Social Security: Long-Term Financing and Reform
SOCIAL SECURITY: LONG-TERM FINANCING AND REFORM
The Social Security Act and its transformation
The provisions of the Social Security Act (signed into law by President Franklin D. Roosevelt on 14 August 1935) were tailored to model a private insurance system and avoid any hint of socialism. Some degree of individual equity would be maintained, with those who paid in more receiving greater benefits upon retirement. OASI (Old Age and Survivors Insurance) would not be means-tested, reflecting American preferences against welfare. These provisions helped to make the Social Security Act the most successful and enduring of the New Deal programs— indeed, many analysts claim that Social Security is the most popular federal government program ever adopted. In truth, however, Social Security has never closely approximated a private insurance plan, and changes to the Social Security Act over the years have moved it ever farther from that model. Thus, while Americans still tend to think of Social Security as a system of ‘‘retirement insurance,’’ in fact almost 28 percent of the beneficiaries of OASI (which excludes disability benefits covered under the full program of Old Age, Survivors and Disability Insurance, OASDI) in 1997 were spouses or survivors of covered workers. Though the discussion that follows will focus on the aspects of Social Security that relate most closely to issues surrounding aging and retirement, it must be kept in mind that Social Security is a much bigger program with broader coverage, and any reforms must take account of the large percent of beneficiaries without normal work histories.
U.S. workers began to pay payroll taxes for Social Security in 1937, and the first benefits were paid in 1940. Over the years tax rates were increased, the percent of the workforce covered grew, and benefits were expanded. A substantial change was made in 1972, when automatic cost-of-living adjustments were added to benefits. The next few years experienced high inflation and slower real economic growth—together these raised program benefit payments and lowered tax receipts, generating the first crisis for Social Security when it was feared that receipts might fall below expenditures. This led to the first significant cutbacks in the program’s history, with inflation adjustments delayed, tax rates increased, and some benefit cuts for civil servants. By the early 1980s it was realized that these changes had not been sufficient. A commission was appointed (with future Federal Reserve Board Chairman Alan Greenspan at its head) to study the long-term financial situation of Social Security. One significant issue that had arisen was the aging of the U.S. population. This was compounded by the baby boom bulge created in the early postwar period when fertility rates (number of children per woman) rose and remained high until the baby boom bust of the 1970s, when fertility rates fell. Combined with rising longevity, this ensures that the baby boomers will create a relatively large number of elderly Social Security beneficiaries and relatively fewer workers to support them between 2015 and 2035. While the problems created by the baby boom receive most of the press, falling fertility rates and rising life expectancy are common experiences in all the major developed nations, leading to the social challenges that result from an aging population. Indeed, on current projections, Social Security will experience its greatest financial problems after all the baby boomers have died.
The Greenspan Commission published findings that resulted in the most significant changes made to Social Security since the addition of Medicare in 1965. These included higher tax rates, imposition of taxes on Social Security benefits, and phased increases in the normal retirement age. Most important, the 1983 revisions changed Social Security from pay-as-you-go to advance funding. In a pay-as-you-go (or paygo) system, current-year revenues are balanced against current-year expenditures. However, as the Greenspan Commission recognized, the aging of America created a special financing problem. During the late twentieth and early twenty-first centuries, OASDI was projected to run large annual surpluses, but sometime during the second decade of the twenty-first century, the program would begin to run annual deficits. Indeed, it was feared that the deficits would eventually become so large that it might be politically infeasible to raise taxes or cut benefits by the amount required to return the program to balance. For this reason, the paygo system was abandoned in favor of advance funding. In an advance funded system, near-term annual surpluses are accumulated in a trust fund that purchases special U.S. Treasury securities to earn interest. When program spending rises above tax revenues, interest earnings supplement revenues to maintain balance. At some point in the future, taxes plus interest earnings will fall below annual benefit payments; then the trust fund can sell its Treasury securities to make up the difference. In this way surpluses over the first three or four decades following the Greenspan Commission’s changes could be used to offset projected annual deficits during the final decades, ensuring long-term financial solvency.
The changes made in 1983, including the move to an advance funded system, were believed at the time to have resolved the challenges created for Social Security by the aging of the population. Over subsequent years the board of trustees developed a rigorous method of financial accounting for the program that reported detailed projections for the next ten years (its short-range forecast) and a projection for the next seventy-five years (its long-range forecast) to capture the effects of demographic shifts, as well as alternative assumptions regarding economic factors, such as economic growth. By the end of the 1990s, they had settled on use of three alternative scenarios for the long-term forecasts: high-cost (pessimistic), intermediate-cost, and low-cost (optimistic). The long-term financial status of the program is summarized in a calculation of the actuarial balance for the seventy-five-year period. This is the difference between the summarized income ratio (the ratio of the present value of payroll taxes to the present value of taxable payroll) and the summarized cost rate (the ratio of the present value of expenditures to the present value of the taxable payroll) over the valuation period. This is essentially similar to any comparison that discounts future revenues and costs to determine long-term net revenues. When the summarized income rate equals or exceeds the summarized cost rate, the program is said to be in actuarial balance. If the difference is negative, the program is in actuarial imbalance with an actuarial gap, measured as a percent of taxable payroll. For example, if discounted revenues fall short of discounted benefit payments by an amount equal to 1 percent of taxable payroll, this is said to represent an actuarial gap of 1 percent. An immediate increase of payroll taxes by a total of 1 percentage point (half on employers and half on employees) would close the gap.
OASDI began to show a large actuarial imbalance by the late 1990s, equal to more than 2 percent of taxable payroll. As an alternative to tax increases, the gap could be closed by cutting benefits or increasing the rate of return earned on trust fund assets. In fact, many proposals for reforming Social Security include provisions that would simultaneously pursue all three alternatives: tax increases, benefit cuts, and higher earnings. In addition, some proposals would move Social Security operations closer to a private insurance fund model—or, indeed, replace Social Security with a privately operated (and even purely voluntary) retirement system. Before turning to such proposals, the underlying causes of the gap will be examined.
