Your greatest retirement fear
Can you count on social security?
October 11, 2002: 10:53 AM EDT
By Walter Updegrave, CNN/Money Contributing Columnist

NEW YORK (MONEY Magazine) - If you want to rile Dean Baker, co-director of the Center for Economic and Policy Research, just suggest that the Social Security system is in dire straits.

Sitting in one of the center's cluttered fifth-floor offices in the Dupont Circle neighborhood of Washington, D.C., Baker is obviously incensed at the notion. "The idea that the system is on some precipice is just not true," he says.

If we do nothing, Social Security will pay benefits until 2041. And even if we don't do a thing until after 2041, the benefits paid would be higher in real-dollar terms than they are today."

Just a few blocks across town, Michael Tanner, director of the Cato Institute's Project on Social Security Privatization, sees the situation, shall we say, somewhat differently.

"Taxpayers are putting money into a program that cannot pay the benefits promised to them," he says. "That's a problem they're facing now, not just down the road."

Tanner believes the system needs to be redesigned as soon as possible to allow employees to invest some portion of their Social Security taxes in stocks and bonds.

So who's right? Baker? Tanner? Or perhaps Henry Aaron, a Social Security expert at the Brookings Institution? Like Tanner, Aaron believes that the system faces major financial challenges that must be addressed sooner rather than later. But, like Baker, he remains committed to Social Security's basic design. "Modest modifications can return the system to long-term solvency," says Aaron. "But individual accounts are fundamentally incompatible with the notion of social insurance, which is to insure basic income."

Welcome to the great Social Security debate, which amounts to nothing less than a battle for the soul of the system. At issue is what type of retirement program we will rely on: a "social insurance" plan much like Social Security today, in which workers support retirees in the expectation that the next generation of workers will do the same for them -- or a system that operates more like pension funds do, investing money today to accumulate assets that will support us when we retire.

This debate heated up during the 2000 presidential campaign and might have come to a head last December when the President's Commission to Strengthen Social Security -- co-chaired by former Sen. Patrick Moynihan and Richard Parsons, CEO of AOL Time Warner (CNN/Money's parent) -- issued a 256-page report recommending that individual accounts be integrated into the system. But by then Sept. 11 had intervened, and the topic had lost its urgency.

The Social Security system has faced serious financial problems before. Still, it has managed to address them while never missing a payment. So is today's situation really different? We'll try to clear away the hype and get down to the irrefutable facts.

To begin, Social Security is definitely not on the verge of bankruptcy, period.

At the same time though, over the long run, the system as it stands now will not be able to pay the benefits that have been promised.

At some point, current workers -- who are funding today's retirees -- could lose confidence in tomorrow's benefits, causing a backlash against paying into the system. After all, if you're not sure you'll be taken care of by the next generation, you're going to need all the retirement savings you can muster.

What that means: It's time for some serious decisions about the future of this iconic program. Yet politicians know they're in for criticism no matter what remedies they recommend, raising the possibility that we'll end up dealing with the system's problems the same way we often have in the past: waiting until a looming crisis forces us to act.

The choices we face are not academic. Every realistic proposal to fix Social Security will either produce lower benefits, raise taxes or require that revenue be shifted from other government programs -- or all three.

The system we end up with will affect how virtually all Americans plan for retirement and will help determine the financial security of the entire nation. There are risks and opportunities no matter what course we take. So how do we decide what to do? And how do we plan for our futures in the meantime?

How the system works

Social Security is massive in scope. It churns out checks that average $720 a month to more than 46 million people, a number that includes not just 32 million retirees and their dependents, but nearly 7 million survivors of deceased workers and 7 million people with disabilities.

The program's design, however, is relatively simple. It collects money from workers in the form of payroll taxes -- currently 12.4 percent, split equally between employers and employees, on a maximum of $84,900 in pay -- and receives a portion of the taxes that higher-income retirees pay on their benefits.

If the system takes in more in taxes than it needs to pay benefits, the excess is used to purchase special nonmarketable Treasury bonds that can be redeemed at face value at any time, even if interest rates have climbed.

Those Treasury bonds make up the famed Social Security trust fund. It's important to understand what that fund is and isn't. It isn't a reserve of the sort that a pension fund creates. The Treasury bonds that the Social Security trust fund own are simultaneously assets of one arm of the government (the trust fund) and liabilities of another (the U.S. Treasury).

