1

Social Security 101:The Program and the

ProblemSocial Security University

August 26, 2002

Presented by:

Michael Tanner, Director of Health and Welfare Studies

Andrew G. Biggs, Social Security Analyst

The Cato Institute, Washington, D.C.

www.socialsecurity.org

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Some Main Issues

Solvency: Can Social Security afford to pay what it promises? How can we strengthen the program?

Rates of return: Will Social Security be a good deal for Americans? Will future generations be as happy with Social Security as past ones have been?

Fairness: Does Social Security treat everyone equally? Can arbitrary differences in benefits be fixed?

Personal Control: Is Social Security flexible enough to accommodate people of different ages, races, marital statuses, and with different attitudes to risk? Will people have a legal right to their benefits?

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What is Social Security?

•The Social Security Act was passed in 1935 and the first benefits paid in 1940.

•A contributory social insurance program: everyone pays in and everyone receives benefits.

•Financed by a 12.4 percent tax on wages up to $85,000 (increases annually); the biggest tax most households pay.

• Provides retirement, survivors and disability benefits to eligible workers and their families.

•The largest government program in the world; takes up almost one-quarter of the total federal budget.

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Social Security and the Budget

Social Security

23%

All other

77%

Social Security is already the biggest item in the budget. Without change, it could eat up 29 percent of the budget by 2020, 34 percent by 2030, and 36 percent by 2075.

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Payments from the Old Age, Survivors, and Disabilities Insurance (OASDI)

programMost Social Security benefits go to retirees, but survivors and the disabled make up substantial shares as well.

Retirement

67%

Disability

14%

Survivors

19%

$291 billion

$60 billion

$81 billion

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How are benefits calculated?

• Determine worker’s “average indexed monthly wage” (AIME). – Index each year’s past earnings for wage growth. (This effectively

pays “interest” at the rate of wage growth, around 1 percent.) Years after age 60 are not indexed.

– Select 35 highest earning years and add together. – Divide the sum by 35 (to produce an annual average), then by 12

(to produce a monthly average).• Run the monthly AIME amount through Social Security’s “bend points.”

– Bend points replace 90 percent of the first $592 of worker’s average indexed monthly earnings, plus 32 percent of earnings between $592-$3,567, plus 15 percent of earnings above $3,567. This produces a “primary insurance amount” (PIA).

• For a single individual, the PIA is their monthly benefit. It is also the basis for spousal, disability and survivors benefits.

(For more information, see http://www.ssa.gov/OACT/COLA/BenForm.html)

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Social Security Revenues

Payroll Taxes $516 Billion

General Revenues1 $13 Billion

Interest on trust fund2 $73 Billion

Total $602 Billion

1 Credited from income taxes on benefits.

2. No actual cash changes hands. Interest to the trust fund’s bonds is paid by issuing new bonds.

Most of Social Security’s revenues come from payroll taxes. A smaller amount is from taxes on benefits, while the trust fund is credited with interest each year.

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How is Social Security Financed?

•Social Security is a “pay-as-you-go” system: taxes collected from today’s workers are used to pay benefits for today’s retirees.

•For that reason, Social Security’s finances are very sensitive to the number of workers paying into the system and the number of retirees collecting benefits from it.

•The “aging” of the population means larger groups of retirees to be supported and smaller generations of new workers to support them.

•Demographics – particularly birth rates and life expectancies – are the key to Social Security’s financing problems.

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Social Security’s Pay-as-you-go Financing•Conventional pension plan: each generation provides for its own retirement by saving and investing its contributions over time.

•Social Security pay-as-you-go financing, taxes collected today pay benefits for today’s retirees. Today’s workers will be supported by workers in the future.

•Advantages:

•can begin paying benefits quickly;

•provides big windfalls to early retirees; First retiree, Ida May Fuller of Ludlow, Vermont, paid $24.75 in taxes; lived to age 100 and collected $22,889 in benefits;

•simple to administer.

•Disadvantages:

•pays very low rate of return to post-windfall generations;

•very sensitive to the ratio of workers paying into the system to retirees collecting.

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Low birth rates mean fewer new workers

1.5

2

2.5

3

3.5

41940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

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2005

2010

2015

2020

2025

2030

2035

2040

Fert

ilit

y R

ate

(num

ber

of

childre

n p

er

wom

an)

The Baby Boom

The Baby Bust

Birth Rates

Continue at Low

Levels

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Increasing life expectancies mean more retirees to support

76

78

80

82

84

86

881940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

2025

2030

2035

2040

Tota

l life

expect

ancy

for

indiv

idual re

ach

ing a

ge 6

5

Male

Female

Future retirees will live years longer than today’s 65-year-olds, and

collect thousands more in benefits.

