Commentary

The New Social Security System: Less Costly than the Old

By William G. Shipman
This article originally appeared in Investor’s Business Daily, October 19, 2004.

During his acceptance speech at the Republican National Convention, President Bush reinforced his commitment to modernize Social Security when he said, “We must strengthen Social Security by allowing younger workers to save some of their taxes in a personal account — a nest egg you can call your own, and government can never take away.” Such legislation would be the most fundamental, and needed, reform since President Roosevelt introduced Social Security in 1935 as part of his New Deal. This reform means moving from a tax-based system to one of saving and investing in the strength of our economy. The nest egg the president referred to would be one’s personal property, a marked improvement over the existing system wherein one has no personal property rights. This would allow retirees to bequeath their accumulated assets to their loved ones should they choose. And for the first time, low-income workers would have the opportunity to accumulate wealth — not magically become multimillionaires mind you — but build a nest egg they would own.

The problem with all of this, many argue, is that it would be too expensive. Their point is that under present law projected payroll taxes will not be enough to pay all promised benefits. Redirecting some of that tax to personal accounts would, therefore, incur a further burden. Some people would have to pay twice, once for their own personal account and then for those already retired receiving Social Security benefits. This double cost may be in the trillions of dollars and our nation, at least at this stage, just can’t afford it.

This argument appears persuasive, and for a couple of reasons. First, there is some truth to it. But more importantly, it is not complete. It does not consider the costs of the existing system should it not be reformed. Recognizing these costs sheds an entirely different light on the benefits of reform.

To compare the two systems’ costs, let’s first assume that Social Security is not reformed. According to Social Security’s Trustees, this would lead to payroll taxes being insufficient to pay all benefits by about 2018. Let’s further assume that the government at that time borrows the difference so that all benefits are honored. Such borrowing would continue through 2078 and then well beyond because the demographic trends which cause the imbalance are well established and not subject to meaningful change. Of course, the government would have to borrow even more than the shortfall in taxes in order to pay principal and interest when due on the funds previously borrowed. The trustees estimate that total borrowing only to 2078 would be about $4.5 trillion in present value terms. Another way of presenting this is each American family would have to give the government about $43,000 today plus pay payroll taxes stipulated in present law in order to afford promised benefits.

Now let’s assume we reform the system as broadly outlined by President Bush. What happens? First of all, not everybody is going to jump on the president’s idea and for good reason. A 64-year-old wouldn’t want to budge from the current Social Security program because he wouldn’t have sufficient working time left to save and invest enough to replace what he would otherwise receive from the government program. Conversely, a 21-year-old would opt for the personal account because he does have time to accumulate enough wealth on which to retire with benefits that most likely would be far greater than those from Social Security.

If a 21-year-old would choose the new system and a 64-year-old would not, then there must be an age between 21 and 64 when one is indifferent; that is, one would get as much from one system as the other. Let’s assume it’s 35. All workers older than 35 would stay with Social Security, pay the full payroll tax and receive the stated benefit. All workers younger than 35 would choose the market-based alternative, save and invest part of their payroll tax for their retirement and continue to pay the remainder of the payroll tax to the government to help provide for those who stay with Social Security. The government is largely off the hook for them and fully off the hook for all new, younger workers who enter the labor force.

The government’s liability, therefore, is now capped at the benefits payable to those over 35 and the much lower accrued benefits of those under 35. Starting almost immediately, the total number of workers and retirees in the older group shrinks because of death and the fact that no one enters the group. When the last person dies, the government’s benefit payments drop to zero. The government’s ongoing liability for the younger group phases out as well because more and more people of this expanding group provide for themselves exclusively through their personal accounts.

The ultimate steady state, when each individual provides for himself, takes decades. In the interim, however, financing is required just as if there were no reform except for the fact that this borrowing is not endless, it’s temporary. Here’s how it would work: First, the year when Social Security will begin running a deficit will be earlier, let’s say 2010, because some of the payroll tax that was earmarked to pay benefits would now be invested in personal accounts. In 2010, let’s assume the mismatch between taxes and benefits is made up by government borrowing, just like the original case. As mentioned earlier, the older group, which continues to receive Social Security benefits, naturally shrinks over time as its members die. At some point, the payroll taxes received from the younger group exceed the benefits paid to the older group. When this happens, no new debt is issued and future payroll taxes from the younger group refund the debt accumulated during the transition. Eventually all the debt is repaid.

At the end of the transition, the government has no future retirement benefit obligations, the payroll tax that was earmarked to pay off the debt drops to zero, and the employer payroll tax drops to zero as well. What remains is each individual’s payroll deduction, which is saved and invested in highly diversified portfolios of wealth-producing assets. Based upon reasonable capital market returns and the new personal property rights one will have with his account, retirement income will be greater and more secure than can possibly be provided by the existing system, which was designed during the Great Depression.

It is true that achieving President Bush’s vision for modernizing Social Security will require a transition period, bridge financing and an earlier date when we experience negative cash flows. But under all reasonable assumptions, a market-based Social Security system will, over the long run, always be less costly than remaining with the present tax-funded structure. And long-term viability must be one of the fundamental goals of any Social Security reform.

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