Reforming Social Security

By Stephen J. Morgan

With so many options to choose from, proponents of changing the Social Security system agree on only one thing: delaying the process will be disastrous.

Politicians have long thought of Social Security as one of the sacred cows of American society. Lay a hand on it and you face the wrath of voters in the next election.

But after repeated warnings that Social Security is headed for insolvency in the 21st century, Congress is expected to give serious consideration in 1999 to reforming the mammoth and frequently misunderstood system. Whether lawmakers will succeed is anybody’s guess, but the stars appear to be aligned for some form of substantive change.

“I think there’s a window of opportunity that [President] Clinton sees as part of his legacy,” says Dick Tewksbury, WG’77, managing consultant in the Philadelphia office of Watson Wyatt Worldwide. “And it’s a narrow window because very soon everyone’s eyes will turn to the 2000 elections and any major decisions will get tabled again. So, whatever that window is, there might be aggressive movement to do something. It’s a profound issue that people have been dodging for many years.”

The reform efforts will largely focus on proposals to allow payroll taxes to be invested in the stock market, either by workers themselves or by the Social Security trust fund, as opposed to the current system in which the taxes are invested by the federal government in U.S. Treasury bonds. The sense of urgency to do something about the system arises not from any immediate threat of insolvency, but from events that will unfold over the next few decades.

“We’re not running out of money this week or month or even this year,” says Olivia S. Mitchell, International Foundation of Employee Benefit Plans Professor of Insurance and Risk Management and executive director of Wharton’s Pension Research Council. “In that sense, it’s not something we have to fix to prevent retirees from going into penury immediately.” What Mitchell does predict, however, is that “the system will not be solvent around the year 2025, give or take a few years.”

A report issued in April 1998 by the Social Security Advisory Board, a bipartisan panel that advises the President, Congress and the Social Security commissioner, forecasts a grim future for the system if it is left untouched. The first gloomy milestone is expected to occur in 2013, when spending by the Social Security Old Age, Survivors, and Disability Trust Fund will exceed the revenue raised through the Social Security tax. At this point, an amount equal to all of the payroll tax income and part of the interest due to the trust fund from outstanding Treasury bonds will be needed to pay benefits.

By 2021, Social Security spending will be greater than all of the system’s income, not only from payroll taxes but from interest on the bonds. “At this point, the government will have to begin paying back the funds it has borrowed from Social Security,” the report says. “This will provide the government with a public finance issue that will need to be addressed because, in order to pay the funds that are due, the Treasury will have to redeem the bonds held by the trust fund.” Only by cashing in the bonds will Social Security be able to pay the full amount of promised benefits until 2032.

Around 2032, though, all of the trust fund assets will have been used up and the ongoing income to the program will not be enough to pay all the benefits owed to people. To be specific, income from the trust fund in 2032 will be enough to pay only 72 percent of benefits. That figure will fall to 67 percent by 2070.

The second and third decades of the next century are critical because that is when the retirement of baby boomers will be in full swing, putting additional strain on an already stressed-out system. It’s no wonder, says Mitchell, that people today are “sitting up and taking notice.”

It’s vital, Mitchell adds, that reform not be postponed because many disillusioned young people already believe that Social Security “won’t be there for them” when they retire.

“One reason young workers today feel worried about the system is that they don’t know what’s going to happen,” she notes. “They don’t know if they should be saving more or working longer. That’s why I propose that reform should happen sooner rather than later. People could then … do what they needed to do to meet the new rules.”

A Pay-As-You-Go System

How did Social Security get into this mess? Launched in 1935 as part of the New Deal, Social Security is a pay-as-you-go system, which means that the taxes paid by today’s workers and employers provide just enough money to pay benefits to today’s recipients. (By law, any Social Security income not needed to pay benefits must be invested in Treasury securities. Trust fund assets are allowed to build up only to the extent required to prevent exhaustion of the trust fund by what the government calls “short term economic fluctuations.”) The pay-as-you-go aspect of the system generally makes Social Security different from most private pension plans, which are funded — meaning that benefits owed to retirees and current workers could be paid by money already in hand.