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In the future, fewer workers will support more retirees.

1960: 5.1 to 1 Today: 3.4 to 1 2030: 2.1 to 1

As a matter of simple math, when the ratio of workers to retirees falls, each worker must bear a greater financial burden.

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Social Security taxes are already high…

The Social Security payroll tax is 12.4 percent of wages. That’s…

•An eighth of the average worker’s total wages…

•The biggest tax the average household will pay.

That’s enough to pay…

•Six months rent on a $700 per month apartment, or…

•A full year of student loan payments at $350 per month, or…

•A keg of Budweiser every weekend (plus chips!).

And if today’s payroll tax seems high, wait ‘til it rises to 18 percent or more!

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…and without reform, they’ll only go higher: by 2030, costs will top 17 percent of payroll.

7.5

10

12.5

15

17.5

201970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

2055

2060

2065

2070

2075

2080

Inco

me/C

ost

as

perc

enta

ge o

f ta

xable

payro

ll

Cost

I ncome

1970:

8.1

2002: 10.8

percent

2025: 16

percent

2080: 20.1

percent

Payroll tax

surpluses

Payroll tax

deficits

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With each passing year, Social Security's long- term

deficits grow larger

$20.09

$22.17$22.84

$25.03

$23.87

$21.74$21.14

$18.71

$15

$17

$19

$21

$23

$25

$27

1999 2000 2001 2002Year of Trustees' projections

Trillion

s $

20

02

75- Year Balance (surpluses minus deficits)Long- term Deficits (if short- term surpluses aren't saved)

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But won’t the trust fund help pay benefits?

IOU

$$

Technically, the government bonds in Social Security’s trust fund will help pay full benefits until 2041… …But why do we say “technically”?

The Social Security trust fund is full of government IOUs. And the only way to turn those IOUs into cash is to raise taxes, cut spending, or borrow.

Those are the same choices we’d face if there were no trust fund at all!

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Unified Household BudgetingIf a woman lends her boyfriend $500, she holds an IOU for $500 while he gets $500 cash.

But if they get married, they don’t have a thousand dollars – they have zero. His debt cancels out her asset.

If he’s gone and spent the $500, then they’re even worse off!

Like it or not, Social Security is “married” to the rest of the budget – there is no true trust fund or lock box to keep the cash separate. Politicians treat the fund as if it’s an asset to everyone but a debt to no one. In truth, it’s a wash.

IOU

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Rep. Robert Matsui and Sen. Bob Graham: “Trust Fund reserves are growing at the pace of a billion dollars a week. But these billions won’t be available to the next generations of America’s retirees. As quickly as the surpluses amass, they are being siphoned off to help finance the deficit. Bluntly put, the federal government is spending more than $1 billion a week of the Social Security surplus as though it were general revenues. All that the Trust Fund gets for these expenditures are chits from the U.S. Treasury. (The Washington Times, September 12, 1990)

Social Security’s Public Trustees: While the bonds held by the trust funds are assets from the vantage point of the Social Security and Medicare programs, from the viewpoint of the unified budget they are liabilities of the U.S. Treasury. No one doubts the U.S. Government will honor the bonds. But since the U.S. Treasury is the ultimate payer of the programs’ benefits and the trust fund assets are also debts of the U.S. Treasury, neither the interest paid on the bonds, nor their redemption, provides any net new income to the U.S. Treasury. When annual revenues from earmarked taxes for Social Security and Medicare begin to fall short of annual expenditures, such shortfalls inevitably must be made up by increased taxation, increased borrowing (i.e., the sale of more U.S. Treasury bonds to the public) and/or a reduction in other government expenditures. This fact is the basis for the view that trust fund assets have no "real" economic value. From a unified budget viewpoint, the trust fund surpluses are a budget accounting device and make no meaningful contribution to funding future Social Security or Medicare expenditures. They simply reflect the fact that in the past, surplus Social Security and Medicare revenues have been used by the U.S. Treasury to fund other government programs or to reduce outstanding Federal debt.” (John Palmer and Thomas Saving, Social Security Public Trustees, 2002)

The Congressional Budget Office: “Although there is no money in the Treasury to pay for future obligations, the obligations to people eligible for Social Security benefits are real. And most important, those obligations are a direct result of federal law, not a consequence of whatever may or may not be credited to the Trust Funds. In particular, the size of the balances in the Social Security Trust Funds – be it $2 trillion, $10 trillion, or zero – does not affect the obligations that the federal government has to the program’s beneficiaries. Nor does it affect the government’s ability to pay those benefits.” (CBO Director Dan L. Crippen and Deputy Director Barry B. Anderson, testimony before the House Ways and Means Committee, Feb. 23, 1999)

Experts Say: Social Security trust fund not a net asset the government can use to pay

benefits.

