Social Security and Baby Boomers

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Mr. Chairman, distinguished members of the committee:

Thank you for the opportunity to appear before this committeeand address one of the most important questions facing this countrytoday: whether today's young workers will have the same opportunityfor a dignified retirement as do today's seniors.

I do not want to begin by attacking Social Security. For 60years, Social Security has largely accomplished its goal. It hassignificantly cut poverty among the elderly and enabled them toretire with dignity. But despite all the good that Social Securityhas accomplished, the system now faces irresistible demographic andfiscal pressures that threaten the future retirement security oftoday's young workers.

Only by moving to a system of privately invested,individually-owned accounts can a system of secure retirement bepreserved.

Just a couple of months ago the Social Security system's Boardof Trustees reported that the retirement system will be insolventby 2029, down from 2030 in last year's report. This represents theeighth time in the last 10 years that insolvency date has beenbrought forward. But focusing exclusively on that date ismisleading. The implication is that Social Security's financing isfine until 2030, at which point benefits will suddenly stop. Thereality is much more complex.

Currently, Social Security taxes bring in more revenue than thesystem pays out in benefits. The surplus theoretically accumulatesin the Social Security Trust Fund. However, the situation willreverse as early as 2012. Social Security will begin paying outmore in benefits than it collects in revenues. To continue meetingits obligations, it will have to begin drawing on the surplus inthe Trust Fund. However, at that point, we will discover that theSocial Security Trust Fund is really little more than a politefiction.

For years, the federal government has used the Trust Fund todisguise the actual size of the federal budget deficit, borrowingmoney from the Trust Fund to pay current operating expenses andreplacing the money with government bonds.

Beginning in 2012, Social Security will have to start turning inthose bonds to the federal government to obtain the cash needed tofinance benefits. But the federal government has no cash or otherassets with which to pay off those bonds.

Of course, the Social Security insists that those bonds aresafe, comparing them to the government bonds in private investmentportfolios. Those bonds are backed by thin full faith and credit ofthe U.S. government. But this is irrelevant.

Pretend for a moment that there was no trust fund and no bonds.What would happen in 2012? The government would have to raise taxesto continue paying promised benefits.

Now, consider what will happen with the trust fund.

The government will have to raise taxes to make good on thebonds to continue paying promised benefits. Either way, thegovernment can only pay benefits by raising taxes--or borrowing andrunning bigger deficits. Even if Congress can find a way to redeemthe bonds, the Trust Fund surplus will be completely exhausted by2029. At that point, Social Security will have to rely solely onrevenue from the payroll tax. But such revenues will not besufficient to pay all promised benefits. If the government is goingto make good on all the promised benefits under both SocialSecurity and Medicare, payroll taxes will have to be increased tobetween 28 and 40 percent.

Social Security's financing problems are a result of itsfundamentally flawed design, which is comparable to the type ofpyramid scheme that is illegal in all 50 states.

Today's benefits to the old are paid by today's taxes from theyoung. Tomorrow's benefits to today's young are to be paid bytomorrow's taxes from tomorrow's young.

Because the average recipient takes out more from the systemthan he or she paid in, Social Security works as long as there isan ever larger pool of workers paying into the system compared tobeneficiaries taking out of the system.

However, exactly the opposite is happening.

Life expectancy is increasing, while birth rates are declining.As recently as 1950, there were 16 workers for every SocialSecurity beneficiary.

Today there are only 3.3. By 2030, there will be fewer thantwo.

The Social Security pyramid is unsustainable.

Moreover, even if Social Security's financial difficulties canbe fixed, the system remains a bad deal for most Americans, asituation that is growing worse for today's young workers. Payrolltaxes are already so high that even if today's young workersreceive the promised benefits, such benefits will amount to a low,below-market return on those taxes.

Studies show that for most young workers such benefits wouldamount to a negative return on the required taxes. Those workerscan now get far higher returns and benefits through privatesavings, investment, and insurance.

