social Security benefits would be the same dollar amount for everyone, which abandons one of FDR’s key principals of Social Security, namely, individual equity (those who pay more into Social Security get larger benefits).  Opponents fear that a small flat benefit would eventually be seen as welfare, which could jeopardize the existence of the program.  This idea has been tried before.  In the 1980s under Margaret Thatcher, Great Britain switched to price indexation.  It helped their program financially, but after 25 years, Parliament realized that benefits were getting too small, so they went back to indexing to average wage growth.  Thus, price indexation can make sense as a temporary measure to gradually reduce benefits, but it probably doesn’t make sense to decrease replacement rates forever.

Raising Taxes:  President Obama proposed raising taxes on those with very high incomes, but that won’t produce anywhere near enough income to fix Social Security’s financial problems.  Unfortunately, Medicare is going to need more taxes too.  It may be difficult to increase taxes much for both programs.

Earnings-Sharing:  There is another indirect way to raise taxes, based on a proposal to share earnings.  Currently, wages are taxed up to the maximum taxable wage base ($106,800).  If one spouse earns more than the maximum, and the other spouse (often the wife) earns less (or has no wages), the second spouse will have a worse wage history than the first spouse, which means her Social Security benefits will not be as good, particularly if they divorce before 10 years of marriage.  The earning-sharing proposal would add up their earnings and split them evenly.  A sole wage earner could be taxed up to 2 times the maximum taxable wage base.  This would bring in more taxes and give both spouses the same earnings history for that year.  Under current rules, the non-wage-earning spouse gets a spousal retirement benefit equal to half of the wage-earning spouse’s benefit, but in many cases, that would not be needed any longer, which would also save money.  In fact, the spousal subsidy could be eliminated for everyone, but that could hurt certain one-earner couples (so it might not be easy to eliminate the spousal benefit to everyone).  Eliminating it, though, would greatly reduce the complexity of the Social Security system, and reduce the subsidy that dual-earner couples and singles pay to one-earner couples.

Investing in Equities:  Over the past 10 years there have been many proposals to obtain a better investment return than Treasury bond rates.  Some Democrats would invest some Trust Fund money in equities (like Canada), but Republicans were concerned about the government owning stock.  Others suggested that workers have Individual Accounts on top of Social Security, but that wouldn’t fix Social Security’s problems and Republicans saw it as a tax increase, even though the money went to one’s own account.  They preferred carving the Individual Accounts out of Social Security (as in Chile) but that just made Social Security’s financial problems worse, since Social Security needs more money not less.  These ideas were initially seen as an easy solution by their proponents, but eventually the public realized it was not a silver bullet.  Investing in equities has now become more controversial than cutting benefits or raising taxes.  Looking back after two “once in a century” market crashes, it may be all right that we didn’t do it for this “safety net” benefit. 

There is another way to give Social Security a higher rate of return that would avoid the governance and risk concerns above: When the Capital Gains tax rate goes back up in 2011, some of it could be dedicated to Social Security.  This was mentioned in a book by the current head of OMB.  Papers by economist Kent Smetters assert that this dedicated tax would be economically equivalent to investing a portion of Social Security assets in the equity markets.  The risk of a market crash is avoided because Capital Losses are limited to $3,000 per year. 

So maybe there are new ways of solving Social Security after all.  How would you fix Social Security?

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One Response to “Social Security Still Ill”

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