According to the Social Security Administration’s 1999 projections, on intermediate-cost assumptions the program achieved actuarial balance only for the first twenty-five years; over the fifty-year period the actuarial gap was -1.26; and it reached -2.07 for the entire seventy-five-year long-range forecast. However, on low-cost assumptions, the program maintained actuarial balance for the whole period, and on high-cost assumptions the program had an actuarial gap even for the first twenty-five-year period. This shows how critical the assumptions used in the forecasts are. Also, any crises are relatively far in the future; indeed, even on high-cost assumptions the actuarial imbalance is quite small for the first quarter of the twenty-first century. According to the 1999 projections, the Social Security trust funds would reach $2.3 trillion by 2008 on intermediate-cost assumptions, peak at more than $4.4 trillion in 2020, then decline to zero by 2035. Using low-cost assumptions, the trust fund would continue to grow over the entire seventy-five-year period, reaching more than $45 trillion by 2075. On the other hand, the trust fund would reach only $2.6 trillion in 2015 according to high-cost assumptions, and would then be depleted quickly, falling to zero by 2025. In other words, if Social Security is analyzed as if it were a private pension plan, it apparently will experience a crisis in 2025 or 2035, using high-cost or intermediate-cost assumptions. Most analysts focus on the intermediate-cost projections, according to which Social Security revenues would be sufficient to cover only three-fourths of expected expenditures after the mid-2030s.
The main demographic and economic assumptions that underlie the projections are fertility rates, immigration, labor force participation rates, longevity, growth of real wages, and taxable base. Together, fertility rates, immigration rates, longevity, and labor force participation rates determine the size of the pools of workers and retirees. The number of Social Security beneficiaries supported by workers will rise sharply in the early twenty-first century. For example, the number of OASDI beneficiaries per one hundred covered workers was thirty-one in 1975, but this will rise steadily between 2010 and 2075, when it will reach fifty-six, on intermediate-cost projections. To put it another way, while the United States had just over 3.3 workers per beneficiary in 2000, it may have fewer than 1.8 by 2075. Thus, the burden required of future workers to provide for OASDI beneficiaries could increase by almost a factor of two. On the other hand, workers in 2075 are projected to support fewer young people. If the population under age twenty is added to the population age sixty-five and over to obtain a dependent population (most of whom would not be expected to be working), the dependency ratio (the ratio of dependents to workers) actually peaked at 0.95 in 1965, fell to 0.71 by 1995, and will rise only slightly to 0.83 by 2075. In other words, the parents of the baby boomers supported more dependents in the mid-1960s than any generation is likely to support in the future.
In any case, as the number of beneficiaries rises relative to the number of workers paying Social Security taxes, the actuarial balance is negatively impacted. This results in part from a falling fertility rate, which reduces the size of the younger population from which workers can be drawn. The fertility rate (children born per woman) stood at just over 2 at the end of the 1990s and was projected to fall to 1.9 under the intermediate assumptions. If the fertility rate were to rise back to 3.7 (where it stood in 1957 during the baby boom), over 90 percent of the actuarial gap would be eliminated. On the other hand, a falling fertility rate can be offset by rising net immigration (since immigrants can add to the worker pool, paying payroll taxes) and by rising labor force participation rates (the number working or seeking work per one hundred population). In the late 1990s net (legal and illegal) immigration reached about 960,000 per year. In their projections, however, the trustees assumed that annual net immigration would fall to 900,000 and remain there throughout the seventy-five-year period. Each additional 100,000 net immigrants above that level would reduce the actuarial gap by about 0.07 percent of taxable payroll. The trustees also project that labor force participation rates for men will fall (from 75.5 percent in 1997 to 74 percent by 2075). In contrast, since World War II, labor force participation rates for women have risen sharply (reaching 60 percent in 1997). The trustees project that this will nearly level off (reaching only 60.6 percent by 2075). If male labor force participation rates did not fall, and if female rates continued to rise, some of the actuarial gap would be eliminated. Finally, the trustees project that death rates will fall by 34 percent over the seventy-five-year period, and each ten percentage point decrease in the death rate increases the long-range actuarial gap by about 0.34 percent of taxable payroll.
While most of the debate over the Social Security program’s solvency focuses on these unfavorable demographic trends, they were mostly known to the Greenspan Commission and the 1983 adjustments should have taken care of them. In fact, the reason for the looming Social Security crisis lies not in the demographics but in the increasingly pessimistic economic assumptions adopted by the trustees in their reports in the 1980s and 1990s. The main economic assumptions that lead to the financing gap are low growth of real wages and a falling taxable base. In 1999 the trustees projected that real wages would grow at only 0.9 percent per year. Real wage growth, in turn, is related to productivity gains. The trustees assume that productivity will grow at just 1.3 percent annually over the long-range period—well below long-term U.S. averages. If real wages were to grow at 2 percent per year, more than half of the actuarial gap would be eliminated. Finally, the trustees have projected that the taxable base will fall from 41 percent of GDP in 1999 to only 35 percent in 2075. This is for two reasons. First, Social Security taxes wages and certain kinds of self-employment income. Other types of income, such as interest income, are exempt. If these rise as a share of national income, the percent of income subject to the Social Security tax will fall. Second, payroll taxes are levied on only a portion of one’s wage income—determined by the contribution and benefit base. In 1999 OASDI taxes were applied only to the first $72,600 of employment income (the contribution and benefit base for that year; this base is increased each year with rising nominal average wages). The trustees have assumed that the taxable base will fall both because a smaller portion of income will be received in the form of wages and because a higher percent of wages will accrue to those with earnings above the contribution and benefit base. Therefore, by 2075, a little over a third of national income will be taxed to support OASDI beneficiaries.
Some analysts have questioned the usefulness of calculating actuarial balance over a seventy-five-year period. Projections of demographic trends and, more important, economic variables over such long periods is inherently difficult, and relatively small changes in assumptions can change the projections significantly. Some analysts have argued that projections are based on rather pessimistic economic assumptions. For example, according to intermediate-cost projections, real GDP and labor productivity will grow at only 1.3 percent per year. In fact, labor productivity has grown at a rate of approximately 2 percent per year since 1870, and at 2.7 percent per year between World War II and 1973, while real GDP grew at an annual rate of 3.7 percent from 1870 to 1973. Even if productivity and GDP grew at only two-thirds of long-term trends, Social Security’s financial problems would be eliminated. A counterargument is that U.S. economic performance since 1973 has generally been worse than long-term averages, and it is more prudent to project weak performance into the future than to presume that high growth might return. On the other hand, it has been noted that these pessimistic assumptions were incongruously adopted in the trustee forecasts during the ‘‘Goldilocks’’ 1990s expansion, when U.S. economic performance did return toward historical averages. Furthermore, the assumptions adopted may not be internally consistent. For example, if labor force growth rates are as low as the trustees have assumed, one might expect that real wage growth should be higher than the assumed 0.9 percent as excess demand for labor pushes up its relative return, and labor productivity growth should be higher as firms substitute capital for scarce labor.
