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Social Security: The Economic Issues

By David Wyss President Bush has proposed a major reform of the Social Security system that would mark its first overhaul since the Greenspan Commission reforms under President Reagan. The system continues to suffer from resources insufficient to support the promises made to retiring baby boomers. Neither tax revenues nor the trust fund can support the growing population of retirees.

The Social Security problem is, however, small enough to fix. The aggregate deficit, although huge ($3.7 trillion), is spread out over 75 years. Keeping reserves up to full funding at the end of that period adds $300 billion to the gap (total: $4 trillion). But a growing economy means the shortfall amounts to only 0.7% of gross domestic product over the entire period. There are many ways to overcome this shortfall, but the accounting deficit represents only part of the problem.

MIXED BAG. Most other industrial countries' systems have fallen into even worse shape than America's. Europe and Japan have slower growing or declining populations, largely due to the lack of immigration, which will result in even higher ratios of elderly-to-working-age populations. Europe's earlier retirement ages and generally richer public retirement programs compound the problem. Only Britain, which partially privatized its system in the early 1980s under Prime Minister Margaret Thatcher, has a manageable load.

The Social Security program has always consisted of a mix of insurance, retirement savings, and transfer programs. The political consensus as to the relative importance of these goals has varied over time. At the beginning, of course, the first generation to receive Social Security had put nothing into the kitty. But few people were collecting. The government set the retirement age at 65, in 1937, when the average American's life expectancy was only 63. Most people never collected Social Security, and the plan was designed as insurance against becoming disabled or growing too old to work.

The program began during the Depression because the elderly were literally starving. Social Security allowed them to live in more dignified circumstances although, in absolute terms and as a percentage of average earnings, benefits were much lower than they are today. The program placed only a small burden on the working population. The low life expectancy meant 40 workers for each retiree. But as life expectancy rose, that ratio dropped to 16 to 1 in 1950 and 3.3 to 1 today. By 2050, it will likely reach 2 to 1.

"LEGAL FICTION." Although the government originally set up Social Security on a pay-as-you-go basis, Americans began to think of it as a pension program, with a trust fund behind it. The Greenspan Commission enshrined this view and sought to make Social Security solvent by increasing the trust fund enough to pay the benefits promised. However, life expectancy caught up with the trust fund, and not all potential retirees are working as late into retirement as Alan Greenspan is.

But a more serious issue remains: For the most part, the trust fund represents a legal fiction. Its only asset consists of a giant IOU signed by Treasury Secretary John W. Snow, because the fund holds only Treasury securities by law. And, on average, for the life of the fund, the federal government has been running deficits larger than the additions to the trust fund. In fact -- if not in law -- benefits will have to come from current taxpayers, not out of this semi-fictional trust fund.

Paying these benefits will require dramatic increases in tax rates or enormous borrowing. If the U.S. does nothing about benefits or tax rates, government debt will rise to 239% -- from its current 65% -- of GDP by 2050.

The President has proposed addressing the problem by privatizing Social Security accounts, allowing individuals to put part of their contribution into a private account. Benefits would be reduced proportionately, in such a way that the system would not have further accrued net liabilities. In spirit, the system resembles the British program put in place more than 20 years ago, as well as those in Chile and other countries. Britain, however, was the only major country to convert to such a system, while the others created public pension systems de novo.

CHILEAN EXAMPLE. Britain enjoyed several advantages in creating its system. Most important, its baby boomers had 30 years before their retirement to build up these private accounts. The U.S. has no such luxury, with retirement fast approaching for its baby boomers.

Even with its time advantage, however, Britain's system has its problems. The baby boom generation is approaching retirement with too little saved, and many worry that retirement will be impossible. On the bright side, Britain has a cradle-to-grave health coverage (run at half the per-capita cost of the U.S. system) and a public housing system that guarantees some form of shelter.

The average British citizen will thus need less in personal retirement funds -- but nonetheless those funds remain in questionable supply for many who are now approaching retirement. Already, one-third of British elderly receive supplementary welfare benefits.

Many of the newer systems, such as Chile's, began because existing systems were bankrupt or nonexistent. Some observers cite the Chilean system as an example of successful privatization, but it covers only 40% of the country's population.