A key problem is the decline in the number of employees per beneficiary. In 1960, 5.1 workers paid Social Security taxes for each retiree. In 1996, the ratio was 3.3 to one. By 2030, as the number of older people continues to grow, the ratio will shrink to two workers per beneficiary. What’s more, unlike a 401(k) plan, Social Security is not merely a retirement system. It is also an antipoverty program designed to redistribute income so that poorer workers have a safety net to help them in old age. “It was no accident that the Social Security system began in the Great Depression when many people had their savings wiped out,” notes Andrew Abel, Robert Morris Professor of Banking, Finance and Economics.

As a social insurance program, the system has worked remarkably well. According to U.S. News & World Report, only one in 10 seniors is poor today, compared with one in three in 1959. Today, seniors are the age group least likely to live in poverty. About two-thirds of today’s Social Security recipients receive at least half their income from the system. In fact, Abel notes, those people who joined the system in its first few decades “got very high rates of return” in the form of handsome benefits relative to what they contributed in payroll taxes.

Social Security also pays benefits to disabled workers who have not reached retirement age, to spouses and children of retired and disabled workers, and to spouses and children of deceased workers. In fact, retired people make up only 62 percent of all beneficiaries, according to the Social Security Advisory Board.

If you think most Americans understand how Social Security works, consider this unscientific piece of evidence: Marshall E. Blume, Howard Butcher Professor of Finance, tells how he once gave a talk to a community group about personal finance. Several educated, well-off attendees told him they believed that the Social Security “contributions” made by themselves and their employers over the years went to accounts with their names on them in Washington, to be drawn from upon retirement.

Three Options for Reform

At the heart of the debate over reform are questions about the fundamental nature of Social Security: should it have at its core the goal of redistributing income, as favored by the political left, or should it be more like a straightforward retirement plan, as favored by the right?

This is one reason why Social Security is so hotly debated. “You get into not only the fiscal aspect of Social Security, but people’s values,” says Jerry Rosenbloom, Frederick H. Ecker Professor of Insurance and Risk Management.

As a starting point, Congress will likely focus on three options that were contained in a 1997 report by the 13-member Advisory Council on Social Security. The council could not reach agreement on a single proposal, so they drafted three, each of which was supported by different members. (The advisory council has been replaced by the five-member Social Security Advisory Board, which has taken no position on the options put forth by the predecessor group.)

One proposal, dubbed the Maintenance of Benefits plan (MB) and supported by six council members, would keep the current Social Security tax and benefit structure pretty much as is. But, among other things, it would increase taxes on Social Security benefits, cover newly hired state and local government workers not currently part of the system (a move that would bring new revenue into the system), and eventually increase payroll tax rates. Most significantly, it would give the government the power to invest as much as 40 percent of the Social Security trust fund in common stocks instead of Treasury bonds.

Another proposal, called the Individual Accounts plan (IA), also involves increasing taxes on benefits and initiating coverage of state and local workers. More important, though, this plan, which is supported by two council members, would create investment accounts for workers. These accounts would be paid for with an additional payroll tax of 1.6 percent. The individual accounts would be held by the government, but workers would have at least some choice as to how to invest in stock and bond index funds. The accumulated money would be converted to annuities when a worker retires. As these annuities become available, there would be offsetting reductions in benefits paid to people as part of the pay-as-you-go portion of Social Security.

The third option, labeled the Personal Security Accounts plan (PSA) and favored by five members of the council, goes further than the other options in giving people control over how their Social Security taxes are invested and in increasing the amount in personal accounts. Under this plan, fully funded accounts would replace a portion of pay-as-you-go Social Security. Five percentage points of the current 12.4 percent payroll tax would be diverted to personal accounts placed with private investment companies that offer more investment alternatives than the IA option. The rest of the payroll tax would pay for a flat monthly benefit of $410 (in 1996 dollars).

