Chairman McCrery, Ranking Member Levin and members of thesubcommittee, I thank you for giving me the opportunity to expressmy views on the reform of our Social Security system. Eleven yearsago, on October 4, 1994, I had the opportunity to speak before thissame Committee and in my written testimony I offered:
As both a son and a father, I am interested that theelderly are well cared for, and that the young have the opportunityto build sufficient assets so that they, too, can retire indignity. Social Security, as presently structured, ultimately willachieve neither objective. Although compassionate in its originalintent, it is flawed in design.
The system’s financial structure is fundamentallyunsound. Legislation of 1977 and 1983 attempted to address this byraising taxes and cutting benefits; Social Security was to be onsound financial footing well in to the 21st century. And now, justa few years later, The 1994 Board of Trustees’ report suggests thatthe system will run out of money seven years earlier than itprojected just one year ago. Legislative initiatives to reducebenefits further and raise taxes are again on the drawing board.This did not work in 1977 or 1983; it will not work now. SocialSecurity’s financial integrity requires an entirely differentapproach. I offer this testimony in the spirit of the startingpoint for an alternative: a concept of privatization whereinAmericans benefit from the engine of a free economy and freechoice. With privatization properly structured, today’s elderlywill be protected, the young will retire with higher incomes, andour political leaders will have offered, once and for all, alasting solution for which all voters will bethankful.
Since that testimony our nation has had a vigorous and opendiscussion. Many new ideas have been offered, ideas not developedprior to 1994. The climate of opinion has changed; more Americansare now aware of the issue, more Americans want the option to saveand invest for their own future. We are getting closer to the pointwhere the “rubber meets the road,” when you, as Members ofCongress, will have to vote. Your decision is more important thanperhaps you know. It has been eleven years since my first testimonyon this issue and in many ways, but certainly not all, little haschanged politically; we’re still talking about raising taxes andreducing benefits. We have wasted precious time.
A Collision Course
Like other nations we face an unprecedented challenge of how todeal with a reality that mankind has never confronted before andone that most people are unaware of. How we and other governmentsrespond will affect each American citizen, our families, businessesacross the land, indeed our very way of life. The reality is notonly unprecedented, it is unyielding.
Dr. Karl Otto Pohl, former president of the German central bank,the Bundesbank, stated it this way: “In a relatively short period,we must adapt our domestic institutions, internationalrelationships, and even our individual life plans to a new, andpowerful reality.”
What he was speaking of, and what confronts each of us here, isthe fact that there are two powerful forces on a collision course.The first is the aging of society, the reality that the elderlypopulation is increasing more rapidly then the population as awhole. In America, but even more so in other countries, the elderlyrely on Social Security to survive financially. Should SocialSecurity falter, many elderly will be destitute.
The second force is that most Social Security systems, includingours, are, in fact, failing. They are financially unstable, and notsustainable as they are presently structured.
The challenge is to avoid the collision of these two forces. Inmy view, the risks are high that we will not. But should we prevailby structuring a lasting solution, the rewards will be asunprecedented as the challenge itself.
The Early Years: Social Security’s Roots
Social Security was enacted in 1935 during the Great Depression.During the first half of the 1930s real GDP fell by about 25percent, unemployment jumped to 22 percent and the stock marketvirtually imploded and fell about 70 percent. Our nation was on hereconomic knees. President Roosevelt had to do something, somethingbig, but large government programs were anathema to the frontierspirit of our young nation. In order to achieve his goals he neededunprecedented authority. To grasp that authority he went before thenation on March 4, 1933 in his first Inaugural Address and askedfor authority “… as great as the power that would be givenme if we were in fact invaded by a foreign foe.” He achieved hisgoal and ushered in Social Security, the flagship program of theNew Deal.
Much like other Social Security programs that preceded ours, thefirst being Germany’s in 1889, benefits paid to the elderly werefinanced by payroll taxes. In our case, during the GreatDepression, people who had jobs were considered the wealthy. Itwasn’t like today wherein Americans have portfolios of stock andbonds, real estate, defined benefit and contribution plans and thelike; you were considered wealthy if you had a job. And needs wereso urgent that the “payroll wealth” was taxed. A saving andinvestment structure would not have worked at that time because ittakes time to compound investment returns to accumulate wealth, andtime was short.
Today: A Fundamentally Flawed Program
Over the decades, however, this sort of urgent safety net hasturned into the rough equivalent of a defined benefit plan. Yet itsfinancial structure has not advanced. The Old‐Age and SurvivorsInsurance part of Social Security, as its finances are presentlystructured, is inefficient, financially unsound and fundamentallyflawed.
