Mr. Chairman, my name is Stephen Moore and I am Director of Fiscal Policy Studies at the Cato Institute. In keeping with the new truth in testimony rules, let me first say that the Cato Institute does not receive a single penny of government funds.
Thank you for the opportunity to comment today on the future of Social Security. I wish to commend this Committee for its willingness to explore the long term prognosis for Social Security.
As everyone on this Committee knows, the long term financial outlook for Social Security is bleak. Depending on how it is measured the unfunded liability of the system ranges from $3 trillion to $5 trillion. This is much like a second national debt. Yet the financial sustainability of Social Security could be assured with a series of conventional reforms that include raising payroll taxes and reducing future benefits. Though young people, of course, are none too enthusiastic about these “pay more in, get less out” solutions.
But the major point that I wish to communicate to you this morning is that the case for converting Social Security into a system of Personal Security Accounts (PSAs) is not primarily based on the system’s financial problems. The real economic and political crisis looming over Social Security relates to the issue of rate of return. For baby boomers and especially for Generation X workers, Social Security offers a low rate of return—even negative for many workers.
I would ask each of you to review for a moment the attached charts from a recent Cato Institute study. They compare the rate of return for Social Security versus investment in private capital markets? The data was compiled for the Cato Institute by Bill Shipman principal of State Street Global Advisors in Boston. It has been reviewed by professional actuaries and certified as accurate.
To derive an estimated rate of return from capital markets in the future, the study assumes that over the next forty to fifty years, workers will be able to obtain a rate of return in capital markets equal to the average historical rate of return on bonds and stocks from the past 70 years (1926-95). For stocks that annual historical rate of return has been 10 percent (nominal); while for bonds the return has been 6 percent (nominal). (Incidentally, over the past twenty years, the financial markets have far exceeded the historical average.
The chart shows that a typical baby boomer born in 1950, will pay over his or her lifetime several hundred thousand dollars more in payroll taxes (plus interest and a normal rate of real return) than the benefits he or she receives.
But the real losers are those in the Generation X cohort—or those born after 1970. These young workers can expect to pay $2 to $5 of taxes (including the foregone normal rate of return on those dollars) for every dollar in benefits collected. Or to state the point differently: if Congress were to allow a 25 year old working woman today to invest her payroll tax contributions in private capital markets, her retirement benefit would be two to five times higher than what Social Security is offering. For our young workers, these are very powerful numbers.
Consider the situation of a low wage worker—someone whose lifetime salary is near the minimum wage. Because of the progressive benefit feature of Social Security, this is typically thought to be the worst case scenario for personal security accounts. It turns out that based on current law, for that worker Social Security promises an annual benefit of roughly $9,000 a year (1995 dollars). If that money were invested in private markets in a portfolio with half stocks and half bonds, the worker would receive an annual benefit upon retirement in the form of an annuity of almost $20,000 per year—or well over twice what Social Security offers. If the money were put entirely into stocks, the worker would have an annual benefit of more than $25,000—or three times what Social Security offers.
Not every worker, obviously will obtain the “average” rate of return. By definition, some workers will do better, some will do worse. But under a PSA system, Congress could place reasonable restrictions on how the money were invested, to protect against losses. For example, Congress might restrict the investments to a select number of mutual funds, where a certain portion of the fund is invested in corporate bonds and treasury bonds. Hence, low-wage workers who might not know much about financial markets, would not choose individual stocks. But a critical point here is that even if these accounts were restricted to an unrealistically risk-averse portfolio, in this case 100 percent corporate bonds, the rate of return would still be higher than under Social Security. In fact, it is virtually impossible to construct an investment scenario where even the lowest income worker does better under Social Security than under a PSA.
So here is the critical point for the members of this Committee to bear in mind when crafting proposals for the future of Social Security: even if the trust fund were entirely solvent—and even if every dollar of promised benefits were to be paid with no tax increases—the system would be a bad deal for our young workers.