More important, it is not clear that a national, public retirement system ought to operate as if it were a private pension fund, building reserves today that earn interest and can be depleted in future years. In, say, 2035 when the trust fund needs to sell securities to the Treasury, the Treasury will have to raise taxes, cut other spending, or sell securities to cover retirement of debt held by Social Security. Surprisingly, this is exactly what the government would have to do even if Social Security had no trust fund at all! Suppose Social Security were operated as a paygo system, with each year’s receipts equal to spending. When revenues began to fall below benefit expenditures, the government would have to increase taxes, reduce other spending, or issue securities to cover the difference. Some, including Milton Friedman, have concluded that the trust fund is nothing more than an ‘‘accounting gimmick,’’ because when Social Security begins to run deficits, existence of a trust fund cannot really provide for financing of its spending. Further, unlike a private firm, the U.S. government’s revenues are not market-determined. If necessary, the government can raise tax rates or can deficit-spend to ensure that it meets its Social Security obligations—things that private firms cannot do. Hence, while government cannot really build up a trust fund, it also does not need to do so.
What really matters is whether the economy will be able to produce a sufficient quantity of real goods and services to provide for both workers and dependents in, say, the year 2035. If it cannot, then regardless of Social Security’s finances, the real living standards of Americans in 2035 will have to be lower than they are today. Those who take this approach argue that any reforms to Social Security made today should focus on increasing the economy’s capacity to produce real goods and services, rather than on ensuring positive actuarial balances. For example, policies that might encourage public and private infrastructure investment will ease the future burden of providing for growing numbers of retirees. In a sense, this would be a real reform rather than a financial reform, although it is possible that financial reforms might encourage greater investment. Indeed, some advocates of privatization argue this will encourage more investment by entrepreneurs. However, even with the trustees’ rather pessimistic economic and demographic assumptions, real living standards are projected to rise substantially for both workers and retirees throughout the seventy-five-year, long-range period. Accordingly, Social Security does not face a real crisis even though it may face a financial crisis. Still, this may not be sufficiently comforting to future workers, because although they will enjoy a growing real economic pie, the share of the pie going to retirees will grow. In fact, the share of GDP going to OASDI will grow from about 5 percent in 2000 to 7 percent for the period between 2030 and 2075. On the one hand, this is a significant increase, but on the other hand, similar shifts have occurred in the past without generating an economic crisis.
Of the most important reform proposals, perhaps the most extreme would be to abolish Social Security altogether, leaving it up to individuals to decide how to provide for their retirement. (However, it should be recalled that Social Security is not simply an old age security program; privatization could leave widows, dependents, and disabled persons to their own devices.) Some reformers recognize that individuals generally underestimate the future costs of retirement, so some sort of mandatory minimum contribution levels should be maintained even if the program is privatized. Another variation would maintain basic coverage in a mandatory, government-run program, but would allow individual control over supplemental investments in privately run pension funds. Finally, some proposals would retain most features of the current system but would direct the trustees to invest a specified portion of the trust funds in private equities.
Some reformers advocate privatization simply as a matter of principle—for example, Milton Friedman has long argued that there is no justification for mandatory participation in a public system. Others emphasize that, as currently designed, Social Security has a strong redistributional element—both within and across generations. They typically use a money’s worth estimate to calculate a return on one’s contributions. Those with high earnings, and thus high contributions, receive low returns when they eventually collect benefits, while those with low earnings receive higher returns. Many beneficiaries never actually contribute; thus, contributions of others are redistributed to them. Returns also vary greatly by generation—early participants in Social Security received very good returns on their contributions, but returns for later generations are much lower. Thus, some reformers emphasize that reform should be geared toward ensuring better money’s worth outcomes for contributors, both within and across generations. It should be noted, however, that while some attention was paid to such equity concerns in the original Social Security Act, money’s worth was not a high priority in the beginning and most amendments since then have moved the program ever farther from this consideration.
Nevertheless, most reformers in recent years have pushed privatization to resolve the long-range financial imbalance of Social Security, with money’s worth calculations playing a smaller role. It is argued that under current arrangements, the trustees can hold only government bonds with relatively low interest rates. Allowing investments in the stock market and other private assets could increase returns on the trust fund. Such arguments were given a tremendous boost by the spectacular performance of U.S. stock markets from the mid-1980s through 2000. Many proponents argue that equity markets should earn real returns of about 7.5 percent per year—as they have averaged since the 1920s— probably more than double the real return on government debt. Over the long-range, seventy-five-year period, these higher returns could resolve Social Security’s financial problems.
However, opponents have raised several objections. First, there will be a costly transition period as the system becomes privatized, during which current workers must finance the cost of the existing Social Security system (paying taxes to finance the benefits going to current retirees), plus the costs of building up their own retirement funds. Thus, a fairly large, immediate tax increase will be required, and must remain in place for several decades until all those covered under the old system have died. Second, it is probably inconsistent to argue that real GDP growth will slow (to 1.3 percent per year, little over one-third its long-term average) without affecting growth of equity prices. Critics have shown that this implies either that the share of distribution of national income going to profits must grow to implausibly high levels (indeed, Dean Baker has calculated that wages must be negative by 2070), or that price-earnings ratios (already at all-time highs in 2000) must rise to truly astronomical levels (on Baker’s calculation, to 485-to-1 by 2070). On the other hand, privatizers believe that the influx of money into stocks would generate more investment, and thus higher economic growth. Third, privatization might place unacceptable levels of risk on workers. Even if the stock market were to grow at an average rate of over 7 percent per year, there could be relatively long periods of below-normal growth. In the past, equity prices have been fairly flat for decades at a time. Unlucky workers whose retirement happened to come after such a period could face deprivation during retirement. Furthermore, if workers are given individual control over their retirement accounts, they might do poorly even if the markets as a whole are doing well.