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The trust fund: both a debt and an asset

The trust fund is an asset to Social Security but an equal and opposite debt to the rest of the government. From the point of view of the government as a whole – and to the taxpayer – the trust fund makes no difference.

The question isn’t whether we’ll honor the trust fund’s bonds – no reform legislation in existence wouldn’t repay them – but how we’ll do it.

That is why people argue that Social Security’s problems begin in 2017, when the program starts running payroll tax deficits, not in 2041 when the trust fund runs out.

The “how” is to raise taxes, cut spending or run a budget deficit (which is nothing more than a tax increase on future generations).

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•By 2018, the cash flow deficit in Social Security would equals the size of Head Start and the Special Supplemental Nutrition Program for Women, Infants and Children (WIC).

•By 2021, the cash shortfall is equivalent to the Department of Education, the Department of the Interior, the Department of Commerce and the Environmental Protection Agency, in addition to those listed above.

•By 2035, Social Security’s cash needs equal all of the above, plus NASA, the Department of Veteran’s Affairs, the Department of Energy, the Department of Housing and Urban Development (HUD), the Department of Justice and the National Science Foundation.

And this is all before the trust fund runs out. In the end, the federal budget would consist of little more than a pension plan with an army.

Annual repayments to the fund will equal the size of whole cabinet departments

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• Some people think we can borrow to get Social Security “over the hump” of Baby Boomer retirements.

• But Social Security’s problems continue and grow larger even after the Boomers are gone.

• Borrowing doesn’t reduce Social Security’s deficits, it is just a stealth tax increase on our children and grandchildren. That’s what Social Security reform is supposed to avoid.

• If we borrowed to cover Social Security’s deficits, the debt would exceed $7 trillion (in today’s dollars) by 2040, $14 trillion by 2050, and over $47 trillion by 2075. This would be larger than the national debt at the end of World War II (as a percent of GDP) and would cripple the US economy

We can’t borrow our way out…

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Ok, so what are our choices?There is no easy solution…but some solutions are a lot easier than others.

Doing nothing is not an option. Without action, benefits will eventually be cut by over 25 percent.

If you don’t have a reform plan, you’re for benefit cuts, because that’s what the law prescribes.

We could raise taxes, but we’ve been there and done that. Do we really want an 18 percent tax rate just to pay for one program?

We could raise the retirement age, but it’s already going up.We could “lift the cap,” applying payroll taxes to all of a

worker’s wages, but that would be the biggest tax increase in history – and it still wouldn’t fix the problem permanently.

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The long-term solution: prefunding.Many analysts favor moving Social Security from pay-as-you-go financing to a funded basis.

Funding means that instead of transferring today’s payroll taxes directly to today’s retirees, those taxes would be saved and invested for the future in real capital assets.

When needed, those assets could be redeemed to pay benefits…without raising taxes.

Funding can be done centrally by the government, or individually through personal accounts.

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Why prefunding?

One reason to prefund Social Security is to smooth burdens across generations: if one generation pays a bit more, the burden is reduced for future generations.

A bigger reason is that prefunding pays a much higher return than Social Security’s pay-as-you-go financing – up to four times higher, in fact.

Higher returns, compounded over decades, mean a more efficient system: higher benefits at a lower cost than pay-as-you-go financing.

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So what’s the catch?Over the long term, a funded system can pay higher benefits at lower cost than the current pay-as-you-go program.

But to get to funded system, we have to put up the funds.

That’s true whether we fund Social Security through personal accounts, collective government investment, or by retiring existing public debt.

When someone talks about the “cost” of personal accounts, they’re really referring to the amount we would put aside today to help pay benefits tomorrow. Is that really a cost?

Optimum solution: use some existing government spending to cover the transition.

Personal accounts are no more “expensive” than any other means of pre-funding Social Security. And they’re a lot cheaper than raising taxes down the road.