There is a better alternative.

Social Security should be "privatized," allowing people thefreedom to invest their Social Security taxes in financial assetssuch as stocks and bonds.

A privatized Social Security system would essentially be amandatory savings program.

The 10.52 percent payroll tax that is the combinedemployer-employee contribution to OASI, the Old-Age and SurvivorsInsurance portion of the Social Security program, would beredirected toward a Personal Security Account (PSA) chosen by theindividual employee. PSAs would operate much like currentIndividual Retirement Accounts (IRAs).

Individuals could not withdraw funds from their PSAs prior toretirement, determined either by age or PSA balancerequirements.

PSA funds would be the property of the individual, and upondeath, remaining funds would become part of the individual'sestate.

PSAs would be managed by the private investment industry in thesame way as 401k plans or IRAs.

Individuals would be free to choose the fund manager that bestmet their individual needs and could change managers whenever theywished.

The government would establish regulations on portfolio risk toprevent speculation and protect consumers.

Reinsurance mechanisms would be required to guarantee fundsolvency.

The government would continue to guarantee a minimum pensionbenefit.

The minimum pension could be set to a benchmark such as theminimum wage.

If upon retirement the balance in an individual's PSA wasinsufficient to provide an actuarially determined retirementannuity equal to the minimum wage, the government would provide asupplement sufficient to bring the individual's monthly income upto the level of the minimum wage.

Given historic rates of return from the capital markets, evenminimum wage earners would receive more than the minimum from thenew system if they participated their entire working lives.

Therefore, in the absence of a major financial collapse, thesafety net would be required for few aside from the disabled andothers outside the workforce.

The idea of privatizing a public pension system is neither newnor untried. Where privatization has been properly implemented ithas been remarkably successful. One of the best examples is theexperience of Chile. Chile's social security system predated ours,having started in 1926. By the late 1970s its benefit payments weregreater than its taxes and it had no funded reserves. On the adviceof Milton Friedman and other free-market economists, Chile decidedto privatize its system.

After 15 years of operation, Chile's experiment has provenitself. Pensions in the new private system already are 50 percentto 100 percent higher than they were in the state run system. Theresources administered by the private- pension funds amount to $25billion, or around 40 percent of GNP as of 1995. By improving thefunctioning of both the capital and the labor markets, pensionprivatization has been one of the key reforms that has pushed thegrowth rate of the economy upward from the historical 3 percent ayear to 7 percent on average during the last 10 years. The Chileansavings rate has increased to 27 percent of GNP, and theunemployment rate has decreased to 5 percent since the reform wasundertaken.

Under Chile's PSA system, what determines a worker's pensionlevel is the amount of money he accumulates during his workingyears. Neither the worker nor the employer pays a social securitytax to the state. Nor does the worker collect a government-fundedpension. Instead, during his working life, he automatically has 10percent of his wages deposited by his employer each month in hisown, individual PSA.

A worker may contribute an additional 10 percent of his wageseach month, which is also deductible from taxable income, as a formof voluntary savings. Generally, a worker will contribute more than10 percent of his salary if he wants to retire early or obtain ahigher pension.

A worker chooses one of about 20 private Pension FundAdministration companies to manage his PSA. Each company operatesthe equivalent of a mutual fund that invests in stocks and bonds.Investment decisions are made by the managing company. Governmentregulation sets only maximum percentage limits both for specifictypes of instruments and for the overall mix of the portfolio; andin the spirit of the reform, those regulations are to be reducedwith the passage of time and as the companies gain experience.

There is no obligation whatsoever to invest in government or anyother type of bonds.

Workers are free to change from one company to another.

For that reason there is competition among the companies toprovide a higher return on investment, better customer service, ora lower commission. Each worker is given a PSA passbook and everythree months receives a statement informing him of how much moneyhas accumulated in his retirement account and how well hisinvestment fund has performed. The account bears the worker's name,as his property, and will be used to pay his old age pension (witha provision for survivors' benefits).