Fourth, numerous small retirement accounts can be very costly to administer and supervise. Current costs of administering Social Security are exceedingly small—well under 1 percent of revenues. Privatizers often point to the Chilean example as evidence that a private system can produce high returns for contributors; however, overhead costs in Chile are above 10 percent. While private fund managers were initially supportive of the move to privatize, they have become less enthusiastic as they have come to realize the logistics of managing many small accounts for lower income workers. Fifth, some critics have argued that because women typically have lower incomes, spend more time out of the labor force, and more often work part-time, most privatization reforms would adversely affect benefits paid to women. Others have noted that because African Americans and Hispanics typically have lower income and lower life expectancies, privatization reforms as well as raising the normal retirement age would have a disproportionately negative impact on those groups. Finally, critics note that privatization schemes do not, and probably cannot, offer the same kinds of coverage currently offered by Social Security. For example, private pension plans do not offer inflation indexing, as Social Security does. As discussed, Social Security also offers coverage for many individuals without significant work histories. If the program is privatized, a new social safety net would have to be created to cover individuals who could not purchase private insurance.
With the large turnaround of the U.S. federal government budget in the late 1990s (from chronic deficits to record surpluses), President Bill Clinton and many others proposed that budget surpluses could be set aside to resolve Social Security’s financial problems. Essentially, President Clinton would have increased the size of the trust fund by an amount equal to just under two-thirds of annual budget surpluses. The larger trust fund would then earn more interest and would have more Treasury securities to sell when program revenues fall below expenditures. However, as noted above, when the trust fund sells securities, the Treasury will have to cut other spending, raise taxes, or sell securities to the general public to cover the payments made to the trust fund. Furthermore, like most financial fixes, this reform will not necessarily increase future productive capacity. Indeed, it is not necessary for the federal government to run surpluses for it to credit the trust fund with more securities—the Treasury can add securities worth any amount to the trust fund at any time (in principle, it can add an amount equal to the entire Social Security shortfall today, thereby resolving any financial difficulties). Alternatively, the Treasury could simply agree to pay a higher interest rate on trust fund assets—paying whatever interest rate would eliminate the actuarial gap. Though somewhat ludicrous, these alternatives emphasize that accumulating a trust fund of Treasury securities really cannot resolve future annual deficits in the Social Security program.
Furthermore, as emphasized above, what really matters is the economy’s capacity to produce real goods and services in the future. Hence, if the amount that can be produced will not be sufficient to provide the level of consumption desired by all generations in the future, it will be necessary to either to boost production or to ration consumption. Extending the normal retirement age (which is essentially a benefit cut) will keep workers in the labor force longer, and will reduce the number of years they must be supported during retirement. Increasing taxes on future workers will leave them with lower purchasing power, ensuring that more of the nation’s output can go to retirees. Cutting future OASDI benefits will do the opposite—allocating more output toward workers and others with incomes that are not dependent on Social Security. Fortunately, given increases in worker productivity that reasonably can be expected to occur, plus increases in production facilities that are likely to take place as a result of public and private investment, it appears quite likely that future workers and future retirees will enjoy higher living standards than do their counterparts today—in spite of the aging of America.
L. Randall Wray
See also Baby Boomers; Population Aging; Social Security, and the U.S. Federal Budget; Social Security, History and Operations.
Advisory Council on Social Security. Report of the 1994–1996 Advisory Council. Vol. I: Findings and Recommendations. Washington, D.C.: Government Printing Office, 1997a.
Advisory Council on Social Security. Report of the 1994–1996 Advisory Council. Vol. II: Report of the Technical Panel on Trends and Issues in Retirement Savings, Technical Panel on Assumptions and Methods and Presentations to the Council. Washington, D.C.: Government Printing Office, 1997b.
Baker, D. ‘‘Saving Social Security with Stocks, Introduction, Policy in Perspective.’’ The Century Foundation. www.tcf.org
Baker, D. ‘‘Saving Social Security in Three Steps.’’ Briefing Paper. Washington, D.C.: Economic Policy Institute, 1998.
Ball, Robert M.; Fierst, Edith U.; Johnson, Gloria T.; Jones, Thomas W.; Kourpias, George; and Shea, Gerald M. ‘‘Social Security for the 21st Century: A Strategy to Maintain Benefits and Strengthen America’s Family Protection Plan.’’ In Advisory Council on Social Security, Report of the 1994–1996 Advisory Council. Vol. 1: Findings and Recommendations. Washington, D.C.: Government Printing Office, 1997.
Clinton, W. J. State of the Union Address, January 19, 1999. Transcript. CNN Interactive, January 20. www.cnn.com
Congressional Budget Office. Social Security Privatization: Experiences Abroad. Washington, D.C.: Government Printing Office, 1999.
Friedman, M. ‘‘Social Security Chimeras.’’ New York Times, January 11, 1999.
Langer, D. ‘‘Social Security Finances are in Fine Shape.’’ Remarks at the Congressional Conference to Fight Social Security Privatization. Washington, D.C.: January 21, 1999.
Langer, D. ‘‘Social Security vs. Stock.’’ Op-ed. Christian Science Monitor, June 19, 2000. Page 19.
Papadimitriou, D. B., and Wray, L. R. ‘‘Does Social Security Need Saving?’’ Public Policy Brief no. 55. Annandale-on-Hudson, N.Y.: The Jerome Levy Economics Institute, 1999a.
Papadimitriou, D. B., and Wray, L. R. ‘‘How Can We Provide for the Baby Boomers in Their Old Age?’’ Policy Note 1999/5. Annandale-on-Hudson, N.Y.: The Levy Economics Institute, 1999b.
Papadimitriou, D. B., and Wray, L. R. ‘‘More Pain, No Gain: Breaux Plan Slashes Social Security Benefits Unnecessarily.’’ Policy Note 1999/8. Annandale-on-Hudson, N.Y.: The Levy Economics Institute, 1999c.
Skidmore, M. J. Social Security and its Enemies: The Case for America’s Most Efficient Insurance Program. Boulder, Colo.: Westview Press, 1999.
Social Security Administration. Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. Washington, D.C.: Government Printing Office, 1998.
Social Security Administration. Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. Washington, D.C.: Government Printing Office, 1999.
Stein, H. ‘‘How to Solve Almost Everything.’’ New York Times, February 3, 1999.
