Will the President’s Proposal Solve Social Security’s Crisis?

Studies | Social Security

No. 280
Wednesday, November 16, 2005
by Andrew J. Rettenmaier and Thomas R. Saving


Introduction

One fifth of America’s senior citizens depend on Social Security as their sole income and two-thirds of our elderly count their benefits as half or more of their retirement income — which is why discussions of changing the program are often met with much resistance and concern. However, as currently structured, the program cannot endure and must change.

By 2017, the system’s revenues will fall short of its costs. In that year and every year thereafter, general federal revenues must be tapped to pay benefits. Some assure us we need not worry until 2041, given that the Social Security Trust Fund’s actuarial balances will be positive until that date. However, the payment of benefits through redemption of Trust Fund bonds will require mounting transfers from the rest of the budget and thus implies higher taxes, reduced spending on other programs or increased government borrowing.

Ultimately anyone who seriously hopes to address Social Security’s finances must offer a plan that balances the system’s cost and revenues in the long run. Such a balancing precludes a repeat of the 1983 reforms — which were expected to solve the problem for only 75 years. Those reforms relied on the notion that a Trust Fund could provide resources for the future, that the government could and would save for the future, and that after the 75-year horizon, the system would be reformed so that the large deficits forecast for the end of the horizon could be met.

If the post-1983 surpluses had been invested in financial instruments purchased in the marketplace, the Trust Fund would represent real savings. But given our collective aversion to the government being a significant stakeholder in U.S. corporations, it is not feasible for the Trust Fund to be invested in the private sector. As a result, the surpluses credited to the Social Security Trust Fund have been spent rather than saved. The Trust Fund’s holdings consist of special government bonds which one government agency (the Treasury) has issued to another (the Trust Fund), and do not represent real savings. And as several recent studies have concluded, the Trust Fund did not add to national savings and may have encouraged spending more than the surplus amounts. 1

This leaves us with two alternative paths to reform, both of which recognize the government’s inability to save and both of which balance the system’s costs and revenues in the long run. The similarities end there.

Option One: Continue Pay-As-You-Go. The first path balances costs and revenues by reducing benefits and raising taxes so that benefit payments in each year are close to the tax revenues in each year. Peter Diamond and Peter Orszag have developed such a proposal that imposes tax increases and benefit cuts on the same higher income workers.2

Option Two: Prefund Future Benefits. The second path relies on prepaying some or all of Social Security’s future benefits through personal retirement accounts (PRAs). President Bush’s approach falls into this category. The president would 1) reduce the growth in initial benefit payments by changing the benefit indexing formula from full wage growth indexation to progressive price indexation, and 2) prefund a portion of future benefits by establishing PRAs for young workers. In many ways, the President’s proposal represents a compromise between those who favor the current arrangement and those who favor personal accounts. The proposal can ultimately produce a solvent system that gives workers ownership of some of their Social Security benefit.

In a previous policy report, we offered a fully prepaid Social Security reform proposal that replicated, on average, the current benefit formula for lower and higher income workers.3 As we demonstrated, replicating the current redistributive benefit structure requires either higher contribution rates to PRAs for lower income workers or progressive contributions.

In this paper we offer a variant of progressive price indexation combined with PRAs similar in size to those suggested by President Bush. In contrast to our previous proposal, which identified the additional contributions that would be necessary to fully prepay benefits, this analysis examines a partially prepaid system combined with a reformed defined benefit. Also in contrast to our previous proposal, this analysis, following the president’s proposal, relies on additional borrowing rather than higher taxes to finance contributions to the PRAs.


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