ADDRESSING THE SHORTFALL. The Bush Administration has said that its proposed changes will apply to no one currently past the age of 55, and will not affect accrued benefits for those under that age. This leaves an accrued deficit of about half the total, with less funding to cover the benefits. The proposal to borrow the amount merely postpones the problem. The debt service on the loan will require future revenue.

Several ways have been discussed to address this shortfall. The Administration has not made a proposal but seems amenable to doing something about it. The most popular solution: raising the $90,000 limit on Social Security taxes, or shifting to consumer-price-index indexation of benefits. If no one funds the shortfall, the proposed solution could exacerbate, rather than alleviate, the problem.

In principle, the Administration proposes to cut benefits but partially offset the reduction by allowing individuals to invest their own funds. The proposal eliminates further increases in the accrued shortfall but fails to close the gap already incurred. Presumably, someone will come up with a proposal to address that problem well. (See more detail of the Administration's plan.)

PERSONAL SAVINGS. The private accounts will affect financial markets, but the extent depends on how households invest their funds. As a first approximation, the impact is small. Government debt will rise by $700 billion, while the private accounts increase to offset the amount over the next 10 years. This has no first-order impact on the national savings rate, and thus none on investment or returns. In fact, if all the private accounts are invested in the government debt, there's clearly no impact at all.

If, however, investors do what the government expects -- invest much of the accounts in equities -- that will have a significant effect. Since the national savings rate still doesn't change, the overall rate of return in the economy won't vary either. However, demand will increase for equities and Treasury debt. As a result, the price of bonds will drop, and that of stocks will rise. (Conversely, bond yields rise, and the expected return on equities declines.)

The impact turns murkier with the prospect of possible reaction in the household savings rate. If individuals consider these accounts their own savings, while they lacked faith in the return on Social Security, they may reduce the savings accumulated elsewhere as they fund their individual accounts (or, alternatively, increase their borrowing against their new assets).

In this event, the national savings rate will decline, reducing investment and lowering growth but slightly raising the average return on capital. The size of the impact depends on many factors, including whether foreign investors grow nervous about the additional government debt. I think it's likely to be small, but I may be placing too much faith in the prospect of households behaving rationally.

"DON'T WORRY, BE HAPPY"? Alternative proposals have been made, but a strong dissenting voice advocates ignoring the problem. Alternative economic projections can erase the shortfall by assuming that revenues will increase enough or benefits rise slowly enough to keep the trust fund solvent. This "Don't worry, be happy" school argues that America should acquaint itself more closely with the problem before addressing it.

But the later it gets, the bigger the problem grows. Several solutions exist, but they seem impossible politically. If the country waits until the Social Security fund goes broke, there will be no solution other than a drastic increase in tax rates or a drastic cut in benefits. Is it right to leave that problem sitting there for the next generation?

Another problem: The assumptions needed to close the gap look unrealistic. Stronger productivity growth offers little help. It would increase future revenues but, because future benefits are tied to average wages, it would also increase future payments.

IMMIGRANTS TO THE RESCUE? The assumptions that actually improve the situation are less pleasant. One is that people will work later in life, thereby both increasing revenues and reducing benefits. As the baby boomers retire, the resulting labor shortage could persuade more people to continue working, at least part-time, into retirement. But the retirement age would have to rise to near 70 to provide significant help. Raising the legal retirement age would help more, because it reduces benefits for early retirees.

Higher immigration rates can postpone the problem, because most immigrants come in as young adults. Their increase would keep the ratio of workers to retirees higher than the 2 to 1 that is now expected, but the entrance of so many presumably less-skilled, less-educated workers would create problems for other government spending -- especially education.

Another argument: Because the Social Security problem pales in comparison to the health-care issue, the government should ignore it until it finds a solution to the bigger problem. I've never quite understood this position. It seems to me that if a problem exists, it should be solved, even if a bigger one lurks around the corner.

CONSPIRACY THEORIST. A more realistic argument states that the Social Security system should be viewed as a pay-as-you-go system rather than a funded pension plan. After all, the first generation to receive benefits put nothing into the program. From an economic viewpoint, the resources to support the elderly have to come out of current production in any event, and to pretend otherwise (especially when the trust fund consists solely of government debt) is just fooling ourselves.

