Michael Tanner’s Senate Testimony on Social Security Reform

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It is a both a privilege and an honor to be invited to appeartoday and offer my views on the need for fundamental reform of theAmerican Social Security system.

Let me say at the outset, Social Security reform should be abipartisan issue. In many ways, Social Security is a creation ofthe Democratic Party. And, more recently many Democrats have beenwilling to speak out on the need for reforming and modernizing theprogram. As long ago as 1998, then-President Bill Clinton waswarning that "Today Social Security is sound, but a demographiccrisis looms if we fail to act. For over the next 30 years, 76million baby boomers will retire. By 2030 there will be twice asmany elderly Americans as there are today. If we don't act now, bythen payroll contributions will only cover 75 percent ofbenefits."

Others, including your former colleagues Bob Kerrey, CharlesRobb, John Breaux, and, of course Daniel Patrick Moynihan, as wellas Congressmen like Tim Penny, Charlie Stenholm, and Harold Ford,not only recognized the urgent need for reform, but embraced theidea that reform could be an opportunity to build a newer, betterSocial Security reform that gave workers ownership and control overtheir retirement income, while allowing workers-especially low- andmiddle-income workers-to accumulate real, inheritable wealth, inshort individual accounts.

You have invited me hear today specifically to discuss theimpact of Social Security reform on seniors' benefits. I ampresuming that you are concerned with benefits of seniors in thefuture, the benefits of those who are currently working but will,obviously, someday retire, since the President has made it clearthat he will not support any Social Security reform proposal thatreduces benefits for current seniors. This principle is reflectedin the major individual account bills that have been introduced inthe last session of Congress, and so far in this session. Theywould explicitly leave the benefits of current seniors untouched.Indeed, they would not even give the option of individual accountsto those nearing retirement; their benefits would also remainexactly as currently scheduled.

However, most individual account proposals, and indeed mostSocial Security reform proposals regardless of whether they includeindividual accounts would have an impact on the future benefits oftoday's younger workers. Yet, it is important that any suchdiscussion must take place in the context of Social Securityfinances. That is because, given Social Security's finances,comparing any reformed Social Security system to thecurrently promised benefits is to compare reality to a fantasy.That is because, given current revenues, promised future benefitssimply cannot be paid.

We can become forever embroiled in semantic debates over whatdoes or does not constitute a "crisis." However, we cannot deny thefundamental facts.

Social Security will begin running a deficit in less than 15years-that is, it will begin to spend more money on benefits thatit brings in through taxes. At that point, in order to continue topay promised benefits, it will have to draw on the Social SecurityTrust Fund. Opponents of reform have made much of the Trust Fundrecently, suggesting that it guarantees Social Security's solvencyuntil 2042, or even 2052 according to some projections. However, asCongressional Budget Office director Douglas Holtz-Eakin has noted"[The Trust Fund] has no real economic resources….The keymoments for Social Security are in 2018. Cash-flow benefits willequal cash-flow payroll taxes, and then after that, the SocialSecurity Administration will have to come back to the rest of thebudget for additional resources to pay promised benefits."

Or to cite a source that might be even more significant to thiscommittee, President Clinton's FY2000 budget, which states "TheseTrust Fund balances are available to finance future benefitpayments…but only in a bookkeeping sense….Thy do notconsist of real economic assets that can be drawn down in thefuture to fund benefits. Instead, they are claims on the Treasurythat, when redeemed, will have to be financed by raising taxes,borrowing from the public, or reducing benefits or otherexpenditures. The existence of Trust Fund balances, therefore, doesnot by itself have any impact on the government's ability to paybenefits."

This is not to say that the Federal government will default onthe bonds in the Trust Fund. I am not doubting the "full faith andcredit" of the U.S. government. However, that does not relieve theFederal government from the obligation to find the money with whichto redeem those bonds, currently $1.5 trillion in present valueterms. To put it in perspective, think of it this way. In 2019, thefirst year after Social Security begins running a deficit, theshortfall will be roughly as much as the Federal government spendson such programs as Head Start and the WIC program. The cost risesrapidly thereafter. By roughly 2023, the cost of redeeming enoughTrust Fund bonds to pay all the promised Social Security benefitswould be nearly as much as the cost of funding the Departments ofInterior, Commerce, Education, and the environmental ProtectionAgency. By 2038, well before the theoretical exhaustion of theTrust Fund, you can add the Departments of Veterans Affairs,Energy, Housing and Urban Development, Justice, NASA, and theNational Science Foundation. Simply redeeming the Trust Fund willbegin to squeeze out all other domestic spending priorities.

