Uncommon Sense #21:
(rev.) by Richard B. Du Boff, Professor Emeritus of Economics, Bryn Mawr College
By any standard, Social Security is the most successful social program ever enacted in the United States, guaranteeing a measure of basic security for nearly all workers and their families. For nearly two-thirds of the elderly, Social Security provides at least half their total income; for 22 percent of them, it is the only source of income. Without it, the poverty rate for the elderly would jump from 10 to 48 percent. Social Security is not just for retirees: it also provides monthly benefits for disabled workers and their dependents, and for the dependents of deceased workers. Together, these two groups comprise 31 percent of all Social Security recipients.
Since its enactment in 1935, Social Security has also been America’s most popular social program, and surveys show continued support. So why do more than half of young people think that Social Security will not be there when they retire? And why do so many people believe that the current Social Security system will be “bankrupt” when the baby boomers retire?
Despite its record, Social Security has always had opponents, who decry “big government” programs and have now created a sense of crisis to try to destroy a successful one. Much of the fear has been stirred up by a stream of scary articles and editorials in the major media, as well as by loud alarms from politicians, warning the younger generation that before they retire Social Security will already be hurtling toward insolvency.
The assumptions of impending Social Security “crisis” purport to be based on an economic reality–the aging of the population as baby boomers retire and as all retirees live longer. A falling share of the population who are still working will have to support growing numbers of elderly, whose retirement benefits could exhaust the Social Security Trust Fund and leave nothing for generations that follow. The conclusion appears unavoidable: without huge increases in tax rates, there will be a ballooning deficit in the fund from which Social Security payments are made. The only solution, we are told, is to allow workers to channel their payroll taxes into their own investment accounts, so that they can benefit from the much higher returns that stocks and bonds will bring them over the long run.
A serious examination of these assumptions is in order: Will there be too many elderly for the working-age population to support? Can we afford the retirement bill? Is privatizing Social Security the answer?
Too Many Elderly for the Working-age Population to Support?
The economic burden of supporting retirees is often estimated by what is called the “dependency ratio”–the number of elderly compared to the number of people of working age (20 to 64 years). This ratio is projected to rise from 20.3 seniors per 100 working-age people in 2005 to 36.8 seniors in 2035, as Americans aged 65 and over increase from 37 million to around 75 million–and from 12 to 20 percent of the population. Thus, as the post-World War II baby boom generation reaches retirement age starting in 2012, it must be supported by the relatively smaller cohort of workers born during the low birth-rate years of the past three to four decades.
The problem here is that the working population supports all those who do not work–children, including students, as well as the elderly. This “total dependency ratio” changes the picture radically: the ratio of all dependents to workers is projected to rise from 66.7 per 100 workers in 2005 to 80.8 by 2035 and 85.9 in 2080. Not only does this represent a much lower rate of dependency growth than when only the elderly are included; it also reveals that total dependency at its estimated future peak will still be well below what it was from 1960 to 1975, when it averaged 89.4 percent of those working and peaked at 94.7 percent in 1965. No demographic projection for the next 75 years puts the ratio anywhere near as high as it was in the 1960s; only “a mortality revolution at the oldest ages” could possibly do that, observes the eminent demographer Richard Easterlin.
Total dependency ratios are anything but irrelevant. In the United States, the costs of educating the baby boomers caused large, probably unprecedented, increases in spending on education following the Second World War. At that time, our economic productivity was far less than today’s. In real (price-corrected) terms, gross domestic product (GDP) per capita in 1960 was 36 percent of what it was in 2005, and much less than what it will be in the years to come. This means that one worker today can produce far more than the same worker did four decades ago, and less than what his or her successor will be able to produce decades from now. It seems safe to say that if we could afford to pay for the education of the baby boomers, we can afford to pay for their retirement.
As a fraction of GDP, spending by state and local governments on education grew from 1.5 percent in 1946 to 5.6 percent in 1975–which understates the actual increase in educational expenditures because it excludes outlays by households on private education (independent and parochial schools and private colleges and universities). This increase of 4.1 percentage points of the GDP, in 29 years, was nearly twice as large as the projected increase for Social Security over the next 75 years (4.3 to 6.4 percent of GDP). Now education spending is on the rise again, as children of the baby boomers and immigrants pack America’s schools. In 1997 enrollment at secondary school level surpassed its 1971 baby-boom peak, reached a record 53 million students by 2000, and, unlike the fall in school enrollment in the 1970s when the baby boom ended, is expected to grow without letup through the rest of the 21st century. Already public school systems face spiraling costs because of teacher shortages and aging, inadequate school buildings and equipment. Why are the doomsday prophets of Social Security silent on this matter?