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How much cheaper?Illustration: in 2042 Social Security will run a payroll tax deficit of $366 billion (in today’s dollars).

We could raise taxes in 2042 – to almost 18 percent – to meet that $366 billion deficit, and continue raising taxes as Social Security’s deficits increase.

Or, we could put aside money today.

If we invested only in government bonds earning 3% after inflation, we’d have to save less than one-third as much today -- $109 billion.

If we invested in stocks and bonds earning 5% after inflation, we’d need to put aside only $49 billion today. That’s the power of higher rates of return.

We can pay a little today, or force our kids and grandkids to pay a LOT tomorrow. Which is the more responsible choice?

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Other reasons for reform:Social Security and the Modern Family

Social Security’s benefit structure is stuck in the past: it assumes that husbands will earn the wages while wives will remain at home, and it punishes couples who do not accord with this 1930s norm.

•Dual entitlement rule: A spouse is entitled to her own benefits or benefits equal to one-half of the higher earning spouse – but not both.

•Working women pay an eighth of their wages as taxes, yet 63 percent receive no additional benefits for the taxes they pay. They could have received just as much by not working and simply accepting the spousal benefit.

•Social Security rewards single-earner families over dual-earner families, even though single-earner families often have higher incomes.

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Tom and Beth Green (age 35)Tom earns twice the average wage, while Beth doesn’t work outside the home.•Tom retires in 2032. •The Greens’ Social Security benefit: •$2098 for retirement, plus •$1049 p/m spousal benefit = $3147 p/m total.•If Tom dies, Beth receives $2098 p/m in widow’s benefit, 66% of the Greens’ initial benefit

Mike and Sue Smith (age 35)Mike and Sue both work and each earns the average wage. •Mike and Sue retire in 2032.•The Smiths’ Social Security benefit:•$1447 p/m for Mike plus $1447 p/m for Sue, equals $2894 combined. •That’s $253 less per month than the Greens•If Mike dies, Sue receives $1447 p/m in widow’s benefit, 50% of the Smith’s initial benefit. That’s just 69% of Beth Green’s benefit, even though Sue paid into the system while Beth did not.

Identical Earnings Can Mean Very Different Benefits

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Spousal and survivor benefits are extended only to ex-spouses married 10 years or more. Marriages ending in divorce have a median length of just 7 years, and fully one-third of all marriages end prior to the 10 years needed for benefit eligibility. An example:

•George and Rita Ball obtain a divorce after 10 years and 1 month of marriage. Rita is entitled to full spousal and survivors benefits based on her ex-husband’s earnings.

•John and Judy Hill end their marriage after 9 years and 11 months. Judy is entitled to no benefits based on her husband’s earnings. If she did not work outside the home, she may have no entitlement to any benefits or protections.

Personal accounts would be split 50-50 between divorcing spouses. These assets, left to compound until retirement, could significantly increase the benefits of women who might otherwise retirement into poverty.

Social Security and Divorce

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Social Security benefits last as long as you live, so the most benefits go to those who live the longest. High-income Americans tend to live longer than African Americans, who have lower incomes on average.

As a result, African Americans receive nearly $21,000 less from Social Security over their lifetimes than whites with identical incomes and family profiles. Identical people, but very different results.

Nearly half of all marriages among African Americans are disrupted by divorce in less than 10 years, making them ineligible for spousal benefits. A greater number of African American women do not remarry after divorce.

African Americans do rely disproportionately on Social Security’s disability protections, but adding personal accounts for retirement can make the system more progressive and fair.

African Americans can be disadvantaged by Social Security

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As Social Security’s finances decline, so does the rate of return it pays

•Early retirees got great deal: paid in for a few years, collected the rest of their lives. Later retirees don’t do nearly so well.

•Over long term, Social Security’s pay-as-you-go funding pays a rate of return = labor force growth rate + wage growth rate. Over the next 75 years, that’s roughly 1.4 percent annually after inflation.

•Real capital assets pay higher returns. Guaranteed government bonds, projected to earn 3 percent, would increase benefits by over 50 percent. Assets such as corporate bonds and stocks could produce higher returns.

•Basing Social Security funding on real capital assets means higher benefits at lower cost. Better protections, lower poverty, more dignity and independence in retirement.