Like the MB and IA proposals, the PSA plan calls for higher taxes on benefits, coverage of state and local government workers, and acceleration of the already scheduled increase in the mandatory retirement age from 65 to 67 in the next century.

The council says all three options would go a long way to making Social Security solvent. Each plan would achieve more advance funding of Social Security’s long-term obligations and give younger workers more of their “money’s worth” by improving the returns on their retirement savings. Under the current system, by contrast, younger workers pay more into the system than they will ever get back when they reach their golden years.

Likely Elements of a Plan

It is impossible to forecast what Congress and the President might do, especially since the devil is in the details when it comes to reform. Mitchell and others, however, believe lawmakers are likely to reach agreement on a plan that allows some measure of individual investment, continues to require participation by workers and continues to pay basic, minimum benefits.

One argument against giving employees full control of their Social Security investments is that they may make poor investment choices, will not have enough to live on in retirement, and will “come back with their hands outstretched” for government help, says Mitchell. “So, the thought is that we have to keep something in place to protect people against themselves.”

Another point of agreement among those with a stake in the debate, Mitchell says, is that there ought to be a safety net imbedded in the system. “If you have been a low-wage worker all your life, some amount of redistribution would be required to help people in old age,” she notes. “But how much redistribution should there be and from whom to whom? Some libertarians would disagree [with the view that a safety net is needed] but that won’t carry the day in the end.”

One group that has analyzed the council’s proposals is the Financial Economists Roundtable, which is comprised of several dozen economists, including Blume. In a 1998 position paper, the roundtable said an improved Social Security system should meet several goals. For one thing, it should become a partially funded system, gradually eliminating part of the current unfunded deficit with funding accomplished through mandatory individual accounts. Furthermore, it must assure that individual accounts are invested prudently and managed efficiently, stipulate that accounts are fully owned by workers, promote saving and preserve a safety net.

The MB plan was dismissed by the roundtable as a “cosmetic improvement only.” The panel gave higher marks to the IA plan for moving toward a partially funded system. But it said the IA option does this too slowly and leaves unclear the issue of whether workers would truly own their own accounts. For instance, if a person dies before retirement, does the account balance revert to the government? Although it did not specifically endorse the PSA plan, the roundtable did say that the PSA approach was better than the IA or MB proposals as a framework for change because it moves toward partial funding of Social Security through individual accounts, preserves a guaranteed monthly payment for retirees and provides transition financing.

Blume prefers that individual accounts be restricted to index funds and that any plan avoid excessive costs for investment management. Administrative costs could prove to be a nightmare, he says, but costs are something “nobody talks about.” Also undecided, he says, is the type of role, if any, investment management firms or mutual fund companies should play in a revamped Social Security system.

It is also interesting to wonder whether it makes any difference who handles Social Security investments, the government or individuals. Kent Smetters, assistant professor of risk management and insurance and formerly an economist at the Congressional Budget Office, believes it would be disastrous to have the government act as a money manager.

Supporters of the MB plan, for example, contend that investing some of the $655 billion trust fund in stocks would raise a lot of revenue and save the system without resorting to privatization. But Smetters says trust-fund investment would actually increase the burden on future generations. The reason: if the stock market goes into a steep decline, Congress would be unlikely to force elderly people to absorb the hit to their portfolios. Instead, legislators would probably raise payroll taxes paid by young workers.

“Investing the Social Security trust fund in equities is a bad idea,” Smetters says. “It’s just a gimmick where you’re not trying to pre-fund Social Security, but you’re having government borrow low by selling debt and investing high by buying equities. You and I don’t borrow money and then invest in the stock market … It’s a foolish, highly leveraged investment.”

