FRBSF Economic Letter
97-14; May 9, 1997
In early January, the Advisory Council on Social Security published
a review of the system and reported that it is in jeopardy. Although the
system is currently accumulating a surplus, actuaries at the Social Security
Administration forecast that the present value of future obligations far
exceeds the present value of future revenues. The magnitude of the projected
shortfall is enormous, amounting to roughly half of the federal government's
current outstanding debt. These projections suggest that the current system
is unsustainable, and the Advisory Council proposed a number of ways to
reform it. This Economic Letter describes the problems underlying
the current system, reviews the reforms proposed by the Advisory Council,
and explains how those reforms might affect the U.S. economy.
As it is now constituted, Social Security is primarily a pay-as-you-go
system, which means that current retirement benefits are paid mainly from
current tax receipts on younger workers. In contrast, a fully funded program
would tax workers when they are young, invest the proceeds on their behalf,
and eventually pay their retirement benefits out of the accumulated interest
and principal. Although the current system does a little of this, it is
mainly a transfer program rather than an investment fund.
A key variable in determining the solvency of a pay-as-you-go system
is the ratio of taxpayers to recipients. Thirty years ago, there were
5.5 workers for each recipient, and Social Security would be in much better
shape if this ratio had remained at that level. However, this ratio has
been falling for some time and will continue to fall. For example, there
are now 4.5 workers per recipient, and demographers project that this
will fall to 2.5 over the next 30 years. One source of this decline is
that a relatively large cohort, the Baby Boom generation, was followed
by a relatively small cohort, the Baby Bust. Another is that while the
retirement age has remained constant, people are living longer and collecting
retirement benefits over a longer span of time. With decreasing fertility
and mortality, the population is becoming older, and the number of Social
Security recipients is rising relative to the number of younger workers
who support them. This demographic fact poses a dilemma for the system.
In order to maintain benefits at current levels, younger workers would
have to contribute a higher fraction of their income to the system. For
example, we could close the gap by raising the payroll tax now by 2.2
percentage points, from 12.4% to 14.6% (combining the contributions of
employers and employees), and leaving it there permanently. Postponing
the tax increase would only increase its eventual magnitude.
Alternatively, if taxes were maintained at current rates, retirement
benefits would eventually have to be cut. The system is currently running
a surplus and investing the proceeds in a trust fund, and it will continue
to do so until 2011. Between 2012 and 2018, the current system will provide
enough revenue from tax collections and interest on the trust fund to
sustain the current benefit schedule. After 2019, benefits could be sustained
by withdrawing principal from the trust fund, but this would exhaust the
principal by 2029. Thereafter, if the current tax rate were held constant,
the system would have to reduce benefits. Without a tax increase, the
system would have to cut benefits by around 25% by 2040 and by 30% by
2070. Thus, without reform, the grandchildren of the Baby Boom would face
substantial benefit cuts when they retire.
The Advisory Council proposed three reform packages: the Maintenance
of Benefits (MB) plan, the Individual Accounts (IA) plan, and the Personal
Security Account (PSA) plan. The packages all incorporate tax increases,
benefit cuts, and changes in investment strategy, but they differ in their
objectives and in how they mix these elements.
The MB plan is the most conservative, in the sense that its primary
objective is to eliminate projected deficits without altering the essence
of the program. According to this plan, tax increases would close roughly
one-third of the gap. Taxes would be increased in three ways: the payroll
tax rate would be increased by 1.6 percentage points in the out years
of the plan, the tax base would be broadened by bringing certain state
and local government employees into the system, and benefits in excess
of contributions would become taxable, in accordance with current laws
governing other defined-benefit plans. Benefit cuts would close approximately
40% of the gap. These would include alterations in the basic benefit formula
resulting in an average cut of 3%, reductions in cost-of-living adjustments,
which are now believed to be overstated due to biases in the consumer
price index, and reallocations of revenues to the retirement fund from
other programs, which would presumably involve cuts in those programs.
The remainder of the gap would be closed by altering the trust fund's
investment strategy. Currently, the trust fund invests only in Treasury
securities, which are safe but earn a lower average return than stocks,
and the MB plan would allocate up to 40% of the trust fund to equities.
This element is perhaps the most controversial. While equities offer higher
average returns, they are also riskier. The government would not be in
a position to guarantee the average real return on equities, and recipients
would have to bear the risk. Households already have the option of holding
equities in private portfolios and yet many choose not to. Therefore,
if the trust fund continued to be centrally managed, as under the MB plan,
and everyone were forced to hold identical portfolio shares, many households
would be forced to bear more risk than they would like.