When the trustees eventually begin to present bonds from the trust fund to the Treasury for money to pay benefits, the only ways the Treasury has of paying those bonds are to divert revenue from other programs, raise taxes or borrow more.

Ultimately, the U.S. taxpayer is on the hook. "It's not as if the bonds are Martian securities and Mars will be sending us money to pay benefits," says Thomas Saving, a Social Security trustee and member of the commission that recommended privatization.

But for the moment at least, Dean Baker's sunny assessment of Social Security is correct. This year alone Social Security projects that it will collect $545 billion and pay out $465 billion, boosting the value of the bonds held by the Social Security trust fund to $1.4 trillion.

This situation will begin to reverse itself in 15 years, as benefit payments start to outstrip income and surpluses give way to deficits.

There are several factors contributing to this reversal of fortune.

First, earlier generations of retirees got generous payments, compared with what they paid into the system. Second, birth rates have been declining while life expectancies have been increasing.

That has lowered what Social Security calls the "dependency ratio," essentially the number of workers per Social Security beneficiary. In 1970 this ratio was at 3.7. It stands at 3.4 today and will slide to 3.1 by the end of the decade and to 2.1 by 2030, when the majority of baby boomers will be collecting Social Security.

Finally, a variety of economic assumptions made in the late 1970s and early 1980s, particularly those related to productivity growth, have also contributed to the system's financial woes.

Although productivity growth had slowed in the 1970s from its levels in the '50s and '60s, the trustees and the system's actuaries thought that it would rebound, raising wages and payroll taxes.

Instead, productivity remained in a funk throughout the '80s and early '90s, and so did payroll tax growth. The result: creating less income for the Social Security system than expected.

Where we stand

What all that means, according to estimates by the Social Security trustees, is that beginning in 2017 the system will have to start relying on the interest on its cache of Treasury bonds and then cash in the bonds themselves to cover benefits. The trustees calculate that the trust fund will last until 2041.

That doesn't mean Social Security would be bankrupt, however, as is sometimes reported in the press. Payroll and income taxes will continue to flow in just as before. But those taxes won't be enough to pay full benefits; they would provide just under 75 percent of what's currently scheduled.

And the situation would worsen from there. To get a full sense of the challenges the system faces, let's look at what the trustees refer to as the "actuarial balance," or the difference between Social Security's income and its benefit payments expressed as percentages of payroll over the next 75 years (a period long enough to gauge the full impact of any program changes). If the taxes collected over that span match the costs of scheduled benefits, the system is in actuarial balance. If costs exceed taxes, then the system is running an actuarial deficit.

According to the latest forecasts, Social Security faces an actuarial deficit equal to 1.87 percent of payroll over the next 75 years. Theoretically, this means you could balance the system by boosting payroll taxes by 1.87 percentage points -- a 15 percent increase. But even if you did this, it wouldn't put the system back on track permanently. That tax hike would provide just enough revenue to cover costs for the next 75 years. But the gap between income and costs would continue to expand year by year. So the system would enter its 76th year facing an immediate deficit of roughly 4.5 percent. We would be leaving future generations to grapple with a deficit more than twice as large as the one we face today.

What if the trustees and actuaries are now too pessimistic in their assumptions? Consider: Even if long-term productivity growth were to jump by almost a third -- a huge increase by historical standards -- the Social Security Administration estimates that its deficit over the next 75 years would shrink by only a little more than 25 percent.

To prevent further deterioration that might require even larger fixes, the system needs to be changed earlier rather than later. The question, of course, is what should we do?

The big divide

The glib answer is to pour more money into the system, scale back benefits or both. But any solution to the system's problems involves more than rejiggering numbers on a spreadsheet to satisfy actuaries. It's going to have to deal with a fundamental philosophical divide that lies at the heart of this debate.

Social Security, as it stands today, formalizes a social compact that societies have honored for ages -- parents caring for their children, who in turn care for their aging parents. Some defenders of Social Security see this social contract as a fundamental strength and propose reducing retiree benefits or raising payroll taxes to preserve it. Others see this same arrangement as Social Security's fundamental flaw. "The problem is that we made these huge promises to people," says Saving, "and because of them people are doing less to prepare for retirement."