Beyond 2042, once the Trust Fund is exhausted, the deteriorationin Social security' finances only increases-and never gets anybetter. Overall, the present value of Social Security's unfundedobligations run to nearly $12 trillion (approximately $1.5 trillionto redeem the Trust Fund, and $10.4 trillion in unfunded benefitsthereafter). [1]

Quite simply, Social Security cannot pay the promised level ofSocial Security benefits with its current level of revenues.Therefore, it is improper to compare benefits under a reformedSocial Security system with today's promised level of benefits.Those promises are simply a fantasy. In fact, by law, SocialSecurity will have to reduce its benefits by approximately 27percent, once it is unable to fund those benefits. This will occurregardless of whether individual accounts are created or not. Asformer Senator Bob Kerrey has said, doing nothing is the same as a27 percent benefit cut.

Given the fact that the Federal government is not likely to waituntil that day and simply allow benefits to suddenly drop 27percent, there are several ways to create a smoother path tobringing benefits into line with revenues. I believe that the bestof these is to change the benefit formula from a wage-indexed basisto a price-indexed one.

Currently the formula for determining initial Social Securitybenefits is adjusted to reflect national wage growth. Because wagesgenerally grow faster than prices, each year's retirees receivehigher benefits (after adjusting for inflation) than those retiringthe year before. The White House is reportedly considering changingthe formula so that it is adjusted by prices or inflation instead.This means that every group of retirees would receive the sameinitial benefits as previous retirees, adjusted for inflation, butnot the benefit increases above inflation that are currentlypromised.

In looking at this proposal, here are some important things tokeep in mind:

  • No future retiree would receive less than those retiring todayadjusted for inflation. Only in Washington is the reduction in therate of increase considered a cut.
  • Building ever increasing benefits into a system that is facing$12 trillion in unfunded liabilities is simply irresponsible.
  • The change will not affect benefits of anyone currently retiredor near retirement. All of the plans under consideration wouldphase price-indexing in over 35 or more years. Most proposals wouldnot even start the change for several years. The only workerslikely to be fully price-indexed are in their early 30'stoday.

Doing this alone would bring Social security into permanentsustainable solvency. Indeed, some studies have suggested that itmay save more money than is necessary to achieve solvency. If thatis the case, the impact might be softened for low-income workers,through a progressive application of the indexing.

However, while changing the indexing formula would restoreSocial Security solvency, it would do so by making Social securityan even worse deal for younger workers, reducing their alreadydismal rate of return, and leaving many low-income seniors withinadequate benefits. It is in this context that individual accountsshould be considered.

Because individual accounts would give workers the chance totake advantage of the higher returns available through capitalinvestment and the power of compound interest, it would enableworkers to offset at least some of the reductions they wouldotherwise incur.

To see how this would work, compare the difference between theexpected return on capital investment and the implied return that ayoung worker can expect from Social Security. On average, workersretiring today can expect to receive a return of approximately twopercent on their Social Security taxes, and future workers canexpect even lower. However, the Social Security Administrationestimates that a balanced portfolio of stocks and bonds couldexpect to earn returns of approximately 4.7 percent, net ofadministrative costs. To provide a vastly oversimplified example: aworker earning $30,000 per year will pay roughly $120,000 in SocialSecurity taxes over a 40 year working lifetime. A two percentreturn on that money yields Social Security benefits equivalent to$185,000. But a 4.6 percent return would yield $344,000, nearlytwice as much. Using only slightly more optimistic assumptions,such as using a 60/40 stock/bond mix, would provide even higherrates of return, though admittedly it would increase thevariability of returns.

Thus a worker giving up a portion of his expected traditionalSocial Security benefits, but investing a portion of his SocialSecurity taxes could reasonably expect a higher return, andaccordingly higher retirement benefits.

Given the above, I believe that individual accounts must be partof any successful Social Security reform. There is no guaranteethat future retirees will receive benefits equal to what they arecurrently promised. But those promises are illusory. However,individual accounts can ensure that future workers will receivehigher benefits than Social Security could otherwise pay them.Moreover, those benefits would have the added advantage ofbelonging to the worker, and could be inherited if the worker diedprematurely.

I do not pretend that individual accounts are a magic bullet.But they are clearly the best answer to Social Security's problems.They will create a better and more secure retirement system forAmerican workers. I urge the Policy Committee to keep an open mind,as this debate unfolds.

[1] Social Security'sfinancial problems are not the only, or in my opinion, even themost important reason to reform the system. If it was-ifmaintaining Social Security's solvency was the only concern-it ispossible to do so by raising taxes or cutting benefits. That is,for example, what Dr. Orszag proposes. However, there are otherissues-and opportunities-that we should consider. For example, itis important to remember, that Social Security taxes are already sohigh that younger workers will receive an extremely poor, and farbelow market, rate of return on the money they pay into the system.The system penalizes working women and those, such asAfrican-Americans with shorter life expectancies, it slows economicgrowth, and it prevents the accumulation of real, inheritablewealth. Most importantly, workers currently have no legal,property, or contractual right to benefits. All of these problemswould be rectified under a system of individual accounts.