The IA plan has two objectives. In addition to balancing the existing
system, this package also would introduce mandatory, supplementary savings
accounts for all participants. To balance the existing system, the IA
plan relies on many of the same elements as the MB plan. For example,
it also alters the basic benefit formula, reduces cost-of-living adjustments,
makes excess benefits taxable, and broadens the tax base. These common
features close roughly three-quarters of the projected shortfall. In addition,
the IA plan calls for greater benefit cuts, chiefly by increasing the
retirement age and reducing payments to middle- and upper-income recipients
by 20%. These provisions close roughly 30% of the gap and, when combined
with the prior elements, would result in a modest surplus.
In addition, the IA plan would increase the payroll tax by 1.6 percentage
points and allow households to invest the proceeds in a variety of government
managed index funds. By allowing a limited degree of portfolio choice,
this plan would not force households to hold riskier portfolios than they
would like. Balanced against this advantage is the fact that these supplementary
accounts would be more costly to manage, perhaps ten times as costly as
the centrally managed MB plan. However, the estimated costs compare favorably
with private sector mutual funds.
The PSA plan incorporates many of the features of the other plans, but
it goes much further in changing the nature of Social Security. Essentially,
this plan proposes a two-tier system for funding retirement. It would
allocate 7.4 percentage points of the current 12.4% payroll tax to a flat-rate
benefit that, by itself, would provide recipients with an income roughly
30% below the poverty line. The remaining 5 percentage points of the payroll
tax would be allocated to personal retirement accounts which would be
managed by individuals and placed with private companies, and income from
these accounts would supplement the basic benefit. The diversion of 5
percentage points of current taxes into personal accounts would leave
insufficient funds to cover current benefits, and the PSA plan calls for
a $2 trillion dollar loan from the Treasury to smooth the transition.
It pays for this loan by levying an additional 1.5 percentage point tax
on payrolls. Thus, the PSA package closes two-thirds of the projected
gap by raising taxes, makes very deep cuts in basic benefits, and replaces
much of that with income derived from personally managed portfolios. This
represents a step away from the traditional pay-as-you-go system, toward
a funded system, and from a defined-benefit plan toward a defined-contribution
plan.
Critics of the PSA plan object that it transfers too much investment
risk from the government to households, but proponents see this as a virtue,
insofar as it allows households to trade off higher degrees of risk for
higher expected returns. Critics also point out that the cost of managing
personal accounts is roughly ten times that of managing the mutual funds
proposed by the IA plan, and they suggest that a less extensive menu of
investment options would be sufficient to preserve freedom of choice while
economizing on management fees.
The macroeconomic consequences of reform depend chiefly on how it will
affect national savings. Government programs contribute to national savings
when they run a surplus and subtract from it when they are in deficit.
Without reform, Social Security is expected to run large deficits in the
next century and become a drain on national savings. All the reform packages
reduce those deficits and hence increase public saving.
The extent to which the reforms increase public savings depends on whether
the system will continue on a pay-as-you-go basis or evolve into a funded
system. Under a pay-as-you-go system, tax receipts are not invested but
are simply transferred to current recipients, and there is no public saving
(if the transfer budget is in balance). In a funded system, tax revenues
are invested on a worker's behalf, and that investment represents public
saving. Therefore, to the extent that reforms shrink the pay-as-you-go
portion of Social Security and replace it with a funded system, they are
likely to increase public savings further.
The reforms are also likely to affect private savings. Social Security
reduces private savings because taxes reduce the income of young workers,
and the promised retirement benefit lessens the need to accumulate private
funds for one's own retirement. Holding taxes constant, a reduction in
retirement benefits is likely to increase private savings, because young
workers will want to replace some of the lost retirement income out of
their own funds. Holding benefits constant, a tax increase is likely to
reduce private savings, because it reduces the income of young workers.
Hence the net effects of tax and benefit reforms on private savings are
ambiguous.
Other elements of reform are likely to reduce private savings. For example,
while mandatory supplementary accounts will increase public saving, households
who now invest in private mutual funds can avoid the supplementary tax
by reducing private savings by an equal amount. The supplementary account
is very much like a private IRA, and no doubt some households will merely
switch their retirement funds from privately managed mutual funds to publicly
managed ones.
On balance, the reforms are likely to raise national savings, although
the magnitude of the increase is uncertain. An increase in national savings
would benefit the economy in a number of ways. The U.S. economy is now
saving less than it invests and borrowing from abroad to make up the difference.
An increase in domestic saving would lessen our reliance on foreign capital.
Similarly, an economy that saves less than it invests also spends more
than it produces and runs a trade deficit vis a vis the rest of the world.
An increase in national saving would close the gap between what we spend
and what we produce and would reduce the trade deficit. Finally, an economy
that saves and invests more accumulates more capital. This increases productivity
and raises the standard of living in the long run.
Timothy Cogley
Senior Economist
Heather Royer
Research Associate
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to
Research Department
Federal Reserve Bank of San Francisco
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