SOCIAL INSECURITY

One thing that I find curious – if not disturbing – is that it has somehow become the conventional wisdom that the American worker’s key safety net, the Social Security system, is broken and thus must be “fixed.” Among the so-called problems that need addressing are that the system’s trust fund is in danger of running out of money and that its assets as such consist of nothing but Washington’s IOUs, whose value might be less than anticipated when they are redeemed to pay benefits.

This mantra that Social Security is in trouble is being repeated constantly by leaders of both political parties, pundits and the press as though it were inevitable, like death and taxes. Fixes that are being bandied about include raising the retirement age, elevating the amount of income subject to Social Security tax, increasing the tax rate itself, decreasing benefits (or at the very least, changing the way benefits are adjusted to account for inflation) and allowing younger people to divert some of their taxes into private savings accounts, where, presumably, they will be able to earn more than they currently do.

Since the system is currently pay-as-you-go, this last idea would require the government to borrow huge sums of money to make up the gap between tax revenues flowing into the system and payments to retirees – borrowing that the Bush administration's assets should not be counted as part of its current budget deficit.

Needless to say, discussions such as these concern a growing number of people. Retirees worry that they won’t get what’s been promised to them. Younger people are disturbed that they will have to work longer for less – and be taxed more in the process. And the financial markets, already trying to digest today’s huge budget deficits, do not like the idea of even more red ink, going forward – witness the recent decline in the value of the dollar in foreign exchange markets.

Let me see if I can shed some light on this important subject. At present, the system is in excellent financial shape. Social Security tax inflows far exceed benefit outflows, putting the system in surplus. Total benefits paid in 2003 were $471 billion, while income was $632 billion. Assets held in special issue U.S. Treasury securities totaled $1.5 trillion. Moreover, under all assumptions made by the system’s actuaries, this annual surplus is projected to grow for at least 10 more years. The combined assets of the system’s trust funds, currently more than three times annual expenditures, are projected to grow to nearly 4 1/2 times annual outlays by 2013.

The problem, according to some, is that this happy state of affairs is expected to reverse around 2018, as benefits paid start to exceed revenues flowing in. Soon after, the trust funds will begin to shrink, and by 2042, these funds will be completely exhausted, according to this projection. This means that if no changes are made, Social Security from that point on will have enough money from payroll taxes to pay only about three-fourths of promised benefits.

This development is based on a number of assumptions underlying the actuaries’ main projection, including one that seems both inevitable and extremely important – a decline in the ratio of working-age people to persons 65 and older. A long-term trend, this is expected to continue well into the middle of this century, due to such ongoing changes in demographics as the aging of the baby-boom generation, a continuation of the low birth rate and increasing life expectancy. But there are other assumptions that go into the actuaries’ projection as well, including net immigration, wage rates, the rate of inflation, interest rates and economic growth. At any rate, the system is expected to have money to pay benefits beyond 2042, only not enough on an ongoing basis.

The next thing you should know is that the system’s actuaries produce not one but three long-range projections, each looking ahead 75 years. These are updated every year. For lack of better terms, they are known as low cost, high cost and intermediate. It is the intermediate assumption that has become the basis for the conventional wisdom that the Social Security system is broken and needs to be fixed.

However, the assumptions underlying the intermediate projection are very conservative – especially when it comes to economic growth. The actuaries’ low-cost projection shows that even though the Social Security system eventually pays out more than it takes in (Chart 1), the gap is so small that the trust fund not only does not run out of money between now and 2080 – its assets actually swell to $70 trillion dollars (Chart 2).

Let’s focus on the growth assumptions, for here the biggest disparity exists between projections for the future and past history. As you can see from Chart 3, the main or intermediate projection assumes that the economy will grow by an annual rate of 1.9 percent per year over the next 75 years. This is far below the 3.6 percent average annual growth rate that the economy has posted during the past 75 years – a period that includes the Great Depression. The low-cost projection assumes, among other things, a slightly faster average annual growth rate of 2.7 percent. While this, too, is below the 75-year average, it produces the result depicted in Chart 2 – a system that never runs out of money.

A couple of other points about these long-term projections should be noted. The first is that the anticipated date for depletion of the system’s assets has been moved forward almost yearly. Five years ago, the system’s actuaries thought the assets of the trust funds would be exhausted in 2032. Two years later it was 2037. Now the exhaustion date is 2042. Meanwhile, the Congressional Budget Office, which makes these projections as well, thinks the system will remain solvent until 2052. In other words – there is plenty of room for differences of opinion regarding when, if ever, the system will run out of money.

Notwithstanding this, the administration has made “reforming” the Social Security system the centerpiece of its second-term economic plan. Although it will no doubt look at some of the proposals noted on page one, in the main, it wants to give workers the ability to take some of their tax revenues and invest them on their own – similar in fashion to today’s 401k plans. This is known as privatizing Social Security, and it could well create more problems than it may solve.

For one thing, as noted earlier, while the Social Security system is currently taking in more money than it is paying out, the fact remains that for all practical purposes, it is pay-as-you-go. In other words, today’s workers’ Social Security taxes go directly to pay the benefits to today’s retirees – even though they get credit as a bookkeeping entry toward their own retirement benefits. Allowing even some of today’s workers to privatize, or invest a portion of their taxes in separate accounts, would leave a gaping hole in the system, which the government would have to plug by borrowing.

The administration would have us believe that this borrowing should not be considered as adding to its current budget deficit. This is because the amount of money being put into these personal retirement accounts reduces the government’s future Social Security obligations by this amount, if not more. In effect, the government is prepaying its benefits obligations. In reality, borrowing is borrowing, and no amount of off-the-books accounting can change this. Indeed, the need for transparency was the very reason why the Social Security system’s income and outgo was commingled with the rest of the government’s budget years ago.

Aside from this, there is the question of investment returns. As you can see from Chart 4, the total return (price changes plus dividends) from the Standard & Poors 500 varies considerably from one year to the next. While the rate of return from investing in equities has averaged 11.8 percent since 1965 compared with the 7.5 percent the trust fund has earned, there have been a number of years when the stock market return was actually negative. Obviously, such losses are significant to someone who happens to be close to or is actually retired. This erratic performance raises serious doubts in my mind regarding the advisability of allowing relatively unsophisticated people to divert into the stock market part of the funds they had been relying on as their safety net.

The foregoing leads me to several conclusions. The first is that, contrary to popular belief, the Social Security system is not in danger of going broke anytime soon. If anything, the system is flush with funds and even if it should run out of money, it will still be able to pay at least three-quarters of promised benefits. And even this can be avoided without making major changes to benefits, tax rates or the retirement age by using the government’s general tax revenues to make up the difference between Social Security’s income and outgo.

Most important, the projection that the Social Security system will run out of money is based on very conservative assumptions – particularly with regard to expected rates of economic growth. Using more reasonable assumptions, the system remains flush with funds as far into the future as 2080, if not beyond.

As far as the assets being invested in the government’s IOUs, the nominal rate of interest is, of course, guaranteed. The real return will be determined by what happens to the rate of inflation over the years. Hopefully this factor will be inconsequential, but only time will tell.