A worker who has contributed for at least 20 years but whosepension fund, upon reaching retirement age, is below the legallydefined 'minimum pension" receives a pension from the state oncehis PSA has been depleted.

What should be stressed here is that no one is defined as "poor"a priori.

Only a posteriori, after his working life has ended and his PSAhas been depleted, does a poor pensioner receive a governmentsubsidy. (Those without 20 years of contributions can apply for awelfare-type pension at a much lower level.)

The PSA system also includes insurance against premature deathand disability. Each company provides that service to its clientsby taking out group life and disability coverage from private lifeinsurance companies. That coverage, is paid for by an additionalworker contribution of around 2.9 percent of salary, which includesthe commission to the managing company.

Upon retiring, a worker may choose from two general payoutoptions.

Under one option, a retiree may use the capital in his PSA topurchase an annuity from any private life insurance company. Theannuity guarantees a constant monthly income for life, indexed toinflation, plus survivors' benefits for the worker's dependents.Alternatively, a retiree may leave his funds in the PSA and makeprogrammed withdrawals, subject to limits based on the lifeexpectancy of the retiree and his dependents. In the latter case,if he dies, the remaining funds in his account form a part of hisestate. In both cases, he can withdraw as a lump sum the capital inexcess of that needed to obtain an annuity or programmed withdrawalequal to 70 percent of his last wages.

In contrast to company-based private pension systems thatgenerally impose costs on workers who leave before a given numberof years and that sometimes result in bankruptcy of the workers'pension funds--thus depriving workers of both their jobs and theirpension rights--the PSA system is completely independent of thecompany employing the worker.

Since the PSA is tied to the Worker, not the company where heworks, the account is fully portable. The problem of "job lock" isentirely avoided.

One challenge is to define the permanent PSA system.

Another is to manage the transition to a PSA system.

In Chile there were three basic rules for the transition:

1. The government guaranteed those already receiving a pensionthat their pensions would be unaffected by the reform. That wasimportant because it would be unfair to the elderly to change theirbenefits or expectations at this point in their lives.

2. Every worker already contributing to the pay-as-you-go systemwas given the choice of staying in that system or moving to the newPSA system. Those who left the old system were given a 'recognitionbond' that was deposited in their new PSAS. That bond reflected therights the worker had already acquired in the pay-as-you-gosystem.

3. All new entrants to the labor force were required to enterthe PSA system. The door was closed to the pay-as-you-go systembecause it was unsustainable. This requirement assures the completeend of the old system once the last worker who remains in itreaches retirement age (from then on, and during a limited periodof time, the government has only to pay pensions to retirees of theold system). That is important because the most effective way toreduce the size of government is to end programs completely, notsimply scale them back so that a new government may revive them ata later date.

The financing of the transition is a complex technical issue,which each country must address according to its own circumstances.Chile used five methods to finance the short-run fiscal costs ofchanging to a PSA system:

1. On the state's balance sheet (which showed the government'sassets and liabilities), state pension obligations were offset tosome extent by the value of stateowned enterprises and other typesof assets. Therefore, privatization was not only one way to financethe transition but had several additional benefits such asincreasing efficiency, spreading ownership, and depoliticizing theeconomy.

2. Since the contribution needed in a capitalization system tofinance adequate pension levels is generally lower than currentpayroll taxes, a fraction of the difference between them can beused as a temporary transition tax without reducing net wages orincreasing the cost of labor to the employer.

3. Using debt, the transition cost can be shared by futuregenerations. In Chile roughly 40 percent of the cost has beenfinanced by issuing government bonds at market rates ofinterest.

4. The need to finance the transition was a powerful incentiveto reduce wasteful government spending. For years the budgetdirector had been able to use this argument to kill unjustified newspending or to reduce wasteful government programs.

