The aging population and rising costs of living mean that retirement is becoming more and more expensive. So expensive in fact, that the 2.8 trillion dollar trust fund will run out of funds in the near future if nothing is done to reform the system. It is important to realize that the social security system, although designed as such, is not simply a pay-as-you-go system. It can also be interpreted as a program in which the government borrows from young in exchange for a promise of payment of principal plus interest in the future. Looking at the system in this manner makes it clear that the debt is on younger people through higher taxes. Because of this potentially unkept promise to repay people, the government would have to immediately increase its debt or cut benefits by 20 percent immediately.
Although this poses a problem to policymakers, there are solutions on the table for them to consider. Privatizing the social security system is one solution to the currently unsustainable model. Access to higher returning asset markets other than US Treasury bonds is a key factor to saving enough money to last through longer retirements. There are risks included in any approach to solve this problem which is why it is important for policymakers to spend time studying the risks and benefits at large currently as well as the benefits of any solution.
II: Social Security Overview
Social Security was a tax funded program implemented during the Great Depression in order to move the large amount of elderly and disabled people out of poverty. This consisted of two programs one for old age beneficiaries and one for disabled beneficiaries and accesses the same fund (OASDI). The system was designed to be a pay-as-you-go system where young people in the workforce would essentially be subsidizing the retirement of the elderly while being promised that they will have their retirement subsidized in the future. The social security tax rate is 12.4 percent of labor income up to $127,000. That percentage is mostly used to pay beneficiaries and some is left over to be saved and used to invest in US treasury bonds that return interest. Historically, this has helped grow the trust’s reserves. It is important to note that these reserves would be paid out progressively. When it was first implemented in 1935, this progressive system solved the problem of elderly poverty.
During the program’s first five decades, Social Security spending grew from less than 1 percent of GDP to nearly 5 percent of GDP by 1983. The ratio of working people to retirees used to be 35 to 1 during the early years of implementation but currently that ratio is close to 2 to 1. This means that there will be an increase in tax on working people. If full benefits were paid under the formulas specified in current law Social Security spending would rise steadily, reaching 6.3 percent of GDP in 2046. The Social Security Office of Policy writes that by 2080 the total population age 65 or older will be 23 percent. At the same time, the working-age population is shrinking to a projected 54 percent in 2080. Consequently, the social security system is experiencing a declining worker to beneficiary ratio, which will fall to 2.1 in 2040. This insolvency problem presents a significant challenge to policy makers.
III. The Insolvency Problem
In 2016 the OASDI reserves were calculated at 2.8 trillion dollars. The trust fund’s adequacy is tested for long term and short term sustainability. As of now, the fund passes the short range sustainability test which means that the fund will operate at a surplus for the next ten years. The trustees say that the total income is projected to exceed the total cost through 2021 with a surplus of about 35 billion. However, the annual balance excluding interest has seen a deficit since 2010 and will average about $51 billion between 2017 and 2020. It will then rise steeply as income growth slows due to the economic recovery completing while the number of retirees claiming benefits continues to grow at a substantially faster rate than the number of covered workers (Summary of the Annual Report, 2017).
In addition, after the crash of 2008, there was a decline in payroll taxes and spike in benefit claims, which caused the cost rate to exceed the income rate in 2010. During recessions there is an observed increase in the amount of people entering retirement and claiming benefits. In 2003, 4.2 percent of GDP was spent on Social Security, then in 2009, there was a sharp increase to 4.7 percent and it continued to rise from there. An increasing number of people working later in their lives means that the spike in benefit claims would be more acute. After the trust is depleted, millions of Americans will see a major reduction in benefits.
In 2021, taxes and interest received will fall short of annual benefit payments. At this time, the government will be required to draw down trust fund assets to meet benefit commitments. The trust fund is then projected to be exhausted in 2034. According to the National Academy of Social Insurance “if Congress does not act before 2034, social security is projected to face a shortfall… and revenue continuing to come into the trust funds… would cover [only] 79 percent of scheduled benefits” (National Academy of Social Insurance, 2017). It is important to note that a deficit would not mean the trust funds would be bankrupt. As stated, tax revenue would still flow in to the fund and would provide almost 80% of the benefits promised.