Because benefits are paid by taxing payroll, benefits canincrease by no more than payroll increases, assuming that the taxrate on payroll is held constant. Over the last four decades or so,payroll has increased by about 1.5 percent per annum in real terms.That is roughly equivalent to saving and investing and receiving arate of return of 1.5 percent. To put this into perspective, if onewere to save $1,000 each year for a 45‐year working career and earn1.5 percent, the saving would accumulate to about $64,000. Duringthe last 79 years a mixed portfolio of 90/10 percent large/smallcompany stocks earned an inflation‐adjusted average annual returnof 9.7 percent. One thousand dollars invested annually for 45 yearsearning that return would accumulate to about $650,000. And aconservative portfolio of 60/40 percent stocks and bonds,respectively, would accumulate to about $288,000. These differentvalues give a glimpse of the lost opportunity that our citizensincur by being required to finance their retirement through payrolltaxes.
But it is worse. For any particular age group it matters howmany workers pay taxes relative to the number of retirees whoreceive benefits. The change in this ratio is largely determined bythe change in national wealth, or GDP per capita. As nationalwealth rises, life spans also rise. We observe this not only herebut across all parts of the globe. When Social Security was enactedlife expectancy at birth was 61 years of age; it is now about 78.In the post‐war period global life expectancy has increased from 45to 65 years of age, a greater increase in the last 50 years or sothan in the previous 5,000 years. This is all new. We didn’t expectit. But now we think it will continue.
Also, as nations become more wealthy birth rates fall. In manycountries they have fallen below the population replacement rate of2.1. The combination of rising life expectancy and falling birthrates causes havoc with pay‐as‐you‐go financed Social Securitysystems. In the United States there were 16 workers per beneficiaryin 1950; today there are about 3.3. It is expected that there willbe only two in just 35 years. Therein lies an interesting paradox:as countries become more wealthy their Social Security systemsbecome more poor. The oddity is driven by the causal relationshipbetween increasing wealth‐and increasing life expectancy as well asdecreasing birth rates‐all wrapped around pay‐asyou‐ gofinancing.
Birth rates have fallen to such low levels in Europe-France‑1.9,Germany‑1.4, Italy‑1.3, Spain‑1.3‑that “there is now no longer asingle country in Europe where people are having enough children toreplace themselves when they die.”
The Global Political Response: Raise Taxes
The political responses to the changing demographics thatsqueeze Social Security’s finances are frequently the same acrossthe world. Governments and politicians tend to see the problem inthe narrowest of lights: merely a solvency issue‐too many benefitspaid, too few taxes received. This near‐sighted analysis is furthercompounded by the focus on just today’s solvency and nottomorrow’s.
But from this myopic perspective the options are clear; raisetaxes, cut benefits. Of the two, governments tend toward raisingtaxes first. This makes sense for at least a couple of reasons.There are more workers to tax than there are retirees from whom tocut benefits. Therefore, if the choice were only one or the other,raising taxes inflicts a lesser per capita burden. The secondreason is that workers are younger than retirees, therefore, theyhave more time to adjust to a tax increase than retirees have toadjust to a benefit cut.
The short‐sighted strategy of raising taxes has been employedworld‐wide. In the United States, for example, in 1950 when therewere 16 workers per beneficiary, the maximum Social Security taxany American worker paid was $90 a year. At that time the tax ratewas 3 percent on only $3,000 of wage income. As the glacial forceof demographics slowly and unrelentingly squeezed the system, the$90 tax rose and squeezed the worker. Now, the tax, just for theretirement portion of Social Security, is 10.6 percent of $90,000,or $9,540. After adjusting for inflation over the last 55 years,that tax has increased almost 2,000 percent. In all likelihood, thereason that we stood for this is that the tax rose slowly; theincrease was never really noticeable in any one year, but over timeit has become more of a burden than the income tax for about threequarters of American workers.
Our friends in Europe, however, would consider us lucky. Thepayroll tax in France is about 50 percent and in Germany, Italy andSpain it ranges roughly between 38 and 42 percent. It is true thatthese countries’ systems provide more services than ours, but thisis not a plus. Europeans are dependent on more of their needs fromgovernment programs that are not sustainable.
As many European nations have raised their payroll taxes toprohibitive levels they have choked individual economic freedom andincentive. Economic growth is stagnant, and unemployment rateshover around 10 percent, even 12 percent in Germany. Civil unrestis now more common in Germany and France as governments tell theirpeople that benefits are no longer affordable and will have to becut, while at the same time they extol the virtues of the welfarestate. We are on the same path, but for the moment we trail farbehind.
Then, Cut Benefits
At some point, the strategy of raising taxes approaches apolitical wall. People sense that maybe, just maybe, they couldachieve more with their hard‐earned wages than they get from SocialSecurity. Politicians sense this and move to the lesser desirableoption of cutting benefits. Such blunt language, however, is notcommonly uttered. Code is employed: progressive price indexing,longevity indexing, adding a third bend point, reducing bend pointfactors, increasing the NRA, decreasing the PIA, and it goes on andon. It’s all code for cutting benefits.
