Social Security: Our Fiscal “Old Yeller”

Way back in the first year of the Reagan Presidency a blue-ribbon commission studied the problems of the Social Security program. The final report of what became known as the Greenspan Commission included 69 separate staff memoranda dealing with seemingly every conceivable “reform,” including a proposal written by three eminent economists advocating the sort of “personal security accounts” that would finally be proposed by President Bush in 2005. So how is it that, almost 30 years later, we’re teetering on the brink of a fiscal crisis that has once more brought discussions of Social Security reform to the fore?

Never being one to fear oversimplification, I will be so bold as to claim that despite all its intracacies, Social Security is based on a very simple idea: If the current workers would agree to pay the current retirees a small percentage of their paychecks each month, and if future workers could somehow agree to give a small percentage of their paychecks to current workers when they became retirees, and if all these agreements could somehow be made among all generations in perpetuity, then everybody would essentially have a claim to a very low-risk pension without the bother of accumulating capital. As an added benefit, the very first generation of retirees would get a big windfall, since they could be paid the “returns” from a fund they contributed relatively little into.

The fuel that powers this mysterious generator of something-for-nothing is a sufficiently high ratio of workers to retirees. To see how it works, suppose we all pay 5% of our wages into a “trust fund” from which benefits are paid to current retirees. If there are 10 times as many workers as there are retirees, and if the average yearly earnings per worker are $50,000, then each retiree will receive a payment of $25,000 per year. Over a 40-year working life, each worker will pay $2,500 annually into the system, and then be entitled to payments over the rest of his life that would require financial assets worth (at 3% interest) about $300,000 if his life expectancy at retirement were 15 years and about $370,000 if his life expectancy were 20 years post-retirement. By contrast, if our hypothetical worker saved the same $2,500 per year and put those savings into perfectly safe assets yielding a 3% annual return, his assets at retirement would be worth $188,5oo. Social security offers up to twice the yield available on comparable private-sector assets. That’s the sunshine, lollipops and rainbows scenario.

Now let’s make one little change in our assumptions–let the ratio of workers to retirees fall from 10 to 5. If we keep the tax rate at 5%, each retiree will receive an annual payment of $12,500. This annuity is worth about $190,000 if his life expectancy is 20 years, and about $150,000 if he expects to live for 15 years after retirement. The advantage of Social Security over private saving has disappeared.

The diligent reader can now readily see what happens if the ratio of workers to retirees falls to 2.5. Annual benefits will fall by half again, to $7,500 a year, which is worth between about $90,000 and $110,000 at the beginning of retirement, depending on life expectancy. Social Security is now a disastrous pension plan.

What if the response is to raise taxes instead of cutting benefits? If the worker-to-retiree ratio falls by half, then taxes have to be doubled in order to keep benefits per retiree constant. All this means is that, during their working lives, Social Security participants will have to pay twice as much to qualify for the same retirement annuity as before. Either way, the participants in the system are worse off.

Leaving our hypothetical world behind, what’s actually happened to the ratio of workers to retirees in the U.S. over the past few decades? In 1970 it was 3.7; today it’s about 3.3, and by 2030 it will probably be around 2.2. In other words, Social Security is about 10% worse a deal than it was 40 years ago, but within the next 20 years it’ll be about 33% worse a deal than it is now. And it’s not a very good deal now.

The standard fix in response to every worsening of the terms Social Security can offer has been to cut benefits (usually by pushing back the retirement age) or raise taxes. These “fixes” don’t fix anything because, as my simple example shows, they can’t fix anything. When the ratio of workers to retirees falls, the rate of return on Social Security must fall. If benefits are cut, in my examples, there’s a fall in the value of the retirement annuity received in exchange for the same taxes paid. If taxes are raised and benefits are maintained, then there’s an increase in the taxes paid in exchange for an unchanged value of the retirement annuity. Changing the mix of taxes and benefits simply shuffles the same shit in different ways.

We really only have two basic options: 1) live with the current system, and endure the losses; 2) follow the Ryan plan of gradual privatization, which will let workers get the market rate of return on their savings (which has been pretty stable over almost all 5-year intervals).

It seems like a no-brainer to me. Chile privatized its system in 1980 and hasn’t looked back. Mexico’s reforms weren’t as clean as Chile’s, but they seem to have worked out well enough. But I’m not sure that Americans are ready to apply the Old Yeller solution to this mangy holdover from the New Deal. We’ve been lied to for so long about the “trust fund” and “lockboxes” that it’s going to take a big blast of reality to put this problem down.

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