A New Social Security for a New Economy

Share

President Bush vows to reform Social Security by letting workers invest partof 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 benefitsof changing the nation's public pension system?

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

Social Security is a bad deal today because the program's rate of return isfalling. In a pay-as-you-go system like Social Security, where taxes paid bytoday's workers are immediately used to pay today's benefits, the rate ofreturn from year to year depends upon the increase in the number of workersand in how much they pay into the system. In other words, Social Security'sreturn is the annual rate of growth of the tax base: labor force growth pluswage 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 ofeconomic security unworkable. People had always had large families. But formost of history, high infant mortality rates kept the population fromgrowing quickly. Improved diet and health care in the 20th century meantthat more of those children would live to adulthood. And the baby boomfollowing World War II increased birth rates even further. More workers wereentering the workforce and paying taxes into the Social Security system.This meant more money for retirees, and benefit levels were increased manytimes during the program's early decades.

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

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

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

Historically, an account split 50-50 between stocks and corporate bondswould have received an annual return of about 5.5 percent after inflation.Even inflation-indexed Treasury bonds—the world's safest investment—pay over3 percent every year. These higher rates of return mean that either benefitsfor retirees could increase or taxes on workers could fall, or both. Ineither case, Americans would be the winners.

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