The Other Trust Fund Report

December 5, 1996 • Commentary

While the latest report warning that the Medicare Trust Fund will be broke by 2001 has garnered headlines, a second crisis has been quietly brewing. The latest report of the Social Security system’s Board of Trustees, also released earlier this year, provides new evidence of the program’s growing financial problems. According to the trustees, Social Security will be insolvent by 2029, back from 2030 in last year’s report. This is the eighth time in the last 10 years that the projected insolvency date has been brought closer.

But even that does not provide the full story of Social Security’s looming crisis. The important date is 2012. Social Security taxes currently bring in more revenue than the system pays out in benefits. The surplus theoretically accumulates in the Social Security Trust Fund. However, in 2012 the situation will reverse. Social Security will begin paying out more in benefits than it collects in revenues. To continue meeting its obligations, it will have to begin drawing on the surplus in the trust fund. The trouble is that the trust fund is really little more than a polite fiction. For years the federal government has used the trust fund to disguise the actual size of the federal budget deficit, borrowing money from the trust fund to pay current operating expenses and replacing the money with government bonds–essentially IOUs.

In 2012 Social Security will have to start turning in those bonds to the federal government to obtain the cash needed to pay benefits. But the federal government has no cash or other assets with which to pay off those bonds. It can obtain the cash only by borrowing and running a bigger deficit, increasing taxes, or cutting other government spending. All those options pose obvious problems.

Even if Congress can find a way to redeem the bonds, the trust fund will be completely exhausted by 2029. At that point, Social Security will have to rely solely on revenue from the payroll tax. But that revenue will not be sufficient to pay all promised benefits. Either payroll taxes will have to be increased–to as much as 40 percent according to some estimates–or benefits will have to be reduced by as much as one‐​third.

Social Security’s financing problems are a result of its fundamentally flawed design, which is comparable to the type of pyramid or Ponzi scheme that is illegal in all 50 states. Today’s benefits to the old are paid by today’s taxes from the young. Tomorrow’s benefits to today’s young are to be paid by tomorrow’s taxes from tomorrow’s young.

Because the average recipient takes out more from the system than he or she has paid in, Social Security can work only as long as there are more workers paying into the system than beneficiaries taking out of the system. However, life expectancy is increasing and birth rates are declining. As recently as 1950 there were 16 workers for every Social Security beneficiary. Today there are only 3.3. By 2030 there will be fewer than 2.

Moreover, even if Social Security’s financial difficulties can be fixed, the system remains a bad deal for most Americans, and the situation is even worse for today’s young workers. Payroll taxes are already so high that even if today’s young workers receive the promised benefits, those benefits will amount to a low, below‐​market return on their taxes. Today’s retirees will generally get back all they paid into Social Security plus a modest return on their investment, but when today’s young workers retire, they will actually receive a negative rate of return–less than they paid in. Young workers today would be better off stuffing their Social Security taxes in their mattresses than counting on benefits from the program.

Those workers can now get far higher returns and benefits through private savings, investment and insurance. In fact, a study by financial analyst William Shipman demonstrates that if a 25‐​year‐​old worker were able to privately invest the money he or she currently pays in Social Security taxes, he or she would receive retirement benefits three to six times greater than under Social Security.

There is, of course, no reason to panic. There is time to make the reforms necessary to ensure that both today’s and tomorrow’s elderly will be able to retire with dignity. We can follow the successful example of Chile and privatize our Social Security system.

Chile’s success can be measured in many ways. The country’s private savings rate is 26 percent of gross domestic product, compared with 4 percent in the United States. The infusion of capital into the private sector has contributed in large part to Chile’s phenomenal 7 percent annual economic growth rate over the past 10 years, double ours.

But most important, retirees are receiving much higher benefits. Since the privatized system became fully operational on May 1, 1981, the average rate of return on investment has been 13 percent per year. As a result, the typical retiree is receiving a benefit equal to nearly 80 percent of his or her average annual preretirement income, almost double the U.S. replacement value.

The crisis is coming. The question is, do our political leaders have the courage to ensure that tomorrow’s retirees will have a secure retirement?

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