Wray, L. R. ‘‘Can the Social Security Trust Fund Contribute to Savings?’’ Journal of Post Keynesian Economics 13, no. 2 (1990–1991).
Wray, L. R. ‘‘The Emperor Has No Clothes: President Clinton’s Proposed Social Security Reform.’’ Policy Note 1999/2. Annandale-on-Hudson, N.Y.: The Levy Economics Institute, 1999a.
Wray, L. R. ‘‘Surplus Mania: A Reality Check.’’ Policy Note 1999/3. Annandale-on-Hudson, N.Y.: The Levy Economics Institute, 1999b.
A federal program designed to provide benefits to employees and their dependants through income for retirement, disability, and other purposes. The social security program is funded through a federal tax levied on employers and employees equally.
The Social Security Program was created by the social security act of 1935 (42 U.S.C.A. § 301 et seq.) to provide old age, survivors, and disability insurance benefits to the workers of the United States and their families. The program, which is administered by the Social Security Administration (SSA), an independent federal agency, was expanded in 1965 to include health insurance benefits under the medicare program and to assist the states in establishing unemployment compensation programs. Unlike welfare, which is financial assistance given to persons who qualify on the basis of need, Social Security benefits are paid to an individual or his family on the basis of that person's employment record and prior contributions to the system.
As a general term, social security refers to any plan designed to protect society from the instability that is caused by individual catastrophes, such as unemployment or the death of a wage earner. It is impossible to predict which families will have to endure these burdens in a given year, but disaster can be expected to strike a certain number of households each year. A government-sponsored plan of social insurance spreads the risk among all members of society so that no single family is completely ruined by an interruption of, or end to, incoming wages.
Germany was the first industrial nation to adopt a program of social security. In the 1880s Chancellor Otto von Bismarck instituted a plan of compulsory sickness and old age insurance to protect wage earners and their dependents. Over the next 30 years, other European and Latin American countries created similar plans with various features to benefit different categories of workers.
In the United States, the federal government accepted the responsibility of providing pensions to disabled veterans of the Revolutionary War. Pensions were later paid to disabled and elderly veterans of the Civil War. The first federal old age pension bill was not introduced until 1909, however. To fill this void, many workers joined together to form beneficial associations, which offered sickness, old age, and funeral benefit insurance. The federal government encouraged people to set aside money for future emergencies with a popular postal savings plan. People who could not manage were helped, if at all, by private charity because it was generally believed that those who wanted to help themselves would.
Congress enacted the Social Security Act of 1935 as part of the economic and social reforms that made up President franklin d. roosevelt's new deal. The act provided for the payment of monthly benefits to qualified wage earners who were at least 65 years old or payment of a lump-sum death benefit to the estate of a wage earner who died before reaching age 65.
In 1939 Congress created a separate benefit for secondary beneficiaries—the dependent spouses, children, widows, widowers, and parents of wage earners—to soften the economic hardship created when they lost a wage earner's support. Such beneficiaries are entitled to benefits because the wage earner made contributions to the plan. Beneficiaries can receive their payments directly upon the retirement or death of the worker.
Social Security originally protected only workers in industry and commerce. It excluded many classes of workers because collecting their contributions was considered too expensive or inconvenient. Congress exempted household workers, farmers, and workers in family businesses, for example, because it believed that they were unlikely to maintain adequate employment records. In the 1950s, however, Congress extended Social Security protection to most self-employed individuals, most state and local government employees, household and farm workers, members of the armed forces, and members of the clergy. Federal employees, who previously had their own retirement and benefit system, were given Social Security coverage in 1983.
Old Age, Survivors, and Disability Insurance
Federal Old Age, Survivors, and Disability Insurance (OASDI) benefits are monthly payments made to retired people, to families whose wage earner has died, and to workers who are unemployed because of sickness or accident. Workers qualify for such protection by having been employed for the mandatory minimum amount of time and by having made contributions to Social Security. There is no financial need requirement to be satisfied. Once a worker qualifies for protection, his family is also entitled to protection. The entire program is geared toward helping families as a matter of social policy.
Two large funds of money are held in trust to pay benefits earned by people under OASDI: the Old Age and Survivors Trust Fund and the Disability Insurance Trust Fund. As workers and employers make payroll contributions to these funds, money is paid out in benefits to people currently qualified to receive monthly checks.
The OASDI program is funded by payroll taxes levied on employees and their employers and on the self-employed. The tax is imposed upon the employee's taxable income, up to a maximum taxable amount, with the employer contributing an equal amount. The self-employed person contributes twice the amount levied on an employee. In 2003 the rate was 6.2 percent, levied on earned income up to a maximum of $87,000.
Old Age Benefits A person becomes eligible for Social Security old age benefits by working a minimum number of calendar quarters. The number of quarters required for full insurance increases with the worker's age. Forty quarters is the maximum requirement. The individual is credited for income up to the maximum amount of money covered by Social Security for those years. This amount is adjusted to reflect the impact of inflation on normal earnings and ensure that a worker who pays increasing Social Security contributions during his or her work life will receive retirement benefits that keep pace with inflation.
Persons born before 1950 can retire at age 65 with full benefits based on their average income during their working years. For those born between 1950 and 1960, the retirement age for full benefits has increased to age 66. Persons born in 1960 or later will not receive full retirement benefits until age 67. Any person, however, may retire at age 62 and receive less than full benefits. At age 65, a worker's spouse who has not contributed to Social Security receives 50 percent of the amount paid to the worker.
The First Payments of Social Security
After the enactment of the Social Security Act of 1935 (42 U.S.C.A. § 301 et seq.) and the creation of the Social Security Administration (SSA), the federal government had a short time to establish the program before beginning to pay benefits. Monthly benefits were to begin in 1940. The period from 1937 to 1940 was to be used both to build up the trust funds and to provide a minimum period for participation for persons to qualify for monthly benefits.
From 1937 until 1940, however, Social Security paid benefits in the form of a single, lump-sum payment. The purpose of these one-time payments was to provide some compensation to people who contributed to the program but would not participate long enough to be vested for monthly benefits.
The first applicant for a lump-sum benefit was Ernest Ackerman, a Cleveland motorman who retired one day after the Social Security Program began. During his one day of participation in the program, five cents was withheld from Ackerman's pay for Social Security, and upon retiring, he received a lump-sum payment of seventeen cents.
