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A New Social Security for a New Economy

by Thomas F. Siems

This article appeared on cato.org on February 1, 2001.

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President Bush vows to reform Social Security by letting workers invest part of their payroll taxes in personal retirement accounts like IRAs or 401(k)s. But does the program really need reform? And what are the costs and benefits of changing the nation's public pension system?

Social Security seemed to start out well. It renewed workers' confidence during the Great Depression that at the end of their working days a retirement income would be there for them. And for many early retirees, the program was a windfall: They collected benefits for many years, though they had paid into the system for only a few years. These early retirees did far better from the program than they could have in private markets, and the program was hugely popular as a result. Today, Social Security isn't nearly as good a bargain, and many younger workers already want to opt out of it to invest on their own.

Social Security is a bad deal today because the program's rate of return is falling. In a pay-as-you-go system like Social Security, where taxes paid by today's workers are immediately used to pay today's benefits, the rate of return from year to year depends upon the increase in the number of workers and in how much they pay into the system. In other words, Social Security's return is the annual rate of growth of the tax base: labor force growth plus wage growth. It is these growth rates that have turned against the system.

Social Security's pay-as-you-go financing was shaped by important social, economic and demographic changes that rendered traditional systems of economic security unworkable. People had always had large families. But for most of history, high infant mortality rates kept the population from growing quickly. Improved diet and health care in the 20th century meant that more of those children would live to adulthood. And the baby boom following World War II increased birth rates even further. More workers were entering the workforce and paying taxes into the Social Security system. This meant more money for retirees, and benefit levels were increased many times during the program's early decades.

Moreover, high economic growth in the 1950s and 1960s?averaging 4.3 percent annually from 1950-1969?meant that wages and payroll tax receipts rose further. The 1950s and 1960s produced a pay-as-you-go return of over 4 percent annually after inflation?better than the returns on most fixed-income investments like corporate or government bonds. For a pay-as-you-go system, these were heady times.

But the future looks different. Since 1973, wage growth has slowed. The Social Security Trustees' predict 1 percent growth, which is higher than over the past 25 years, but even if the "New Economy" further raises productivity and wages, labor shortages will cut payroll tax revenue. The retirement of the baby boomers and low birth rates mean the labor force will barely grow. Combined, the total return from Social Security will average just 1.4 percent per year. Of course, some workers will do better than others by virtue of their longevity, income or marital status, but that's the average. And that average is lower than what the safest investments would yield.

So, as was the case in the 1930s, the traditional system of retirement security has become unworkable. But this time the traditional system is Social Security. The solution is to transform Social Security from an unfunded pay-as-you-go system to a funded program of personal retirement accounts. Once done, workers would not receive the system's 1.4 percent estimated future annual return but would receive the full return on the investments their accounts hold.

Historically, an account split 50-50 between stocks and corporate bonds would have received an annual return of about 5.5 percent after inflation. Even inflation-indexed Treasury bonds—the world's safest investment—pay over 3 percent every year. These higher rates of return mean that either benefits for retirees could increase or taxes on workers could fall, or both. In either case, Americans would be the winners.

That's why today's budget surpluses are such an opportunity. They provide the means to transition from a low-returning pay-as-you-go system to a funded system with higher returns. Using these surpluses, we could begin to finance the transition to personal accounts without raising taxes or cutting benefits. Over the long run, workers, retirees and the economy would be much better off.