IV: The Accounting Problem
Social security economist Laurence Kotlikoff writes that the government has taken on tens of trillions of dollars in additional liabilities in order to guarantee that people get their social security benefits. Officially recognizing the fiscal gap (or as stated in the trustees report, the “unfunded liability”) would be a risky position for the government to take. Officially noting the debt that the fund owes to young people in the future would cause interest rates to rise and could cause inflation. A main concern is that the government is using overleveraging tactics to finance social security. Kotlikoff points out that “successive Congresses and administrations… spent the past six decades accumulating… liabilities that [were] kept off the books via … use of language” (Kotlikoff, 2017). Instead, documenting these obligations as borrowings or promised repayment of borrowings, official documentation uses the words “taxes” and “future transfer payments” thus keeping these liabilities out of the official debt. A table (table VI.F1.) in the appendix of the trustees report shows the trust’s unfunded total obligations without a time horizon. This number is $34.2 trillion. He points out that, if this number is added to the official debt, “the current debt-to-GDP ratio rises from 77 percent to 252 percent of GDP” (Kotlikoff, 2017).
Sources such as the Center for Retirement Research record the 75 year time horizon deficit and compare it to 75 years worth of GDP. This ratio shows the debt across that time frame at .9 percent of GDP across that same time frame. Thus showing a total of 12.5 trillion dollars of debt. This is a valid way to present the data but, Kotlikoff’s argument is that people have already paid into the system, essentially giving incremental loans to the program, and are expecting benefits to be paid once they are eligible. Therefore, there is no reason not to count all of those people into the current official debt calculations. In fact, other countries have recently started accounting for fiscal gaps in their official reports. The European Union releases a metric called the S2 indicator for its member states, which is the fiscal gap divided by the present value of projected future GDP. The S2 indicator for the US is 10 percent meaning the US needs to raise taxes by 10 percent of each future year’s GDP or cut spending by 10 percent of each future year’s GDP to eliminate its fiscal gap (Kotlikoff, 2017).
V. Proposed Solutions
The social security gap poses a potentially harmful but solvable problem for the US economy because there are other potential options for reform. A widely supported solution called The Inform Act, a bipartisan bill introduced by Sen. John Thune and Sen. Tim Kaine, would require the CBO, Government Accountability Office, and the Office of Management and Budget to put everything on the books by using the fiscal gap definition, not the official debt, to gauge the US’s fiscal condition. This bill is an important step in the process of addressing the worsening problem.
However, solving the problem might require a cut in benefit outlays. The National Academy of Social Insurance proposes that “timely revenue increases and/or gradual benefit reductions can bring the program into long-term balance, preventing the projected shortfall” (National Academy of Social Insurance, 2017). A report done by the Social Security Bulletin found that roughly half of the elderly population live in households that receive at least 50 percent of total family income from Social Security and about one-quarter of the aged live in households that receive at least 90 percent of family income from Social Security. Voters will not support a policy that takes away their income especially if these voters have been paying into the program throughout their life and have been promised a certain amount of benefits. This poses yet another problem to policy makers because they are not only tasked with finding the best way to combat the insolvency problem, they have to balance their own personal interest in keeping voters with passing legislation that solves the problem. Although many, including Kotlikoff, would argue that the proposed solutions would not systemically fix the problem, it is important to know what solutions are currently being discussed.
Representative Sam Johnson proposes that there be three reductions in benefits. One being to raise the full retirement age to 69 years old. Raising this would account for the fact that seniors are working later in life due to increased healthiness later in life and would there for not restrict beneficiaries as much as it would help save money in the fund. Another proposal is to cut benefits for above-average earners, thus making the social security system more progressive. In addition, he proposes to reduce cost-of-living adjustments (COLA) which are extra benefits calculated based on the individual beneficiaries living costs. Specifically, this proposal eliminates the COLA for individuals with income above $85,000.
In contrast, Representative John Larson proposes two revenue changes and a series of small benefit increases. He proposes that there be an increase in the combined OASDI payroll tax of 12.4 by 0.1 percent each year until it reaches 14.8 percent in 2042. He also suggests this tax apply to the payroll tax on earnings above $400,000. He also proposes to enhance benefits by using the Consumer Price Index for the Elderly, which rises faster than the regular CPI, to adjust benefits for inflation and to increase the special minimum benefit. These two proposals summarize the range of options the american people have, just short of restructuring the whole system, in terms of how they would like benefit cuts and tax increases to be allocated.