5. The increased economic growth that the PSA system promotedsubstantially increased tax revenues, especially those from thevalue- added tax. Only 15 years after the pension reform, Chile isrunning fiscal budget surpluses.

Since the system began to operate on May 1. 1981, the averagereal return on investment has been 12.8 percent per year (more thanthree times higher than the anticipated yield of 4 percent). Ofcourse, the annual yield has shown the oscillations that areintrinsic to the free market--ranging from minus 3 percent to plus30 percent in real terms--but the important yield is the averageone over the long term.

Pensions under the new system have been significantly higherthan under the old, state-administered system, which required atotal payroll tax of around 25 percent. The typical retiree isreceiving a benefit equal to nearly 80 percent of his averageannual income over the last 10 years of his working life, almostdouble the U.S. replacement value.

The new pension system, therefore, has made a significantcontribution to the reduction of poverty by increasing the size andcertainly of old-age, survivors, and disability pensions and by theindirect, but very powerful, effect of promoting economic growthand employment.

What would happen if the United States followed Chile's example?The benefits to the U.S. economy would be substantial.

The U.S savings rate, the lowest in the industrialized world,would increase dramatically.

In addition, the movement of so much capital into privatemarkets would have a significant impact on economic growth. Harvardprofessor Martin Feldstein, for example, estimates that "thecombination of the improved labor market incentives and the higherreal return on savings (of moving to a fully funded Social Securitysystem) has a net present value gain of more than $15 trillion, anamount equivalent to 3 percent of each future year's GDPforever."

Chile's reforms are seen as such a huge economic and politicalsuccess that countries throughout Latin America, includingArgentina, Peru, and Colombia, are beginning to implement similarchanges.

In Europe, Britain has allowed some people to opt out of itsupper tier of benefits and Italy has begun to privatize someaspects of its social security system.

Obviously, privatization of Social Security in the United Stateswould not come without questions and problems.

First, the current Social Security system involves severalelements of social insurance that make it much more than a simpleretirement system. For example, portions of the payroll tax supportthe Disability Insurance and Medicare programs. Transferring thoseprograms to the private sector is both possible and desirable, butentails considerably more difficulty than privatizing theretirement portion of Social Security. Their fate should be decidedseparately.

Social Security also currently provides survivors' benefits thatwould disappear under a privatized system. But that would belargely offset because privatization would make benefits part of anindividual's estate. In addition, it would be relatively easy touse a portion of PRA funds to purchase life insurance.

Finally, it's important to recognize the redistributional aspectof Social Security. Benefit formulas are calculated on aprogressive basis that provides a relatively higher return tolow-income workers than to higher. A privatized system wouldgenerally reverse that. High-wage individuals would receive ahigher return on their investment, leading to greater incomeinequality.

Still, and far more important, low-wage workers would likelyreceive far more in benefits than they do under the current system.Because low-income workers are far more likely than the wealthy torely on Social Security for all or most of their retirement income,the current system's low rate of return actually hurts them themost. Indeed, some studies show that because of the regressivenature of the payroll tax and the shorter life expectancy of thepoor, they are the major victims of today's system.

The most difficult issue associated with any proposedprivatization of Social Security is the transition. Put quitesimply, regardless of what system we choose for the future, we havea moral obligation to continue benefits to today's recipients. Butif current workers divert their payroll taxes to a private system,those taxes will no longer be available to pay benefits. Thegovernment will have to find a new source of funds.

The Congressional Research Service estimates that cost at nearly$7 trillion over the next 35 years.

While that sounds like an intimidating figure, much of it isreally just making explicit an already existing unfundedobligation. As noted above, the federal government already cannotfund as much as $4.9 trillion of Social Security's promisedbenefits.

Those who claim we cannot afford to finance the transition haveyet to explain how they will continue to fund benefits for ourchildren. Even so, proponents of privatization have an obligationto explain how they would fund the transition. The reality willprobably involve some combination of four approaches.

