This article was originally published in the Fall 2002 issue of MONEY Magazine.
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 said.
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 working Americans to invest some portion of their Social Security taxes in stocks and bonds.
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.
To know what we should do next, you first have to understand how the system works. What follows is an adaptation of a story that ran in the Fall 2002 issue of MONEY Magazine. For the complete version, click here.
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 fairly 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 $87,000 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 out, the excess is used to purchase Treasury bonds that can be redeemed at face value at any time, even if interest rates have climbed. Those bonds make up the famed Social Security trust fund.
Where we stand
For the moment at least, Social Security appears to be in good shape. For 2004, the administration projects it will collect $582 billion and pay out $499 billion, boosting the value of the bonds held by the Social Security trust fund to $1.7 trillion.
This situation will begin to reverse itself in 2018, 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 received overly generous payments. Second, birth rates have declined while life expectancies are on the rise.
What all that means, according to estimates by the Social Security trustees, is that beginning in 2018 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 2042.
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. It's just that those taxes won't be enough to pay full benefits; they would provide just under 75 percent of what's currently scheduled.
The situation would worsen from there, as costs begin to outstrip income to the system. A tax hike to make up the difference would be a short-term fix and potentially leave future generations to grapple with a deficit more than twice as large as the one we face today.
So what's the solution? Creating private accounts within Social Security 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.
Would you be better off under this system than our current one? The commission says workers opting for personal accounts can reasonably expect to collect larger benefits than those who stick with traditional Social Security.
But privatization 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 the government would have to come up with other money to pay current retirees.
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 2018 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.
Still, 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's not 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. In return for the freedom to invest your own money, you have to take on market risk in yet another part of your retirement portfolio. 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 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 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 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 bull market.
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 this figure is no more certain than the commission's private-account projections. 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.
Eventually, we're going to have to make some decisions, as a nation and as individuals. 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 choose.