NEWSLINK, V3N1 Fall 1998: Rate of little return: Social Security as we know it

With the federal budget now in “surplus,” policymakers are focusing on what may be the hottest public policy issue of the day: How to provide for the nation's growing retirement population while increasing national saving and investment.

Elected officials see Social Security as the “third rail of American politics.” Economists see a demographic time bomb ready to tear through future federal budgets. Nearly everyone agrees Social Security needs to be reformed. How that happens is another matter.

President Clinton has indicated that he would direct most of the surplus to “saving Social Security first,” although he hasn't yet explained how he would recast the program. On the other side of the aisle, many economists and policymakers would privatize – to various degrees – the program, while maintaining at least the same level of benefits now drawn by retirees.

Unlike most pension plans, current revenues earmarked for Social Security go to support current retirees. As baby boomers begin to retire around 2013 or so, fewer workers will be available to pay the necessary Social Security taxes to support retirees under this “pay-as-you-go” system.

In 1950, for example, 16 workers supported one retiree. By 2014, in part because people are living longer, that ratio will be 2.7 workers to one retiree. To fund such a dramatic increase without changing benefits, the current 12.4% Social Security taxes would have to be increased to anywhere between 18% and 24%.

Not even the most ardent defenders of the status quo believe that raising Social Security taxes is the solution. Past remedies such as increasing the payroll tax, cutting benefits and raising the retirement age might not, in themselves or in combination, be adequate to resolve the problem. Adding to the problem is the lack of an intergenerational consensus. That is to say, how can “saving Social Security” restore the faith of Generation Xers who, according to public opinion polls, don't believe the system “will be there for them.”

Economist and Federal Reserve Board Governor Edward M. Gramlich underscores the new thinking driving the debate. This fall, at a Boston Citizens' Seminar at the State Street Bank, Gramlich identified three approaches to reform: (1) develop a plan that would preserve the safety net, (2) develop a plan that would rely on the market, or (3) devise a hybrid that would combine both plans. Gramlich favors this third way.

Gramlich would fine-tune the present system by “kindly and gently” cutting benefits for future retirees, gradually raising the retirement age to 70 and increasing contributions for higher wage earners. But Gramlich and others acknowledge that these adjustments would do little to satisfy one major goal of reform: improving the nation's saving rate. For this Gramlich offers what he calls “a middle of the road” approach: individual add-on accounts that would supplement Social Security. These mandatory accounts would encourage people who are not currently saving to set aside money in accounts similar to publicly managed 401(k) plans.


Raising taxes to save or reform Social Security is a bad deal for working people today.

Not everyone likes this idea. Economist Peter Ferrara of Americans for Tax Reform says any tax increase or benefits cut would foreclose real opportunities for individuals to accrue benefits that outperform Social Security's “internal rate of return" of 1 %. "The bigger problem is that taxes are already so high on Social Security that it's become a bad deal for working people today.”

Ferrara and other free-market thinkers believe the United States should follow the lead of Chile, which in 1981 set up individual accounts for its citizens. “Because of the private retirement system in Chile,” says Ferrara, “The average Chilean worker today already has more savings than the American worker even though the average American worker earns seven times as much as the average Chilean worker.”
He adds, “The only solution to the long-term bankruptcy problem is to allow people a private option.” This would be of particular help to low-income and younger workers. It would also promote social equity by making them owners of the means of production and, by one count, add trillions to the nation's real economy.

Stephen J. Entin, Executive Director of the Institute for Research on the Economics of Taxation, points out that private IRAs represent a better deal for savers than does Social Security.

“The more you cut the system the better off you are because it's running a negative return or at least a return much lower than the private sector investments that we have as an alternative,” Entin says.

But like Gramlich, Entin is concerned about private investment. As long as government continues to spend at current levels, it will continue to absorb saving at existing levels, whether or not people channel their saving to government through Social Security or through Individual Retirement Accounts. The real challenge is to cut federal spending, thus freeing up saving to flow away from government and into private investment.

“You can increase national saving if you can restrain the government from borrowing or taxing the money back," explains Entin. The reason is that “with real national saving going into real private investment, productivity goes up and wages go up and people are better off while they are working as well as when they are retired. With more output we can take care of the elderly without having to take output away from the younger generation. The elderly will live on savings that produce higher output. They are taking their share of the added production. They are not dipping into their kids' real income.”

Identifying what he calls “political risks” associated with individual accounts, MIT's Peter Diamond thinks individual accounts don't solve the transition problem. Any dollar that goes into an individual account is a dollar that doesn't go into the trust fund. Thus, the financial problems of the unfunded obligation are exactly the same with individual accounts as without individual accounts.

He advises that emphasis on Social Security's rate of return is misplaced. One reason for the small return is “the fact that earlier beneficiaries of the system enjoyed higher rates.” Had this been otherwise, the rate of poverty for the aged would have been dramatically increased and would have increased other federal spending on old age income support. “To compare the rate of return on a portfolio with the rate of return on your taxes is to compare apples and oranges,” says Diamond. He also says that regulation of any privatized system would impose an enormous burden on government, requiring it to oversee millions of individual accounts.

This, however, presupposes a naivete on the part of savers that may be unjustified. “To hide behind the argument that investing in equities is `too risky' is something from a bygone era,” says John Gallahue, Jr., Executive Director of the MBTA Retirement Fund. “Those of us who have been in the pension industry have seen the benefits of investing in the equity markets.”

Gallahue believes future retirees are wiser than experts think. “I can show you a lot of bus drivers that can give me a lesson on the stock market on a daily basis.”

Rate of little return:: Social Security as we know it

Rate of little return::
Social Security as we know it