Commentary

Merely tinkering will trap workers inside the box

Challenging problems require creative solutions — thinking outside the box, to use a well-worn term.

One problem we now face is Social Security’s troublesome financial future. A recent idea to meet this challenge, and one that has caused a fair amount of buzz, is progressive indexing.

Given the attention it has received, two questions are worth considering: Why has this idea caught the imaginations of so many, and does it fix Social Security’s problems? The answers may help us understand where reform is headed.

Social Security’s finances are problematic because they are based on an insurance model. Insurance works well when many people are subject to an event that has little chance of happening to any single individual.

An example is homeowners’ fire insurance. Many people buy fire insurance, yet few homes burn. Because the number of homes insured is many times the number of homes that burn, the annual insurance premium is low relative to the replacement cost of one’s house. Insurance companies are the medium through which individual uncertainty of loss is transferred to, and financed by, the group.

The insurance model does not work well when the entire group experiences the event. Think of fire insurance again. If it were certain that everybody’s house would burn down, say, when the owner reached age 65, then insurance companies would have to charge annual premiums the future value of which would be the cost of rebuilding all the houses. Those premiums would be a large multiple of the premium charged for the uncertain case.

Social Security is frequently heralded as social insurance. “Social” means that the government plays the role of the insurance company. When Social Security was enacted in 1935, life expectancy was 61 but benefits weren’t payable until age 65. Now benefits are payable at age 62 and life expectancy is 78. Uncertainty has flipped upside down; once born, reaching age 62 and needing retirement income is almost certain. There is very little risk to transfer to the group; therefore, premiums must be enough to accumulate to a sum that will finance retirement income.

Under those conditions, social insurance cannot provide benefits at a lower cost than saving and investing for retirement. However, it can and does provide them at a higher cost, for two reasons. With Social Security’s pay-as-you-go financing, benefits can increase by no more than taxable wages increase, which is much less than the return on invested savings. Second, the number of wage earners has been, is and will be shrinking relative to beneficiaries. Therefore, the per-capita payroll tax must continue to rise.

Social Security’s finances are caught in a time warp; in the age of the iPod, Social Security is a 78-rpm, wind-up phonograph. Unless protected by the state, it can neither compete nor survive.

Enter progressive indexing.

Social Security benefits are based on a multipart formula, one component of which updates past earnings by a procedure called wage indexing. An alternative is price indexing, which would lower benefits relative to wage indexing but is a difficult political sale.

Progressive indexing is a blend of the two, sort of a financial rheostat. Lower-income folks get the higher wage-indexed benefits; higher-income people get the lower price-indexed benefits. Those in the middle get a little of each. The progressiveness in the formula is the cause of the buzz. It offers the appearance of a compassionate way to cut benefits.

Yet progressive indexing remains a captive of the insurance model and allows Social Security’s pay-as-you-go financing to limp along a bit longer while at the same time its advocates can say they’re helping low-income workers. They aren’t. Low-income workers’ scheduled benefits under progressive indexing are a fraction of what they would be in a market-based system.

Thinking outside the box would give each worker the option to save and invest for retirement. This freedom would determine which system would prevail, a threat to so many who want to preserve the old system. If necessary to protect it, they’ll reduce benefits, raise the retirement age, increase the tax rate on higher-income workers, but above all they will not allow Americans the freedom to invest their own payroll taxes in a personal account, for they know what will happen; they’ll exercise it and the old system eventually will expire.

Social Security reform is not dead, but it’s getting close. Progressive indexing further shields pay-as-you-go financing from the realities that it faces. Political leaders should be encouraged to spend their efforts on the values of choice, freedom, personal-property rights, ownership and the accumulation of wealth for all Americans, irrespective of income.

Ironic, isn’t it, that in the “land of the free” such thinking is outside the box?

William G. Shipman is chairman of CarriageOaks Partners LLC and co-chairman of the Cato Institute Project on Social Security Choice.