Payments of monthly benefits began in January 1940. On January 31, 1940, the first monthly retirement check was issued to Ida May Fuller of Ludlow, Vermont, in the amount of $22.54. Fuller died in January 1975 at the age of one hundred. During her thirty-five years as a beneficiary, she received more than $20,000 in benefits.
Since 1975 Social Security benefits have increased annually to offset the corrosive effects of inflation on fixed incomes. These increases, known as cost of living allowances (COLAs), are based on the annual increase in consumer prices. Allowing benefits to increase automatically ended the need for special acts of Congress, but it has also steadily increased the cost of the Social Security Program.
A person who continues to work past the retirement age may lose some benefits because Social Security is designed to replace lost earnings. If earnings from employment do not exceed the amount specified by law, the person receives the full benefits. If earnings are greater than that amount, one dollar of benefit is withheld for every two dollars in wages earned above the exempt amount. Once a person reaches age 70, however, he does not have to report earnings to the SSA, and the benefit is not reduced.
The Future of Social Security
The payment of old-age, survivors, and disability insurance (OASDI) benefits has been a cornerstone of U.S. social welfare policy since the establishment of the social security administration in 1935. At the same time, the long-term financial stability of OASDI has been a constant worry. In the early years of the twenty-first century, concerns about Social Security mounted as policy makers assessed the impact of the retirement of the "Baby Boom" generation. Many younger people raised the issue of "generation equity." They express doubt that Social Security benefits will be available when they retire, and anger that they will be forced to pay, through payroll taxes, for the baby boomers' retirement benefits.
Reform of the Social Security system has always been a political hot potato. Retirees and those approaching retirement form a strong lobbying force, and they zealously protect their benefits. Employers and employees are equally vocal in their opposition to higher payroll taxes to fund OASDI. Thus, changes in Social Security required bipartisan support, which materialized in the face of an impending Social Security crisis. The 1982–83 National Commission on Social Security Reform successfully secured from Congress the short-term financing of OASDI. As a result, Congress passed a series of laws meant to accumulate surpluses as a hedge against future burdens. The Social Security surplus is the amount by which revenue from the federal payroll tax exceeds the amount of Social Security benefits paid out.
Shortly after these new laws went into effect, Social Security began running a surplus. Surplus Social Security revenue can be used to fund other government programs and to help retire the national debt. During the favorable economic climate of the late 1990s, Congress began to use the surplus to pay down the federal debt, hoping to better position the government to meet its obligations to future retirees. And, in 2000, the federal government generated enough revenue so that the entire Social Security surplus was available for paying off debt.
The state of Social Security became a major campaign issue in the 2000 elections, with both Republicans and Democrats attempting to appear as though they were guardians of Social Security assets. Candidates from both parties promised to create a "lockbox," meaning that the Social Security surplus would be spent entirely on debt retirement. With the advent of fiscally lean years in the early 2000s, the lockbox approach was largely disregarded by politicians who advanced other ideas about what to do with Social Security surpluses. These ideas included using the surplus to help offset decreases in revenues brought about by tax cuts and using the surplus to fund new or expanded spending initiatives.
Analysts argue that the real issue often is clouded. It is not how to spend the surplus now, but how to maintain the long-term solvency of the Social Security trust fund. Planners estimate that the income from the trust fund will exceed expenses each year until 2020. The trust fund balances will then start to decline as investments are redeemed to meet the increased expenses from a swelling retired workforce. Although it is estimated that 75 percent of the costs would continue to be met from current payroll and income taxes, in the absence of any changes, full benefits could not be paid beginning in 2030.
In its 1996 report, the Social Security Administration's Advisory Council looked at various long-term financing options for OASDI. The council could not reach consensus on a specific long-term plan, but it did suggest several types of financing that represent a marked departure from previous efforts to fund Social Security. The council noted that past efforts have generally featured cutting benefits and raising tax rates on a "pay-as-you-go" basis. The council agreed that this approach must be changed and offered three ways of restoring financial solvency.
One approach, called Maintenance of Benefits (MB), calls for an increase in income taxes on OASDI benefits, a redirection of some revenue from other trust funds, and, most importantly, the adoption of a plan allowing the federal government to invest a portion of the trust fund assets directly in common stocks. Rates of returns on stocks have historically exceeded those on federal government bonds, where all Social Security funds are now invested. If the returns were to continue, the MB plan would maintain Social Security benefits for all income groups of workers and reassure younger workers that they will get their money's worth when they retire.
A second approach, labeled the Individual Accounts (IA) plan, would create individual accounts that would work alongside Social Security. The IA plan would increase the income taxation of benefits, accelerate the scheduled increase in retirement age, reduce the growth of future benefits to middle- and upper-income workers, and increase employees' mandatory contributions to Social Security by 1.6 percent. This increase would be allocated to individual investment accounts held by the government and controlled by the worker, but with a limited set of investment options available. It is estimated that the combined income from both funds would yield essentially the same benefits as promised under the current system for all groups.
A third approach, labeled the Personal Security Accounts (PSA) plan, would create larger, fully funded individual accounts that would replace a portion of Social Security. Under this plan, five percent of an individual's current payroll tax would be invested in his PSA, which he then could use to invest in a range of financial instruments. The rest of his payroll tax would be used to fund a modified OASDI program. It would provide a flat dollar amount (the equivalent of $410 monthly in 1996), in addition to the proceeds of the individual's PSA. This approach would also change the taxation of benefits and move eligibility for early retirement benefits from age 62 to 65. The combination of the flat benefit payment and the income from the PSA would exceed, on average, the benefits promised under the current system.
In 2001, the concept of individual accounts was once again proposed, this time by the george w. bush administration's Commission to Strengthen Social Security (CSSS). The CSSS introduced the idea of Social Security individual accounts, also called Personal Retirement Accounts (PRAs). PRAs would earn a market return over the workers' lives and replace some of the retirement benefits promised by Social Security. These plans are also known as "carve-outs" because they carve out or redirect some portion of a worker's 12.4 percent Social Security payroll tax into a personal retirement account that can be invested in stocks and bonds. The accounts would be owned and presumably managed by individual workers.