Can We Afford the Retirement Bill?
Ultimately, our ability to support the dependent population hinges on two issues: Will our economy be able to produce the goods and services those people require? And will the government be able to finance its pension and other commitments? When the Social Security Act was passed in 1935, Congress specified that it was to be financed by a special payroll tax (now called FICA) on workers and their employers. This was done to muster political support; it was not an economic necessity. President Franklin Roosevelt favored such a payroll tax because he felt it would assure Americans that they had “earned” their benefits and had a right to them, and “with those taxes in there, no damn politician can ever scrap my Social Security program.”
The economic fact is that no matter how pensions are financed, the goods and services to be consumed by retirees cannot be stored up in advance but must be produced at the time: the bread eaten in the future will be baked then, and the doctors and nurses who provide medical care must be available then. These goods and services will come from the nation’s economic output, not from the money in the Social Security Trust Fund. If our economy fails to grow, future consumption by retirees will cut more deeply into the goods and services available to the working population, whether that population is taxed to pay the retirement benefits or those benefits are paid from some accumulated trust fund, public or private.
Social Security is simply another claim on society’s resources and production. Its future viability depends on how large the labor force will be, what fraction is employed, and how high the productivity of its workers will be–in other words, on how fast the output of goods and services grows in future decades.
The “Crisis” Projections: How Reliable?
To estimate the future condition of the Social Security Trust Fund over periods ranging up to 75 years, as they are required to do, the Social Security Trustees must make assumptions about the growth of the economy (GDP), labor productivity, wage income, unemployment, fertility, net immigration, mortality, marriage, divorce, disability incidence, and retirement patterns. It can readily be seen how each of these variables affects either the number of people working and the amount of FICA taxes they are paying, or the number of retirees and disabled and the amount of benefits they are receiving, or both (wage income and unemployment, for example, determine FICA revenues flowing into the Trust Fund and also the credits earned by current workers toward their future retirement benefits.) Because of the uncertainties associated with all these variables, the Trustees offer three “alternative” projections, based on three sets of economic and demographic assumptions, to show the range of possible outcomes–the “low-cost” or optimistic projection, the “high-cost” projection, and the “intermediate” alternative that the Trustees call their “best estimate of the future.”
In recent years the Trustees’ “best estimate” or intermediate alternative has been based on pessimistic assumptions about the most important variable for the future of Social Security–the rate of economic growth, which is the major determinant of employment and unemployment, and taxable wage income. The low-cost or “optimistic” alternative is only slightly less pessimistic. Both assume that in years to come real GDP will grow much more slowly than it has over the past century or more, when it has averaged around 3.2 percent per year. In the intermediate alternative, growth rates over the next decade are projected to average 2.5 percent per year, and only 1.8 percent per year from 2016 to 2080. If the economy grows as much as 2.6 percent a year over the next 30 to 75 years, as the Trustees’ “optimistic” alternative assumes, the Social Security deficit will disappear. Yet even the relatively sluggish economy of 1973-1996 produced an annual growth rate of 2.8 percent. Just eight years of faster growth and lower unemployment from 1997 through 2004 increased FICA tax revenues enough, according to the intermediate alternative, to push back the date by which the Social Security Trust Funds are predicted to be exhausted, from 2029 to 2041. At that time it is estimated that annual payroll tax revenues will still be sufficient to cover 74 percent of benefits due under the current benefit structure, and from 2042 to 2080 an average of 70 percent of benefits due could be covered by payroll taxes.
If we nonetheless accept the Trustees’ intermediate alternative, how large are the deficits for Social Security, which are predicted to start in 2015? The Trustees measure them by calculating the immediate and permanent increase in the Social Security payroll tax needed to eliminate the deficits and establish “actuarial balance” for the Trust Fund over the next 75 years. As of 2005, the FICA tax of 12.4 percent would have to be raised to 14.32 percent–or by slightly less than 1 percentage point on both workers and employers, who each pay 6.2 percent on the first $90,000 of earned income (so that a worker’s FICA tax would be raised from 6.2 to 7.16 percent).