VI: Chile and the Privatization of Social Security
During the 1970’s, Chile experienced an economic crisis to which their social security problem heavily contributed. Following the tactics used for recovery in Chile could give policymakers insight as to how the US could mitigate this impending situation. Chile saw a failure in their social security system in due to an economic crisis and subsequently changed it in 1981. A problem for the Chilean system before the crisis was that employers would hire workers informally due to the pension fund contribution cost of formally hiring workers. When the crisis hit, the problem escalated and the government lowered the contribution rate to try to incentive more formal hiring. However, the worker-to-beneficiary ratio still declined to 2 to 1. As a result, the Chilean social security deficit grew to 25 percent of its GDP. Chile made an overhaul of their social security system to fix their insolvency problem. For Chile, privatizing the system meant that workers would be in charge of their own retirement savings and would have access to higher returning asset markets. This, in turn, would help stimulate employment and eliminate the social security funds’ deficit by getting rid of it all together.
Whether it’s informal hiring in Chile or an aging population in the US, Chile’s solutions can give insight as to how the US could mitigate its insolvency problem. Raising tax rates further to pay for the benefits promised would do damage to the US economy. However, cutting benefits to the level where a tax increase is unneeded would mean a significant decline in the living standard of the elderly. Many policymakers have concluded that the system of financing social security cannot continue unchanged. The model for a privatized social security system might include mandatory contributions from individuals and their employers on their behalf. They would be required to make contributions to individual savings accounts, like a 401K plan, that would be invested through mutual funds into portfolios of stocks and bonds instead of US Treasury Bonds. At retirement, most of the accumulated balances would be paid back in annuities (a lump sum payment or series of payments in return for regular payments beginning at some point in the future). The shift from the existing system to a pre-funded system based on mandatory saving can mitigate the liability the government takes on from the pay-as-you-go system.
VII: Risks of Privatization
Put simply, privatizing social security complicates the ethics and functionality of social security. Because there are so many different ways to privatize, it is hard to pinpoint a critique that applies to every different form of privatization. However, it is important to note these critiques even if they are solvable and circumstantial. For example, if the system were to be significantly cut and outsourced to private wealth managers and funds (much like Chile’s solution) there wouldn’t be a specific age in which someone could claim benefits or officially retire. The whole retirement process would have to be managed individually which puts significant burden on participants. Another, more centralized proposal is that the system maintains its current pay-as-you-go structure but the funds are simply invested in higher returning assets other than treasury bonds. Privatizing could also entail outsourcing to mutual funds or other institutions. However, this brings up the question of who gets to manage the trillion dollar portfolio and what corporate interests, biases, and representation are at stake. For instance, if congress gets to manage the portfolio, it is important to consider what political connections they have to corporations that support their agenda.
In addition, adding stocks to the fund’s portfolio adds risk. If a birth cohort is about to reach retirement age and a market downturn occurs, those people might see a loss in their savings (or benefit payments depending on how privatization is structured) large enough that they won’t be able to retire on time. But, there are simple solutions to that critique, slowly adjusting asset allocation according to risk exposure throughout a lifetime would help mitigate the effects of a timely downturn. For instance, the old age fund could be divided into different portfolios categorized by risk. This way, when a cohort is young, their contributions would be put into a risky portfolio because it would have higher returns and, if a downturn happened, they would have time to recover. Once the cohort gets older, their contributions would get transferred to a low risk portfolio. This could help build up the fund’s wealth and ensure its sustainability. Since there are so many nuances to privatization, it is important for policymakers to think thoroughly about its critiques before taking action.
Because of aging demographics, if the social security system is left alone, it will be insolvent in the near future, leading to a further spike in government debt or severe reductions in benefits for recipients. The accounting techniques used to record the fund’s deficit implicates a larger than shown liability on the government’s books and recognizing the fiscal gap could pressure reform before the problem worsens. Policymakers have proposed tax increases and spending cuts to address the impending insolvency but sustainably addressing the problem would entail a restructuring of the whole system. Privatization offers promising solutions but a complete overhaul is not as simple as increasing taxes or decreasing benefits. In order for an overhaul to be successful, critiques have to be addressed around adding risk and decentralizing the system. It is important to recognize that this financing shortfall is manageable but should be addressed soon to mitigate potential harm.