Now let’s return to the situation of a low-wage worker. I have discovered in conversations with members of Congress and with working Americans that there is an understandable concern about how this will impact our lowest income workers who are most likely to depend exclusively on Social Security payments when they retire. To be viable, any PSA plan must make these most disadvantaged workers better off, not worse off. The chart presented above actually understates the advantage of Social Security privatization to the poor and to minorities. The reason that it understate the benefits of PSAs to the poor and minorities is that these are the workers who are most likely to have started their working years at an earlier age, to have worked more years over their career, and to die earlier after retirement. For precisely these reasons, even accounting for the progressive nature of the benefit structure, low-income and black workers actually pay in the most relative to the benefit they forego from a private system.
Social Security offers the worst rate of return for that part of the population that it is supposedly most benefited from the system: minorities and the poor. Moreover, it is precisely because the poor elderly tend to have no other source of retirement income, that they stand to gain the most from a privatized system that would yield them a 30 to 50 percent higher monthly payment.
I have attached for the record a recent Cato study by my colleague Michael Tanner that explains in greater detail why the poor would gain the most from PSAs.
Incidentally, the Tanner study is also relevant to the spurious argument that workers can not be given the right to opt out of the system because of an “adverse selection” problem. There is no adverse selection problem associated with a voluntary Social Security Personal Security Account plan, since with very few exceptions, every worker in America would be financially better off investing in private capital markets than by staying in the current system.
The argument is sometimes made that there are always risks involved in investing money privately. The stock market doesn’t always go up in the short term—though in the long term it must or America will be a very poor country in the next century. Rates of return are not guaranteed. Stock markets crash. Bear in mind, however, that the historical rate of return assumed in this analysis takes into account the Depression-era stock market crash, the 1987 crash and the decade long sag in the market from the late 1960s to the early 1980s.
So yes, there are investment risks associated with PSAs. But remember, from the point of view of the worker, there are also huge political risks associated with staying in the government-run Social Security system. There is the risk that benefits will be cut in the future or that the payroll tax will be raised.
In fact, I would maintain that given the current financial plight of Social Security, it’s a virtual certainty that Congress will enact either or both of these Social Security “reforms.” Hence, the rate of return comparisons presented above are an unlikely “best-case scenario” for Social Security. The charts assumes that no change in promised benefits and no change in the payroll tax rate will occur over the next forty years.
Even the staunchest opponents of privatization and the most vocal advocates of maintaining the structure of the current system agree that benefits and taxes need to be revised. Former Social Security Commissioner Robert Ball, a leading foe of privatization, advocates a slight rise in the payroll tax, an increase in the retirement age, and other assorted reductions in future benefits. Each of the proposals advocated by the Advisory Council suggested benefit reductions and future tax increases.
It is imperative for this Committee to understand a critical point about the future of Social Security: any or all of the conventional “fixes” to the program will only make the system a worse deal for young people.
Consider, for example, the proposal to raise gradually the payroll tax by two percentage points (above the current 15.3 percent rate) and a gradual rise in the retirement age before collecting benefits (as is now being considered for Medicare). If this combination of reforms were enacted, rather than paying $2 to $5 of taxes for every dollar of benefit received, our young worker would now pay $3 to $6 of taxes for every dollar of benefit.
This is why all conventional fixes, if they are not tied to an exit strategy that allows young workers to capture the returns from private markets, are a bad deal for the young. This also explains why the 18-30 year old demographic group is the most enthusiastic about a private alternative to Social Security. A personal security account (PSA) system is the only option available to Congress that improves the financial situation of young workers. All of the rest of the leading proposals make the young financially worse off.
I believe that most of the members of this Committee would be in favor of moving gradually to a PSA system if there were a way to do so without blowing a hole in the deficit. We all agree that benefits to current retirees (and soon to be retirees) cannot and should not be cut. We must keep the promises that have been made to seniors.
If we allow workers to place all or a portion of payroll tax revenue into private accounts, and we continue to pay benefits to the elderly, then the budget deficit will rise in the short term.
To overcome this paradox the members of this Committee must keep in mind that the $3 trillion of unfunded Social Security liabilities are sunk costs. Sunk costs are sunk. The liabilities will need to be paid off regardless of whether Social Security is privatized or not. PSAs simply push those liabilities forward, making them transparent, so they are recognized and dealt with today, not 25 years from now. The budgetary impact of PSAs is the equivalent of paying off a future liability immediately, as companies often do to get unfunded pension liabilities off their books.
