FRBSF Economic Letter
99-20; June 25, 1999
 Economic
Letter Index
Understanding the Social Security Debate
A recent poll indicated that there is considerable confusion about the
state and the fate of the Social Security system (NPR 1999). While most
Americans are aware of Social Security's impending financial crisis, confusion
over the dimensions of the program's problems appears to be undermining
support for the measures required to resolve them. This Economic Letter
reviews some of the basic facts about the U.S. Social Security system,
describes how it is financed and the factors contributing to its future
insolvency, and discusses options for restoring its financial health.
U.S. Social Security system
The Social Security program was enacted in 1935 in response to the economic
hardships imposed by the Great Depression. While the original program
paid benefits to a limited number of retired workers, numerous expansions
have made Social Security the most comprehensive public program in the
United States. Over 90% of American workers participate in the Social
Security system, contributing payroll taxes in exchange for publicly provided
retirement, disability, and survivors' insurance for themselves and their
families. In addition to providing near universal, as well as portable
and inflation-resistant, insurance against earnings loss, the Social Security
program has a redistributive function that shores up the retirement incomes
of life-time low earners, a feature not available in private pension plans.
Impact on retirement security
The Social Security program has dramatically improved the economic well-being
of the elderly. Estimates suggest that when Social Security began close
to 50% of the elderly lived in poverty. By 1959 the rate had fallen to
35%, but remained higher than that of other groups, including children
and working-age adults. During the 1960s and early 1970s, Social Security
benefits increased substantially and poverty rates among the elderly declined
rapidly (Figure 1). By 1974,
the poverty rate for elderly Americans had fallen below that for children,
where it has remained since. In 1993 it fell below the rate for working-age
adults. Today only 11% of the elderly have incomes below the federal poverty
line.
Studies show that without income from Social Security, the poverty rate
for the elderly would be much higher. The Social Security Administration
estimates that 47% of individuals age 65 and older would live in poverty
without Social Security benefits, four times as many as are in poverty
today (SSA 1999). Social Security's poverty reducing record, along with
its inclusiveness, have made Social Security one of the most popular social
programs in history.
Social Security financing
Although the language used to describe Social Security speaks of payroll
contributions, retirement savings, and a trust fund, Social Security is
unlike any private pension plan. Instead of investing workers' payroll
tax contributions when they are young and allowing them to draw down the
interest and principal during retirement, Social Security uses taxes from
current workers to finance payments to current beneficiaries, a system
known as pay-as-you-go. In the event that more Social Security taxes are
paid in a year than are necessary to fund current beneficiaries, the Social
Security Administration purchases special securities from the Treasury
Department and holds them in the Social Security trust fund. The bonds
in the trust fund earn interest equal to the average rate of return on
publicly traded government debt; this interest is credited to the trust
fund in the form of additional Treasury securities.
In 1998, the Social Security Administration collected $440 billion in
taxes and paid $382 billion in benefits and administrative fees, generating
a yearly surplus of $58 billion dollars to be invested in Treasury bonds.
Interest earned on existing trust fund assets during 1998 totaled $49
billion, producing an overall annual surplus of $107 billion. With the
addition of this surplus revenue, the Social Security trust fund closed
1998 with about $763 billion in assets.
Long-term financial imbalance
Although Social Security currently is booking a surplus, collecting more
taxes than it pays out in benefits, major demographic changes threaten
to erode its solvency. Based on intermediate projections by actuaries
at the Social Security Administration, benefit payments will outstrip
tax revenues beginning in 2014. By about 2022, benefit payments will be
larger than tax revenues plus interest from the trust fund, and Social
Security will need to sell Treasury securities to generate sufficient
revenue to pay claims. By 2034, the trust fund itself will be depleted
and the Social Security system will depend completely on tax revenues,
which are expected to cover 71% of outstanding claims (Figure
2).
The trust fund
Despite the fact that the Social Security trust fund is expected to last
through 2034, the costs of the Social Security imbalance will be felt
20 years earlier, when the Social Security Administration begins to redeem
its Treasury bonds. Under the unified budgeting system, surplus revenues
given annually to the Treasury by Social Security in exchange for bonds
are used to finance deficit spending by other areas of government. Some
of these activities can be thought of as investments, such as transportation
and education, but many others are pure consumption--transfer payments,
for example. Either way, when payroll tax revenues no longer cover benefit
claims in 2014, the Social Security Administration will turn to the Treasury,
which will need to finance the interest and principal payments by borrowing
from the public, reducing spending on other federal programs, or raising
revenues. Taxpayers likely will feel the costs in the form of increased
taxes or in the form of reduced resources for other activities.
How did this happen?