This tax increase hardly seems onerous for a rich nation whose taxes take the smallest share of GDP of any high-income country. Nor is it necessary to increase the tax for lower-wage workers. More than half of the actuarial gap could be closed by removing the income ceiling on the amount of earnings subject to the payroll tax ($90,000 in 2005, $94,200 in 2006) and imposing the tax on all incomes with no upper limit. This has much to recommend it, in view of the rising inequality of income in the United States since the 1970s that has lifted a greater share of wages above the taxable maximum. The point has not been lost on the Social Security Trustees: they have consistently reported since 1984 that the ratio of taxable earnings to total earnings in covered employment has been declining “due to the increasing proportion of total covered wages earned by very high wage earners.” An even better approach would be to restore more progressivity to the personal income tax and use it to help Social Security. The editors of Business Week, who have called the Trustees’ intermediate estimate of future GDP growth “a ridiculously low number,” also suggest that “using future general revenues to finance Social Security solves most of the ‘crisis'” (February 1, 1999).
Under the Trustees’ low-cost, or optimistic, alternative, Social Security will have increasing surpluses in the future, so no tax changes are needed. This holds true, it should be noted, even under the optimistic assumption that from 2005 to 2080 the economy will grow 2.6 percent per year, well below its long-term historical rate of 3.2 percent, and that population will grow at the annual rate of 0.7 percent–less than it did during the Depression years 1929 to 1941. If, as seems likely, population, and numbers of workers contributing to Social Security, grow faster than this scenario would have it, there could be even larger surpluses in the Trust Fund–one more reason to dismiss talk of a Social Security “crisis.”
Is Privatizing Social Security the Answer?
Those who recommend privatizing Social Security would redirect workers’ payroll taxes into personal retirement accounts to be invested in financial markets. For corporate stocks in particular, they claim, returns are historically higher than any eventual rate of return on the FICA taxes paid in by workers during their income-earning years. The fact, however, is that compared to Social Security, private investments expose their owners to higher administrative expenses and far less insurance coverage, along with fluctuations in financial markets and volatility in rates of return.
The annual costs of running Social Security amount to less than 1 percent of its benefit payments. The life insurance industry has costs that average 12 to 14 percent of benefits, an indication of what would lie in store for a privatized Social Security system entailing tens of millions of small accounts, placed with scores of competing financial institutions marketing diverse products and trying to maintain high profit margins. Furthermore, a government-run system is universal: it includes all workers rich and poor, well and unwell, and spreads risk across income classes and generations. Social Security covers major contingencies of life, is portable from one job to the next, and is financed by contributions that are not directly related to benefits. Because it is weighted in favor of workers with lower lifetime earnings, it keeps millions of elderly out of poverty. It is also an inflation-adjusted, lifetime benefit, guaranteeing that recipients will not outlive their savings.
The failures of the private insurance market are all the more striking when the full range of insurance provided by the Social Security system is taken into account–something that privatizers stubbornly refuse to acknowledge. Social Security provides not only retirement benefits, but also disability coverage and benefits to survivors of workers who die before retirement. For workers, the chances of becoming disabled or dying before age 65 are four in ten. The only disability insurance for three-quarters of all workers comes from Social Security. In a typical example, for a 27-year-old couple working at average wages, with two small children, disability protection is estimated to be equivalent to a $240,000 policy in the private sector. A comparable survivor policy is worth $355,000. Disabled workers and their dependents account for 17 percent of total Social Security benefits paid out, with the average monthly benefit (as of mid-2005) worth $959.
Another compelling reason to preserve Social Security as a government enterprise is the failure of the private pension system itself as one of the three “legs” of the retirement stool for Americans (with personal savings and Social Security). Only one-third of private-sector retirees receive monthly pensions, and fewer than one in three have ever received a cost-of-living increase. In growing numbers of pension plans for current workers, retirement incomes are not guaranteed in advance (“defined benefit”) but depend upon the investment skills of individuals and the performance of financial markets, as well as lifetime earnings (“defined contribution,” or 401[k]-type plans). The New York Federal Reserve Bank reported in 1998 that 35 percent of workers do not participate in any 401(k) plans, and that nearly half of all workers who had a 401(k) in a previous job took a lump sum distribution before retirement age; only 28 percent rolled their 401(k) over into another tax-qualified plan. Only ten percent of the total income of the elderly comes from private pensions; 21 percent comes from earnings by those who continue working, and 30 percent from government employee pensions and income from personal assets. Social Security provides 39 percent of all elderly income; the average monthly benefit (mid-2005) is $959, and for retirees with an aged spouse, $1,578.
Privatization advocates claim that over the past century the inflation-adjusted rate of return to stocks has averaged around 7 percent per year, and that for most future retirees the return on their FICA contributions may be less than half as much. But it is also an axiom of economics that higher returns are attached to investments with greater risks. Thus, the returns to Social Security should be lower because it is essentially a riskless security in a taxpayer’s portfolio. Two analysts (Olivia Mitchell of the Wharton School, University of Pennsylvania and Stephen Zeldes of Columbia University) have concluded that claims that individual accounts will produce higher returns on Social Security contributions are “inaccurate and misleading . . . .it is unlikely that a privatized system’s risk-adjusted rate of return, net of other new taxes [to compensate current Social Security participants for loss of promised benefits], would exceed that promised under the current Social Security systemâ€ (American Economic Review, May 1996).