The first of those is a partial default. Any change in futurebenefits amounts to a default.

That could range from such mild options as raising theretirement age, reducing COLAs, or means testing benefits to'writing off" obligations to individuals under a certain age whoopt into the private system. For example, any individual under theage of thirty who chooses the private system may receive no creditfor past contributions to Social Security.

The second method of financing the transition is to continue asmall portion of the current payroll tax.

For example, rather than privatize the entire OASI portion ofthe payroll tax, workers would be allowed to invest 6 or 8percentage points, with the remainder temporarily continuing tofund a portion of current benefits.

Third, Congress can identify additional spending cuts and usethe funds to pay for the transition cost. Steve Entin, an economistwith the Institute for Research on the Economics of Taxation(IRET), estimates that fully funding the transition would requireslowing the rate of growth in federal spending by an additional onehalf percent beyond currently envisioned cuts, eventually reachinga reduction of $60-70 billion per year.

The final proposal often suggested for funding the transition isfor the government to issue bonds to current system participantsand taxpayers. The present value of the actuarially determinedannuity due each system participant may be easily calculated andeach system participant may be issued zero-coupon T-Bonds maturingat the participant's projected retirement date. The bonds would beplaced in each individual's PSA.

However, while that has the virtue of making explicit thegovernment's long-term obligations, it is really simply andaccounting gimmick. Ultimately, the government will still have tofind the funds to make good on the bonds.

Let me conclude by saying something about the politics of SocialSecurity privatization.

Social Security has long been, in former House Speaker TipO'Neill's words, the "third rail' of American politics--touch itand your political career dies. This was because of a perceptionthat American voters would not tolerate any major change to theprogram.

However, according to a poll of registered voters conducted byPublic Opinion Strategies on behalf of the Cato Project on SocialSecurity Privatization, the public understands Social Security'sproblems and strongly supports efforts to privatize the system.

No one should doubt the continued popularity of Social Security.Our poll results clearly showed that Social Security remains one ofthe most popular of all government programs, with two-thirds ofthose polled holding a favorable view of the program.

This popularity cuts across all age groups.

Even among so-called baby-boomers and Generation X, groups thathave expressed skepticism about the program's future, SocialSecurity is viewed as a program that has succeeded for 60 years inensuring a dignified retirement for America's elderly.

Beneath the surface, though, there is growing awareness thatSocial Security is faces significant problems and needs reform.

Only 37 percent of Americans believe that the current SocialSecurity system is fair.

In addition, far more Americans describe the current system asrisky than describe it as safe or secure.

A majority of Americans, 56 percent, believe the system eitheris already in trouble or will be in trouble in the next five to 10years.

That is why young people do not believe that Social Securitywill be there for them.

Fully 60 percent of all individuals under the age of 65 expressthis belief, with larger majorities among younger voters.

As a result, more than two-thirds believe that Social Securitywill require "major" or 'radical" change within the next 20years.

Among younger voters, approximately half believe that major orradical change is needed today.

The support for change cuts across ideological and partylines.

What about solutions to the Social Security crisis? Our pollshowed that a majority of voters reject most traditional SocialSecurity reforms such as raising the retirement age, raisingpayroll taxes, or reducing benefits. They correctly perceive thatsuch tinkering with the system will simply make the system a worsedeal for young workers, who will have to pay higher taxes for fewerbenefits.

However, privatization does have strong popular support amongvoters.

More than two-thirds of all voters, 69 percent, would supporttransforming the program into a privatized mandatory savingsprogram. More than three-quarters of younger voters supportprivatization. Support for privatization, particularly among youngvoters, cut across party and ideological lines.

As this public support emerges into the political process,Social Security will no longer be the third rail of Americanpolitics. Indeed, if politicians refuse to deal with SocialSecurity's problems, they may soon face a new third rail in theirsearch for support among younger voters.