The viability of pay-as-you-go financing schemes depends heavily on the
size of the pool of taxpayers (workers) compared to the pool of beneficiaries
(retirees). In 1935, when Social Security was conceived, there were roughly
16 workers for every beneficiary, more than enough to support a modest
pay-as-you-go retirement program. Over time, program expansions and behavioral
changes steadily reduced this ratio so that today there are just 3.3 workers
per beneficiary. Shifting demographics will reduce the worker-to-beneficiary
ratio further during the next 30 years. Official projections indicate
that by 2030 there will be just 2 workers for every person collecting
Social Security benefits.
A major contributor to the projected decline in the worker-to-beneficiary
ratio is the rapidly approaching retirement of the baby boom generation.
The oldest of the generation will reach retirement age (65) in 2011, and
the youngest will reach it in 2029. The aging of such a large generation
alone would strain the ability of the program to pay benefits, but the
stress is compounded by the fact that a relatively small generation, the
baby bust, follows, and subsequent fertility rates have remained low.
As a result, the population of elderly as a share of the U.S. population
is expected grow from 13% to 20% during the baby boom's retirement, an
increase of 54%.
Exacerbating these population trends are increases in life expectancy
and declines in the average retirement age. In 1950 life expectancy for
males after age 65 was 12.8 years and the average retirement age was 69.
Thus, for the average male retirement lasted about 9 years. Today, male
life expectancy after age 65 is 15.7 years, and the average retirement
age has fallen to 64, meaning that the average male will spend approximately
17 years in retirement, about twice as long as earlier recipients. Projections
indicate that these trends in life expectancy and retirement will continue.
In 2030 men who reach the age of 65 are expected to live an additional
17.3 years, and spend nearly one quarter of their lives in retirement.
Restoring solvency
Although talk of reform dominates the current debate, Social Security's
long-term financial balance can be restored without changing the program's
basic structure. For example, the 75-year actuarial balance could be restored
simply and quickly by raising the current payroll tax by 2.1 percentage
points, from 12.4% to 14.5%. Revenues could also be increased by expanding
the taxable payroll level on earnings, including nonwage compensation
as covered earnings, and increasing the income taxation of Social Security
benefits. On the other hand, expenditures could be reduced by eliminating
or decreasing existing benefits, altering the benefit formula, increasing
the normal and early retirement ages, limiting or removing cost-of-living
adjustments on benefits, strengthening the earnings test, and imposing
means-testing for benefits. (For estimates of the effects of each of these
proposals, see GAO 1998.)
Measures like these have been used before (in 1982 for example), but
polls indicate that currently there is little support for restoring Social
Security's solvency by raising taxes or reducing benefits. Younger workers
are reluctant to accept additional payroll taxes, particularly when they
do not expect to receive Social Security benefits themselves; older workers
are opposed to higher ages for retirement and means-testing benefits;
and retirees do not want to see cost-of-living adjustments eliminated.
The lack of consensus around these options has prompted unprecedented
discussion of more basic reforms of the Social Security system.
Ideas for reform
Investment diversification, privatization, and prefunding are three concepts
receiving the attention of policymakers. Although many plans incorporate
all three reforms, each could be implemented independently. Diversification
refers to altering the investment strategy of Social Security, allowing
funds to be invested in assets other than Treasury securities. The idea
behind diversification is to take advantage of the historical return advantage
of common stocks over other financial assets (see Lansing 1998 for a discussion
of investment diversification). Privatization describes a system of personal
retirement accounts that are owned and directed by participants. The key
element of all privatization plans is that they award individuals greater
investment freedom; in exchange, individuals take on the investment risk
currently borne by the government. Prefunding involves saving privately
issued assets (like corporate bonds and equities) to finance future claims
against the system. Advance funding would make the Social Security system
more like private retirement programs where each generation builds up
assets sufficient to cover its future retirement costs.
Key to success
Proposals for reforming Social Security abound and range from maintaining
the current structure and tinkering with the investment strategy to dismantling
Social Security altogether and privatizing retirement savings. The key
to the success of any of these alternatives is early implementation. Each
year that no action is taken shortens the number of years over which the
costs are shared and shifts a larger portion of the costs to future generations.
Mary C. Daly
Economist
References
Annual Report of the Board of Trustees of the OASDI Trust Funds. 1999.
Washington, DC: U.S. Department of Health and Human Services.
Lansing, Kevin. 1998. "Can the Stock Market Save Social Security?" FRBSF
Economic Letter 98-37 (Dec. 11).
National Public Radio. 1999. "NPR, the Kaiser Family Foundation, and
Harvard University's Kennedy School of Government's Poll on Social Security."
http://www.npr.org/programs/specials/poll/990518.ss1.html.
Social Security Administration, Office of Research, Evaluation, and Statistics.
1999. "How Does Social Security Help Americans?" http://www.ssa.gov/policy/pubs/bgpRevOASDI.html.
U.S. General Accounting Office. 1998. Social Security: Different
Approaches for Addressing Program Solvency. /GAO/HEHS-98-33.
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