And with respect to stocks, the risks for individual investors cannot be evaluated by looking at returns that average 7 percent over the â€œlong-runâ€–the past 100 years or more. Over the past century returns to stocks have not only followed long waves up and down, with bull markets peaking in 1901, 1929, 1966, and 2000 and in each instance giving way to decline and prolonged stagnation; returns have also varied widely from one year to the next, in many years doing better than the 7 percent average, but often worse. From 1926 through 2003 (78 years), investors fared better than the average slightly more than half the time (41 of those years) and matched the average in six of those years, but they made less than the average in seven years (9 percent of the time) or lost money in 24 years (31 percent of the time). Another historical analysis of stock returns, based on Standard and Poorâ€™s Security Price Index Record, shows that for 1872 through 2002 investors lost money 37 percent of the time (during 48 of 131 years).
In the face of volatility of this order, investors are subject to stock market swings that can erode, even wipe out, a lifetimeâ€™s worth of savings just when they are needed to live on: someone might buy stocks in years when prices are bullish and have to sell in later years when the market is down, sometimes way down. For most people, the bulk of saving for retirement is done in the last two decades of their working lives–if that long. Thus, someone who invests in stocks during a 15 to 20 year period, or less, then retires during two or three bad years stands a good chance of ending up with meager gains or losses. Between 1900 and 1998, there were 22 twenty-year periods during which annual returns to stocks came in at less than 2.5 percent–the return on U.S. government bonds over the same period. For example, someone who purchased a representative group of stocks in 1929 and held them for 20 years would have had annual returns averaging â€”0.2 percent by 1949; for someone holding stocks from 1965 to 1985, returns would have averaged 0.7 percent. Others lucky enough to be holding stocks when they peaked well above the long-term average could have had annual gains as great as 10 percent, which was true for nine twenty-year periods between 1900 and 1998. All these returns were calculated on the assumption that management fees averaged 1 percent per year; any higher fees would have lowered returns and made this historical record look less robust.
Even over earning-and-saving periods longer than 20 years the same risks are present. For the period 1871 to 1997, Brookings Institution economist Gary Burtless calculated returns for workers who began to work at age 22 and retired at 62. Each worker saved 6 percent of his wages annually, invested it in a “total stock market index” fund, and at retirement converted the balance into an annuity. Burtless found that the amounts that workers could expect at retirement differed dramatically–timing was nearly everything. A worker who retired in 1969 would have been able to convert his proceeds into an annuity providing 104 percent of his former annual earnings; a worker retiring just six years later would have replaced only 39 percent of his prior earnings.
Another insight into the risks of owning stocks over anything less than the long run–whatever that might turn out to be–comes from the period 1966 to 1981, which brought an unrelenting bear market and negative returns to most stockholders. The Dow Jones index reached 995 in February 1966, spent most of the next 15 years below that level, and never surpassed 1052 until November 1982, while the inflation rate was escalating dramatically during these years. The only reason stocks have moved back toward their 7 percent average return is nothing less than the subsequent bull market, the greatest in history. Wharton School Professor Jeremy Siegel, author of Stocks for the Long Run (third ed., 2002), notes that “the superior equity returns” of the 1980s and 1990s â€œhave barely compensated investors for the dreadful stock returns realized in the preceding 15 years, from 1966 through 1981, when the real rate of return was â€”0.4 percent. In fact, during the 15-year period that preceded the current bull market [that ended in 2000], stock returns were more below their historical average than they have been above their average during the 1982-1999 great bull market run.â€
Those who predict continued, higher long-term returns to stocks as a reason for privatization have another problem to grapple with. Can anyone believe that if future returns to Social Security are adversely affected by slower economic growth, returns to financial assets would not be? If the Social Security system runs higher deficits because of the slower economic growth that the Trustees’ intermediate alternative assumes, it is illusory to think that returns to stocks will fare any better. Stocks have produced real returns of 7 percent per year over the past century when the economy averaged 3.2 percent annual growth. If the intermediate-range projections for GDP growth hold true, the rate of return on capital will be less too. If the economy grows at a faster rate, the stock market will rise at a healthy pace–but Social Security will also have the funds it needs to keep solvent throughout the retirement of the baby boom generation.