This fundamental argument can be made in either direction. The conspiracy theorist alleges that the argument for a pay-in-advance system is just an excuse for making the tax system more regressive. A tax is a tax, and more money comes into the government from the regressive Social Security and Medicare taxes than from the progressive income tax. Since the Social Security surplus is used just to fund general government spending (with only an accounting fiction of a trust fund), the total tax system is in fact regressive, not progressive.

The relatively manageable size of the Social Security shortfall makes many solutions possible. The Democrats would prefer to concentrate on raising revenues rather than lowering benefits or transforming the program into a semiprivate system. Republicans would prefer to cut benefits and leave taxes alone. Proposals from the AARP and the Democratic members of Congress have focused on eliminating or raising the income level on Social Security contributions from its current level of $90,000. A 2-percentage-point increase would essentially close the shortfall. Eliminating the income cap would get rid of the already accrued shortfall but with only 10% of Americans earning more than $90,000, would not totally fund the current program.

DELAYING RETIREMENT. Benefit cuts involve either reducing the indexation of benefits or raising the retirement age. When phased in, the 1983 Greenspan Commission reforms gradually increased retirement age to 67. Increasing it further would reduce costs and possibly also increase revenues, since Americans might continue to work into later life.

The extent of the reduction depends on what the response would be. If workers actually retire later, the change helps the deficit more than it would if they still retire at the same age but take reduced benefits. (Of course, retirement is often not completely voluntary. In a 2001 Labor Dept. survey, 60% of early retirees said their decision was at least in part forced.)

I think the most likely result would be a pattern of partial retirement, with workers shifting to fewer hours as they near 65, but delaying taking Social Security. Obviously, not all workers may be economically or physically able to delay retirement but, with health improving, many would. Still, the extent to which this would reduce the Social Security deficit is hard to estimate.

REPLACEMENT RATIO. Some observers have proposed reducing the indexation to help close the accrued deficit. Under current law, Social Security benefits index to average wages. Indexing them instead to consumer prices has been suggested. How much this would help depends on assumptions regarding productivity growth, but if productivity averages the 2.5% growth of the past 50 years, it could close most of the current gap.

It should be noted, however, that if productivity growth reverts to the 1.5% average of the 1970s and 1980s, this change would add up to much less of a benefit. Congressional Republicans seem to be pressing for a combination of CPI indexation and privatization as a solution to the problem.

This change would reduce the replacement ratio for Social Security recipients in the future. Currently, Social Security replaces 42% of the average workers earnings, in line with the 40% assumed by the Greenspan Commission in 1983. A shift to CPI indexation could cut this ratio to 29% by the time it fully phases in, depending on productivity assumptions.

Representative William Thomas of California, chairman of the House Ways & Means Committee, put forth one of the most interesting proposals. He has advocated shifting to a national sales tax as a substitute for payroll taxes. The proposal has several major advantages: It would provide Medicare with an adequate funding source. It would eliminate the discouragement of employment inherent in a payroll tax. Also important, it would bring the U.S. tax code closer to that of other major countries, reducing the relative discouragement of exports and encouragement of imports.

The following table gives a rough estimate of the options to closing the estimated $4 trillion Social Security shortfall:

Alternative Policies to Close the Gap


75-year Impact (Trillion $)

Partial privatization with proportionate reduction in benefits


Raise contribution cap to $140,000


Use CPI instead of wage indexation


Raise retirement age to 70


Raise payroll tax one percentage point


In a recent survey, the National Association for Business Economics (NABE) found most support for raising the retirement age and eliminating the cap on contributions. Support for privatization was lukewarm.

RAMPANT SKEPTICISM. The Administration and Congress are not yet close to agreement. The President has stated that he expects action next year, not this year. Even that may be optimistic given the lack of consensus. There's no sense of urgency yet in the national debate, and emotions run high against change.

However, something must be done, and the longer change is postponed, the more difficult and disruptive it will be. Social Security would be better off now if changes came 20 years ago, at the time the Greenspan Commission put forward its reforms and Britain changed its program. But America can't go back. Now is not as good as earlier, but it's much better than later.

Nevertheless, skepticism runs rampant. In a recent survey, the NABE found only a 36% probability that Congress will pass any major Social Security reform. The public is losing its enthusiasm for the Administration's reforms as it realizes the new accounts aren't free. Congress seems likely to delay action until the crisis is much nearer.

Editor's Note: Related video clips can be found under under "Hot Topics" on S&P's Web site Wyss is chief economist for Standard & Poor's

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