The Brookings Institution's Henry Aaron, author of "Countdown to Reform: The Great Social Security Debate," is among those who want to preserve Social Security as it stands, and he has outlined a series of benefit cuts and revenue increases that he says could restore it to financial health. He begins by noting that the age at which you can receive full benefits is already scheduled to rise from 65 to 67 by 2022. Aaron advocates moving that date up to 2011 and then continuing to boost the full benefits age to reflect rising life expectancies. He'd also raise the age at which you can qualify for reduced benefits from 62 to 64 by 2011 and increase it in line with life expectancy thereafter.

To effectively cover the historical tab for providing generous benefits to people who have already retired, Aaron would transfer funds from general tax revenues. And to boost revenue from payroll taxes, he would require all newly hired state and local government employees to be part of the Social Security system. Aaron would also tax Social Security benefits much the way private pensions are taxed, which would amount to a benefit cut for existing as well as future retirees.

Finally, he recommends allowing Social Security's trustees -- not the beneficiaries -- to invest 20 percent or so of the system's surplus in stocks, and he would permit the trustees to invest in the bonds of Fannie Mae and government agencies as well. This would give the trust fund a higher return than it currently receives on Treasury bonds.

Would it all work? The math adds up, but Aaron acknowledges that as a practical matter, benefit cuts and tax hikes are unpopular solutions that no political leader has been willing to champion. "Most of these things wouldn't get 10 votes in the Senate or 30 in the House," says Aaron.

Private accounts

Creating private accounts within Social Security, on the other hand, has plenty of vocal supporters -- but it also faces high political hurdles. Its champions want to give you the option to invest some portion of your payroll taxes in an account that you, not the government, would own. In effect, you'd be saving for your own retirement, much the way you do when you invest in IRAs and 401(k)s. You would also have access to a broad range of investment options, such as stock and bond funds.

Last December, the President's Commission to Strengthen Social Security recommended three models of private accounts in December 2001, one of which -- Model 2 -- is generating the most interest. Without going into the plan's myriad details, here's the gist of how it would work.

You could voluntarily direct 4 percent of your Social Security payroll taxes into a personal account, up to a maximum of $1,000 a year. The rest of your taxes would continue to go into the Social Security system. You would decide how to invest the money in your private account, presumably divvying it up between stock and bond funds.

If you chose this option, however, you would have to give up a portion of your traditional Social Security benefits. Specifically, your regular benefits would be reduced by the amount you contributed to your account, compounded at an annual rate of 2 percent above inflation. The upshot: If your investments earned more than two percentage points a year above inflation -- a feat that diversified portfolios of stocks and bonds have often, though not always, managed to do over long periods -- you would come out ahead.

Would you be better off under this system than our current one? The commission says that workers opting for personal accounts can reasonably expect to collect larger benefits than those who don't choose private accounts and stick with traditional Social Security. Plus, workers with private accounts should do better than current retirees, after adjusting for inflation.

But there's a rub with this plan. It turns out that projected benefits under private accounts are lower than what future retirees are slated to get under existing Social Security rules. That's because the commission would tie starting benefits to inflation rather than linking them to wage growth, the present, more generous, practice.

In other words, even the private-account scenario assumes benefit cuts. Commission member Thomas Saving makes no apologies about this. He refers to it as "capping the promise" and considers it an integral part of the commission's reforms -- a way for retirees to keep at least some of their benefits without saddling future workers with ever-increasing taxes. Of course, the idea of capping the promise is likely to be as politically unpopular as Aaron's proposed cutback.

Privatization shares something else with Aaron's plan to shore up the existing system -- it too would have to tap general tax revenue, at least temporarily, to keep the trust fund solvent. That's because letting people now in the work force fund private accounts means diverting some payroll taxes from the Social Security system. That, in turn, means that the government would have to come up with other money to pay current retirees.

Again, no apologies. Charles Blahous, executive director of the President's commission and a member of the National Economic Council, argues that while diverting money to private accounts would raise costs in the short run, privatization would generate far lower deficits over the long run. "You pay a little price up front," he says, "and save a ton of money over the long term."