Privatizers assure us that we are now a nation of savvy investors. But public opinion surveys consistently bring out what Securities and Exchange Commission Chairman Arthur Levitt Jr. in 1998 called a “knowledge gap.â€ More than half of all Americans do not know the difference between a stock and a bond and only 16 percent say they have a clear understanding of what an Individual Retirement Account is. A 2000 survey of households with incomes from $25,000 to $75,000–then covering 48 percent of all households–showed that only 20 percent felt confident about choosing appropriate investments, 25 percent felt knowledgeable about mutual funds, and 34 percent admitted they didn’t know anything about funds. Of those owning life insurance, 25 percent didn’t know whether they had term or cash-value insurance. A 2001 survey, taken in the midst of the longest stock market decline since the 1930s, found that only one person in five knew that there is no insurance for stock market losses.
The September 1998 collapse of the Long Term Capital Management hedge fund inflicted heavy losses on its investors, which included some of the savviest of all–Merrill Lynch, Bear Stearns, PaineWebber, Dresdner Bank AG, the Bank of Italy, Union Bank of Switzerland, St. John’s University (New York). On LTCM’s payroll were 25 PhDs, two of them Nobel Laureates for their pathbreaking work in financial economics (Myron Scholes and Robert Merton). Widespread surprise, and worry, followed the stock market slide of 2000-2002 as trillions of dollars of household wealth vanished, with serious impact on 401(k) retirement funds now tying millions of households to the fickle fortunes of Wall Street. By October 2002 the composite index for the NASDAQ, where the hot high-tech and dot.com stocks were traded, had dropped 78 percent from its all-time high in March 2000.
Americans might recall that Britain allowed workers to opt out of the public pension system and invest in private accounts in 1988, in an arrangement similar to the privatization scheme promoted in the United States. The new accounts proved costly to set up; some charged 25 percent of the account value in commissions and administrative fees. Even before the stock market crash of 2000, there were widespread complaints about bad financial advice, high fees, and outright deceptions–a public â€œmis-sellingâ€ scandal. By 2005 the financial services industry was forced to shell out $28 billion in restitution payments, the average public pension had fallen to $150 per week, and many Britons were calling for a return to system much like U.S. Social Security. In Chile a military dictatorship privatized the public pension system in 1981 by having people pay 10 percent of their salaries to investment accounts they controlled. From the start, fees and commissions absorbed 20 percent of contributions; on retirement another fee of 9 percent was charged to convert the account to an annuity. Twenty years on the system was doing so poorly that the government began asking some workers to delay their retirements. Even middle-class workers who contributed regularly were finding that their private accounts, hit with fees that had eaten away a third of their original investment, were failing to deliver as much in benefits as they would have received from the old system. Many Chileans are now trying to create institutions to deal with this â€œpension damageâ€ (New York Times, January 27, 2005).
Social Security’s “Bottom Line”
“Rate of return” calculations for Social Security and projections of possible “bankruptcy” inappropriately apply free market criteria to a nonmarket institution, in this case the most successful one in our history. Comparing returns on FICA contributions for one generation of Social Security beneficiaries against another, or calculating “unfunded liabilities” that the present generation will allegedly pass on to the next, is irrelevant, unless it is assumed that succeeding generations will live in an economy less productive, and poorer, than today’s–an unlikely prospect. Pooling resources so that everyone shares the major risks of life is the essence of social insurance, allowing people to make transfer payments to themselves at appropriate stages of the life cycle. Social Security is part of this public-sector process, which private enterprise cannot, nor should be expected to, carry out.
The way to preserve the health of Social Security is jobs for all at decent pay–the prime goal of national economic policy advocated by the National Jobs for All Coalition. As the late Robert Eisner put it, “to bolster Social Security, the best way is to increase economic growth rates and increase the wages that finance Social Security.”
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Dean Baker and M. Weisbrot, Social Security: the Phony Crisis (Chicago: University of Chicago Press, 1999)
Board of Trustees, Federal Old-Age and Survivors Insurance and Disability Trust Funds, The 2005 Annual Report
Peter Diamond and P. R. Orzag, Saving Social Security (Washington: Brookings Institution, 2005).
R. B. Du Boff, “The Welfare State, Pensions, Privatization: Social Security in the United States,” International Journal of Health Services, no. 1, 1997.
Robert Eisner, Social Security. More, Not Less (New York: The Century Foundation Press, 1998)
John Mueller, “The Stock Market Won’t Beat Social Security,” Challenge, March-April 1998.
Editors: June Zaccone, Economics (Emer.), Hofstra University and Helen Lachs Ginsburg, Economics (Emer.), Brooklyn College, City University of New York