Much of the problem stems from the fact that the United States government is about the only institution in the world that still uses a cash-flow accounting system. If the federal government ran its books—using accrual accounting—as every business does, all of the bookkeeping problems with Social Security PSAs would disappear. Tax revenues would decline, but so would offsetting future liabilities—because today’s workers would no longer be accumulating rights to benefits. If any individual worker wished to exit from the system and stop paying the tax, then the financial impact on the system would be roughly a wash—unless that worker pays more into the system than he gets out of it. If the worker could be impelled to pay the government to get out of the system, then the impact on the government’s balance sheet would be positive.
And herein lies the way out of the dilemma facing Congress. It starts with the recognition that the financing problem of converting to a privatized Social Security system is a short-term cash-flow problem, not a balance sheet problem. From a public policy standpoint, what Congress should be primarily concerned with is how to improve the federal government’s balance sheet. It turns out that the gains are so large from privatization of Social Security—Martin Feldstein of the National Bureau of Economic Research estimates that the net economic benefit from Social Security privatization is $10 trillion—that a plan could easily be devised whereby the gains are shared by the government and the worker—to the benefit of both.
Here is one potential method of sharing the gains. What if we offered the following deal to every American worker? If you promise to forfeit any claim on Social Security benefits—even those you have already accumulated—we will let you invest all of your future payroll taxes into private markets. Since the rate of return is so much higher in the private markets than with Social Security, many workers would gladly accept this deal. It turns out, for example, that the age of ambivalence between staying in the system and continuing to pay the tax, versus forfeiting future benefits and putting the subsequent payroll tax revenues into a PSA, is roughly 40 years old—for an average income worker.
For a worker just now entering the workforce, the decision would be clearcut. For example, take a typical female worker who just started working and earns a salary of $22,500, which will go up with the rise in average wages over her lifetime. When she retires Social Security will pay her a $12,500 annual benefit in today’s dollars—assuming no change in benefits. If she were permitted to simply place her payroll taxes in a mutual fund with a 7 percent real rate of return (the average rate over the past fifty years), she would have a nest egg worth $800,000 to $1 million at retirement age. This would allow the worker to draw a $60,000 benefit per year until death (assumed at age 80). This is five times higher than what Social Security offers for the same level of investment.
For workers in their 20s and 30s the rate of return is so much higher in private markets than under Social Security that most would be willing to pay in effect an exit tax for the right to invest payroll tax payments privately. The exit fee is the forfeiture of benefits already accrued. There is no adverse selection problem under this scheme because the government makes money on every worker who opts out—regardless of their income.
How big are the gains to the government from this opt-out transition system? Bill Shipman and Marshall Carter with State Street Global Advisers calculate that if every worker under 40 opted out, the reduction in the unfunded liability of Social Security would be on the magnitude of $1 to $1.5 trillion. Hence, up to one-third of the current unfunded liability would be eliminated through this transition plan.
In summary, allow me to enumerate the economic advantages of converting out of our pay-as-you-go government-run Social Security system to a program of PSAs:
1) Privatization offers a much higher financial rate of return to young workers than the current system.
2) Privatization gives workers—rather than politicians—control over their own retirement nest egg. The funds deposited in private retirement accounts, are funds that can never be easily taken away by the government.
3) A privatized system will increase worker ownership in American businesses and assets. This is a “share the wealth” strategy that will help create a nation of capitalists and raise the level of savings and investment.
4) Privatization is the equivalent of a tax cut for workers. Currently the Social Security payroll tax is treated by many young workers as simply a tax, not a deferred form of compensation. The tax reduces their take-home pay—and thus reduces the incentive to work. Since the privatization option deposits these funds into a personal account, they are now “owned” by the worker.
5) The increased flow of funds into private capital markets will reduce the cost of capital, and thus increase capital formation, business creation, and ultimately wages and living standards.
6) By sharing the trillions of dollars of economic gains from the higher rate of return from private accounts, Congress could adopt a strategy that would improve the financial status of individual workers and the federal government. This establishes a win-win situation for the government and the worker.
Thank you again for the opportunity to testify before this Committee.