What it means for you

So what are we to make of all this -- the conflicting visions, the jumble of numbers, the projections that stretch out longer than most of us will live? The place to begin is with this sober assessment: Even if 2017 seems far off, in the world of retirement planning, 15 years is not the distant future. And although approaches to fixing the system are dramatically different, there are two common threads: First, you can expect to continue to earn Social Security benefits. But second, they will be getting smaller.

Does that mean you should heed some planners' advice and enter a big "0" for Social Security on retirement planning worksheets? No. Benefits for people already retired or nearing retirement are by and large secure -- any cuts would likely be indirect, in the form of higher taxes. The rest of us, however, are much more likely to see our benefits scaled back from what we're expecting. It wouldn't be unreasonable to factor in cuts of, say, 25 percent or so into your long-term planning -- and then ramp up your own savings to close that gap.

Otherwise, the two main options to reform Social Security present different risks and potential pitfalls -- both to individuals and to the retirement system as a whole. Let's start with private accounts. You may feel more comfortable investing your own money rather than relying on the government for your retirement income. But in return for the freedom to invest, you have to take on market risk in yet another part of your retirement portfolio. Depending on your skill -- or luck -- as an investor, your Social Security benefit could be far lower than what the President's commission projects. And even if you invest wisely throughout your career, a market setback on the eve of your retirement could force you to scale back your standard of living considerably, as many retirees have had to do recently.

And while private accounts certainly let you tap into the wealth-building power of equities, it's important to remember that we can't all boost our returns by investing in stocks. If hundreds of thousands of private-account owners begin funneling vast amounts of money into the stock market, all other things being equal, stock prices would rise, dampening the potential for future returns, while the opposite would happen with other assets such as bonds. So although an individual investor may be able to earn a higher return by moving from bonds into stocks, we can't boost the returns to society as a whole simply by shifting from one asset class to another. Stocks can't save Social Security.

Finally, it's hardly a given that private accounts will lead to greater saving overall -- either for the nation or for individuals. Over the next seven decades the commission estimates that private accounts would accumulate some $12.3 trillion -- a tidy retirement reserve by any measure. Even if those projections are on target, however, it doesn't necessarily mean that Americans' overall retirement savings would have increased by that amount. It's possible that, as people see the balances of their private accounts swell, they might feel so flush that they save less in other accounts, much the same way the American savings rate dropped during the 1990s as the bull market pumped up our investment accounts. In short, there are financial projections, and then there are the psychological factors that influence the way people behave -- and the two don't always square.

Sticking with the current system may seem like a more certain bet -- at least one portion of your retirement is not riding directly on the financial markets. Today you can go to the Social Security Administration's benefits calculator, plug in some information about yourself and get a precise dollar figure of the benefit you're scheduled to receive.

But in reality this figure is no more certain than the commission's private-account projections. The reason is that even though we've come to think of Social Security benefits as guarantees, they're not.

More than 40 years ago the Supreme Court ruled that policy makers can change the benefit formula to reflect shifting conditions. So Congress can cut benefits anytime and has done so several times over the years. Lawmakers don't come out and say this openly, of course, but by raising the age at which participants can collect full benefits or by subjecting Social Security benefits to taxes, that's what they've done.

As a practical matter what this means is that with our pay-as-you-go Social Security system, the risk you face is a political one. This system ultimately relies on future generations agreeing to pay higher taxes. To keep the system going after 2075, workers could be hit with payroll taxes upwards of 20 percent, a 55 percent increase from today. How realistic do you think that is?

Making the choice

At this point, it's still unclear when we'll address Social Security reform in earnest. Even if politicians had the stomach to take on the issue, homeland security and the situation in Iraq seem to be their major concerns at the moment. Any timetable for reform will also depend on the outcome of the November congressional elections. It's possible that the whole issue could be put off until the next presidential election -- or even beyond.

Eventually, however, we're going to have to make some decisions, as a nation and as individuals. Either a fix like the one Aaron proposes or the introduction of private accounts could restore stability to the system and ensure continued benefits. In the end, the choice is as much a philosophical decision as a financial one, hinging on how we believe a society should plan for the security of its citizens.

The future of Social Security -- and by extension the retirement security of this and future generations of Americans -- hangs in the balance. And the longer we put off dealing with reforms, the tougher the adjustment will be, no matter what type of retirement system we finally choose.  Top of page

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