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Real Rates of Return Falling for All Retirees

(Assumes No Change in Law, Retirement at Age 65)

Birth Year Single Male (Medium wages)

Single Female (Medium wages)

Single Earner Couple (Medium Wages)

Two-Earner Couple (Medium/Low wages)

1970 1.13 1.59 3.42 2.24

1980 0.91 1.36 3.31 2.08

1990 0.88 1.29 3.14 1.97

2000 0.86 1.25 3.02 1.88

Source: May 27, 2001 calculation by the Social Security Office of the Actuary

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Property Rights

“To engraft upon the Social Security system a concept of ‘accrued property rights’ would deprive it of the flexibility and boldness in adjustment to ever changing conditions that it demands.”

Flemming v. Nestor (1960)

“The proceeds of both employer and employee taxes are to be paid into the treasury like any other internal revenue generally, and are not earmarked in any way.”

Helvering v. Davis (1937)

The Supreme Court has ruled that individuals have no legal right to their benefits. This may give “flexibility” to the government, but it denies security to workers and retirees. It also encourages politicians to make promises today that they may not be able to keep tomorrow.

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Criteria for Reform: To be successful, Social Security reform should…

Increase economic growth: In the future, smaller numbers of workers will support larger populations of retirees. Social Security reform can help make each worker more productive by raising national saving, thereby increasing worker productivity and boosting economic growth.

•Increase personal control: Reform should give workers true legal ownership of their retirement savings, prevent the government from “raiding” Social Security for other purposes, and give all Americans the opportunity to build wealth and pass it on.

Increase fairness: The current system can be unfair to African Americans, who often do not survive to retirement age; to working women, who often do not receive spousal benefits; and the young, who must pay high taxes into a system that will be insolvent by the time they retire. Reform should correct these flaws so all Social Security participants feel they are treated fairly.

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Time is money: Why we must act soon

Social Security is currently running surpluses, but in 2017 those will turn to deficits.

These deficits grow very big, very fast: $97 billion in 2021, $186 billion in 2025, $332 billion in 2035 (in $2002).

If we wait to act we will have so much trouble just covering the program’s deficits that prefunding may become too expensive.

The only alternatives then would be tax increases or benefit cuts, which everyone wants to avoid.

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How would personal accounts be set up?

Every plan is different, but…

•Workers could invest part or all of their payroll taxes in accounts holding stock and bond mutual funds.

•In return, they would give up part of their traditional benefits.

•Only diversified funds would be allowed. Workers could not invest in single stocks like Enron or WorldCom. Choices would likely be limited at first to keep costs low.

•At retirement, workers could purchase an annuity or take gradual withdrawals of their money.

•If the worker died before the account was exhausted, the remainder would pass onto his spouse, children or a chosen charity.

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What is a “Benefit Cut”?

Many critics charge that reform plans would “cut benefits.” But versus what? •For instance, a low-wage worker retiring in 2042 is promised a benefit of $896 per month (in today’s dollars).•Under one of the President’s Commission’s plans, that same worker would receive $806 from the traditional system, a “cut” of $90. But this ignores that…•Under law, the insolvent Social Security system can actually afford to pay that worker just $655 per month, plus…•The personal account would add $180 per month, raising total Social Security benefits to $986 per month.•That’s $90 more than the current system even promises, and $331 more than it can actually pay.

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Are accounts investing in stocks too risky?

Just the opposite. A single male worker retiring today can expect a 1.74 percent real return from Social Security. Married couples can expect around 2.5 percent.

If he had a personal account invested only in the S&P 500, he’d have received around a 6 percent real return – even after the market decline.

The stock market has never lost money over 20 years or more, and today is no exception.

Workers wanting absolute safety could invest in risk-free government bonds. They’d still receive higher benefits than the current system, plus they’d have a true legal right to their savings.

If workers retiring today would get higher benefits with personal accounts, who wouldn’t?

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Even after crash, personal account invested in stocks would still pay more.

$-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

$800,000

1957

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

Accum

ula

ted v

alu

e o

f contr

ibuti

ons

Personal account, S&P 500

Social Security, notional wealth

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•Flexible: Your money works for you, whether you’re working or staying at home.

•Equitable: Resolve many of the inequities concerning divorce, dual-earner families, widow’s benefits, African Americans.

•Empowering: Low earners could create wealth without paying higher taxes, and could pass that wealth on to their heirs.

•Voluntary: Personal accounts would be voluntary – it’s your money, it’s your choice. No one would be required to invest in the stock market.

•Most of all, they’re yours: you would own the account, you could control it, and no politician could raid it to pay for other programs. When you die, you could pass it on to your heirs.

Personal accounts are…