Any type of personal retirement account privatizes a portion of Social Security, which means a significant shift in the way Social Security is funded. Proponents claim that they will generate more advance funding for Social Security's long-term obligations. They would also result in a higher level of national saving for retirement. In addition, advocates point to the fact that individuals gain more control over their future because they are allowed to invest as much or as little in Social Security plans and private retirement plans as they choose.
The PRA system, however, raises several concerns:
- Would the government be permitted to manipulate the stock market or make politically motivated investment decisions with PRA funds?
- Would inexperienced investors make poor investment choices and be left to suffer the consequences?
- Would a precipitous stock market decline cause workers to lose their retirement funds?
According to the CSSS, the answer to all these questions is "no." Under the current system, retirees receive only a one to two percent return on government bond investments. Even under the worst stock market conditions, an individual historically has been guaranteed a lifetime real return (based on 63 years) of 6.3 percent. The CSSS also promises that all retirees will be paid out a guaranteed minimal "safety net," regardless of stock market performance.
The debate on both sides continues, and will not likely be resolved until legislation is passed by Congress that would allow PRAs. One thing remains clear, however, some type of reform has to be enacted to protect a system that is predicted to evaporate in the coming years.
Benavie, Arthur. 2003. Social Security Under the Gun: What Every Informed Citizen Needs to Know About Pension Reform. New York: Palgrave Macmillan.
Friedman, Sheldon, and David C. Jacobs, eds. 2001. The Future of the Safety Net: Social Insurance and Employee Benefits. Champaign, Ill.: Industrial Relations Research Association.
President's Commission to Strengthen Social Security. 2001. Strengthening Social Security and Creating Personal Wealth for All Americans: Commission Report. Washington, D.C.: CSSS.
Survivors' Benefits Survivors' benefits are paid to family members when a worker dies. Survivors can receive benefits if the deceased worker was employed and contributed to Social Security long enough for someone his or her age to qualify for Social Security.
Both mothers and fathers earn protection for their families by working and contributing to Social Security. If a wage earner dies, his unmarried children are entitled to receive benefits. If the child of a wage earner becomes permanently disabled before age 22, he or she can continue to receive survivors' benefits at any age unless she becomes self-supporting or marries.
Survivors' benefits can also go to a surviving spouse when the worker dies. A surviving spouse who retires can begin collecting survivors' benefits as early as age 60. If a worker dies leaving a divorced spouse who was married to the worker for at least ten years, the ex-spouse
can receive survivors' benefits at age 60 if she retires. In addition to monthly checks, the worker's widow or widower, or if there is none, another eligible person, may receive a lump-sum payment of $255 on the worker's death.
Disability Benefits In the 1970s, the SSA became responsible for a new program, Supplemental Security Income (SSI). The original 1935 Social Security Act had included programs for needy aged and blind individuals, and in 1950 programs for needy disabled individuals were added. These three programs were known as the "adult categories" and were administered by state and local governments with partial federal funding. Over the years the state programs became more complex and inconsistent until as many as 1,350 administrative agencies were involved and payments varied more than 300 percent from state to state. In 1969 President richard m. nixon identified a need to reform these and related welfare programs. In 1972 Congress federalized the "adult categories" by creating the SSI program and assigned responsibility for it to the SSA.
A person who becomes unable to work and expects to be disabled for at least 12 months or who will probably die from the condition can receive SSI payments before reaching retirement age. Workers are eligible for disability benefits if they have worked enough years under Social Security prior to the onset of the disability. The amount of work credit needed depends on the worker's age at the time of the disability. That time can be as little as one and one-half years of work in the three years before the onset of the disability for a worker under 24 years of age, but it is never more than a total of ten years.
A waiting period of five months after the onset of the disability is imposed before SSI payments begin. A disabled worker who fails to apply for benefits when eligible can sometimes collect back payments. No more than 12 months of back payments may be collected, however. Even if workers recover from a disability that lasted more than 12 months, they can apply for back benefits within 14 months of recovery. If workers die after a long period of disability without having applied for SSI, their family may apply for disability benefits within three months of the date of the worker's death. The family members are also eligible for survivors' benefits.
A disability is any physical or mental condition that prevents the worker from doing substantial work. Examples of disabilities that meet the Social Security criteria include brain damage, heart disease, kidney failure, severe arthritis, and serious mental illness.
The SSA uses a sequential evaluation process to decide whether a person's disability is serious enough to justify the awarding of benefits. If the impairment is so severe that it significantly affects "basic work activity," the worker's medical data are compared with a set of guidelines known as the Listing of Impairments. A claimant found to suffer from a condition in this listing will receive benefits. If the condition is less severe, the SSA determines whether the impairment prevents the worker from doing his former work. If not, the application will be denied. If so, the SSA proceeds to the final step, determining whether the impairment prevents the applicant from doing other work available in the economy.
At this point, the SSA uses a series of medical-vocational guidelines that consider the applicant's residual functional capacity as well as his age, education, and experience. The guidelines look at three types of work: one type is for persons whose residual physical capacity enables them to perform only "sedentary" work on a sustained basis, another for those able to do "light" work, and a third for those able to do "medium" work.
If the SSA determines that an applicant can perform one of these types of work, benefits will be denied. A claimant may appeal this decision and ask for a hearing in which to present further evidence, including personal testimony. If the recommendation of the administrative law judge conducting the hearing is adverse, the claimant may appeal to the SSA Appeals Council. If the claimant loses his appeal, he may file a civil action in federal district court seeking review of the agency's adverse determination.
Persons who meet the OASDI disability eligibility requirements may receive three types of benefits: monthly cash payments, vocational rehabilitation, and medical insurance. Provided proper application has been made, cash payments begin with the sixth month of disability. The amount of the monthly payment depends upon the amount of earnings on which the worker has paid Social Security taxes and the number of his eligible dependents. The maximum for a family is usually roughly equal to the amount to which the disabled worker is entitled as an individual plus allowances for two dependents.
Vocational rehabilitation services are provided through a joint federal-state program. A person receiving cash payments for disability may continue to receive them for a limited time after beginning to work at or near the end of a program of vocational rehabilitation. Called the "trial work period," this period may last as long as nine months.
Medical services are available through the Medicare Program (a federally sponsored program of hospital and medical insurance). A recipient of OASDI disability benefits begins to participate in Medicare 25 months after the onset of disability.