Some economists would like to privatize Social Security entirely because they figure that rates of return under an individual account system would be much higher than they are under the current system. After all, the Standard & Poor’s 500 has posted an annual inflation-adjusted return of 9.4 percent from 1926 to 1996, compared to 2.3 percent on intermediate-term government bonds, according to Ibbotson & Associates, a financial research and consulting firm.

However, in a paper co-authored with faculty members at Yale and Columbia universities, Mitchell argues that this assumption is wrong because it doesn’t take into account the need to pre-fund the system. Pre-funding means raising revenue to close the gap between the benefits promised to retirees and the assets available to pay for them.

“My point is that if you stop paying tax into Social Security, then somehow revenue must be raised to pay [benefits to retirees],” Mitchell says. “One way to raise taxes is to tax workers. If you do that, you will cut down on the rate of return to individual accounts. There’s only so much to reallocate. What we’re trying to say is, if you let people keep all Social Security taxes and invest them, then you’ll have to tax them some other way. There’s no free lunch.”

Managing Your Money

What about the impact that the investment of billions of Social Security dollars in stocks rather than Treasury bonds would have on the securities markets?

“If you’re going to buy stocks, it means the government doesn’t get that money,” says Blume. “That means the government has to issue more bonds [to raise revenue], which will change the relative returns on different instruments. Returns on government bonds and corporate bonds will get higher. Rich people will then at least initially reduce their commitment to equities because bonds are now relatively more attractive –- and you don’t know how all this is going to play out in the end.”

Congress will also have to think about whether Americans know enough about investing to handle the responsibility of individual Social Security accounts. To be sure, many people have become accustomed to contributing to 401(k)s, 403(b)s and other tax-deferred vehicles in recent years. But that does not represent everyone in the workforce.

One way to prevent investors from hurting themselves is to limit their choices to plain-vanilla investment vehicles such as index funds consisting of both stocks and bonds. To foster a feeling of at least some control, says Blume, perhaps workers could be given three relatively benign choices: a mix of 40 percent stocks and 50 percent bonds, 50 percent stocks and 50 percent bonds, and 60 percent bonds and 40 percent equities.

“A significant portion of the population would need investment education,” says Dennis Mahoney, W’79, associate academic director of the Certified Employee Benefits Specialists Program at Wharton and former manager of benefits at Penn. Such an effort would require a multimedia approach consisting of, say, written materials, videos and meetings at work with benefits experts. And it must be kept in mind, Mahoney says, that lack of knowledge about investing afflicts professionals with college degrees as well as blue-collar workers.

A Need for Action

In the end, Social Security reform can go down any number of roads. But faculty and alumni alike agree that the worst thing Congress could do is sit on its hands. “The biggest pitfall,” says Rosenbloom, “is that . . . people think the problem will just go away.”

For his part, Watson Wyatt Worldwide’s Tewksbury, who works with corporate clients to develop and communicate benefit plans, says the elements in the advisory council’s IA plan comprise a good first step. He dismisses the MB option because, he says, allowing government to invest Social Security taxes raises issues of conflicts of interest and accountability. The PSA plan, he says, is “just too dramatic a change at this point.”

And how do Americans feel about the issue? It appears they have become less open to reform following the stock market’s slide in August. A Wall Street Journal/NBC News poll in October showed that voters by 52 percent to 43 percent oppose the idea of turning part of Social Security into individual accounts. The Journal said this was almost the reverse of public opinion in April when the market was soaring.

Mitchell declines to publicly advocate any particular approach. But she does believe that whatever shape reform takes, it should be explained in such a way that it can be understood by all Americans.

“It’s better to be clear who’s getting income transferred to them and from whom,” says Mitchell, who has been studying Social Security for 20 years and has testified on retirement topics before the U.S. Senate and the British parliament. “I don’t think any benefit is [to be had] from confusing people. The Social Security system faces an insolvency problem. Let’s do it calmly and surefootedly. And let’s get started because if we wait 25 years, we’ll all be unhappy.”

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