In 1980 Congress made many changes in the disability program. Most of these changes focused on various work incentive provisions for both Social Security and SSI disability benefits. The SSA was directed to review current disability beneficiaries periodically to certify their continuing eligibility. This produced a massive workload for the SSA and one that was highly controversial, as persons with apparently legitimate disabilities were removed from SSI. By 1983 the reviews had been halted.
The Contract with America Advancement Act of 1996 (Pub. L. No. 104-121) changed the basic philosophy of the disability program. New applicants for Social Security or SSI disability benefits are no longer eligible for benefits if drug addiction or alcoholism is a material factor in their disability. Unless they can qualify on some other medical basis, they cannot receive disability benefits. Individuals in this category already receiving benefits had their benefits terminated as of January 1, 1997.
The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 (Pub. L. No. 104-193), which concerns welfare reform, terminated SSI eligibility for most noncitizens. Previously, lawfully admitted aliens could receive SSI if they met the other requirements. All existing noncitizen beneficiaries were to be removed from the rolls unless they met one of the exceptions in the law.
The Medicare Program provides basic healthcare benefits to recipients of Social Security and is funded through the Social Security Trust Fund. President harry s. truman first proposed a medical care program for the aged in the late 1940s, but it was not enacted until 1965, when Medicare was established as one of President Lyndon B. Johnson's great society programs (42 U.S.C.A. § 1395 et seq.).
The Medicare Program is administered by the Health Care Financing Administration (HCFA). The federal government enters into contracts with private insurance companies for the processing of Medicare claims. To qualify for Medicare payments for their services, healthcare providers must meet state and local licensing laws and standards set by the HCFA.
Medicare is divided into a hospital insurance program and a supplementary medical insurance program. The Medicare hospital insurance plan is funded through Social Security payroll taxes. It covers reasonable and medically necessary treatment in a hospital or skilled nursing home, meals, regular nursing care services, and the cost of necessary special care.
Medicare's supplementary medical insurance program is financed by a combination of monthly insurance premiums paid by people who sign up for coverage and money contributed by the federal government. The government contributes the major portion of the cost of the program, which is funded out of general tax revenues. Persons who enroll pay a small annual deductible fee for any medical costs incurred above that amount during the year and also a regular monthly premium. Once the deductible has been paid, Medicare pays 80 percent of all bills incurred for physicians' and surgeons' services, diagnostic and laboratory tests, and other services, but does not pay for routine physical checkups, drugs, and medicines, eyeglasses, hearing aids, dentures, and orthopedic shoes. Doctors are not required to accept Medicare patients, but almost all do.
Medicare's hospital insurance is financed by a payroll tax of 2.9 percent, divided equally between employers and employees. The money is placed in a trust fund and invested in U.S. Treasury securities. The fund accumulated a surplus during the 1980s and early 1990s. It was projected that the fund would run out of money by the early 2000s as outlays arose more rapidly than future payroll tax revenues, but this proved not to be the case.
The Future of Social Security
From its modest beginnings, Social Security has grown to become an essential facet of modern life. In 1940 slightly more than 222,000 people received monthly Social Security benefits. In 2002, 39.2 million people received Old Age and Survivors Insurance, 7.2 million received disability insurance, and 41.1 million were covered by Medicare. One in seven individuals received a Social Security benefit, and more than 90 percent of all workers were covered by Social Security. As of 2003, the SSI program had nearly doubled in size since its inception in 1974.
By the 1980s the Social Security Program faced a serious long-term financing crisis. President ronald reagan appointed a blue-ribbon panel, known as the Greenspan Commission, to study the issues and recommend legislative changes. The final bill, signed into law in 1983 (Pub. L. 98-21, 97 Stat. 65), made numerous changes in the Social Security and Medicare Programs; these changes included taxing Social Security benefits, extending Social Security coverage to federal employees, and increasing the retirement age in the twenty-first century.
By the 1990s, however, concerns were again raised about the long-term financial viability of Social Security and Medicare. Various ideas and plans to ensure the financial stability of these programs were put forward. The budget committees in both the House of Representatives and the Senate established task forces to investigate proposals for Social Security reform. Other task forces, such as one established by the National Conference of State Legislatures, investigated the impact of Social Security reform on interests at the state and local levels. By the end of the 1990s, the federal government had achieved a budget surplus, and President bill clinton and some members of Congress advocated use of the surplus to save Social Security. However, no political consensus as to what changes should be made had emerged by the end of the 1990s.
The issue of Social Security was at the center of a major debate between george w. bush and al gore during the 2000 presidential election debates. Bush advocated then, as he did after assuming the presidency, that employees who pay into the Social Security system should be allowed to pay the funds into personal retirement accounts. Under this proposal, employees would have the option of converting these funds into other investments, such as stock. However, during the first three years of his presidency, Bush did not successfully establish this initiative.
As of December 2002, the annual cost of Social Security represented 4.4 percent of the gross domestic product. The Social Security Administration predicted that the OASDI tax income would fall short of outlays by 2018, and the OASDI trust fund was predicted to be exhausted by 2042, though some commentators refuted this finding. The total combined OASDI assets in 2002 amounted to $1.378 trillion.
Gramlich, Edward M. 1998. Is It Time to Reform Social Security? Ann Arbor: Univ. of Michigan Press.
Mitchell, Daniel J. B. 2000. Pensions, Politics, and the Elderly: Historic Social Movements and Their Lessons for Our Aging Society. Armonk, N.Y.: M.E. Sharpe.
Sass, Steven A. 1997. The Promise of Private Pensions: The First Hundred Years. Cambridge, Mass: Harvard Univ. Press.
Schieber, Sylvester J. 1999. The Real Deal: The History and Future of Social Security. New Haven, Conn.: Yale Univ. Press.
Social Security Administration. Available online at <www.ssa.gov> (accessed November 21, 2003).
Social Security and Medicare Board of Trustees. "Status of the Social Security and Medicare Programs." Available online at <www.ssa.gov/OACT/TRSUM/trsummary.html> (accessed August 26, 2003).
so·cial se·cu·ri·ty • n. any government system that provides monetary assistance to people with an inadequate or no income. ∎ (Social Security) (in the U.S.) a federal insurance program that provides benefits to retired persons, the unemployed, and the disabled.