Fundamental Reform: Retarded by the Claim ofInsurance
Eventually, after cutting benefits hits its political wall, thethinking shifts to fundamental reform, saving and investing inwealth‐producing assets for all workers. This idea of market‐basedfinancing for retirement income is not new, in fact it is old andwell established in the private sector, but it is viewed with somedisdain from advocates of the status quo. They object to the notionthat Social Security should be an investment structure and defendtheir objection by claiming that it is insurance. This claim hadsome merit decades ago. Not now. In fact, Social Security’sfinances are in trouble largely because they are inappropriatelybased on the insurance model.
Insurance works well when many people are subject to an eventthat has little chance of happening to any single individual. Agood example is homeowners’ fire insurance. Many people buy fireinsurance to protect their homes and yet few homes burn. Becausethe number of homes insured is many times the number of homes thatburn, the annual insurance premium is very low relative to thereplacement cost of one’s house. Insurance companies are simply themedium through which individual uncertainty of loss is transferredto, and financed by, the group.
The insurance model does not work well when the group is subjectto an event that the entire group experiences. For example, if itwere certain that everybody’s house would burn down, say, when theowner reached age 65, then insurance companies would have to chargeannual premiums the future value of which would be the cost ofrebuilding all the houses. This premium would be a large multipleof the premium charged for the uncertain case. Central to theinsurance model is that the ratio of the annual premium to thedollar value of what it protects is negatively correlated to theuncertainty of individual loss.
Social Security is frequently heralded as insurance, moreprecisely social insurance. The ‘social’ part of the term merelymeans that the government plays the role of the insurance company.Other than that, it remains the insurance model. When SocialSecurity was enacted in 1935, life expectancy was 61 but benefitsweren’t payable until age 65. Now benefits are payable at age 62and life expectancy is 78. The element of uncertainty has kind offlipped upside down. Because of this, the retirement component ofSocial Security isn’t insurance; once born, reaching age 62 andneeding retirement income is almost certain. As a result, there isvery little risk, or uncertainty, to transfer to thegroup,resulting in the fact that annual premiums must be enough toaccumulate to a sum, including interest, that will financeretirement income.
Under these conditions, social insurance cannot provide suchincome at a lower cost than saving and investing for retirement.Unfortunately, however, it can and does provide it at a higher costbecause it is financed through the payroll tax and is subject tounyielding demographic forces. In a perverse way Social Security’sfinances and its adherence to the insurance model are caught in akind of time warp; in the age of the iPod Social Security is a 78RPM, wind‐up phonograph. Unless protected by the power of thestate, it can neither compete nor survive.
The State Monopoly Faces Competition
Being protected by the power of the state really means that for10.6 percent of their wage income American workers are not free tochoose among alternatives for their retirement. Bad as that is, the10.6 percent doesn’t buy much relative to reasonable and availablealternatives. This is why Social Security is mandatory; few wouldparticipate if they had the freedom not to. Competition, as always,is a threat to the status quo. For workers, however, competition istheir hope.
Competition would allow all workers to invest part of theirpayroll tax in capital markets around the world, in professionallymanaged portfolios that are highly diversified across assetclasses, national borders and time. Such an opportunity would allowone to accumulate enough wealth to replace the pay‐as‐you‐gobenefit entirely.
For an average wage worker retiring this year at age 65, SocialSecurity’s scheduled benefits are projected to replace about 42percent of his last year’s wage. But for workers retiring in thefuture full benefits won’t be paid until age 67. For those futureretirees, should they choose to retire at age 65, benefits willreplace only 36 percent of their last wage. The worker’s cost forthese scheduled benefits, which are in excess of what is affordablebased on present law, is the 10.6 percent payroll tax.
The Market‐Based Alternative
The market‐based alternative is significantly more attractive.Over the last 79 years a conservative portfolio of 60/40 percentstocks and bonds, respectively, earned a real return of just alittle over 7 percent. Investing just half of the retirementpayroll tax, 5.3 percent, each year for 45 years would provide aretirement benefit equal to 97 percent of one’s last year’s wage.This assumes that there is no interruption in saving each year,that the market return is as stated and falls by 2 percent duringthe distribution phase, and that life expectancy upon retirement is20 years. Each of these assumptions can be changed. Work may beinterrupted. Markets may do worse or better. Life expectancy may bemore or less than 20 years once retired.
To take a conservative path, if the market return were only 5.5percent and if life expectancy were 30 years at the onset ofretirement‐about 10 years more than assumed by Social Security‐thenunder these conditions the replacement rate would 39 percent,higher than Social Security’s scheduled benefits at age 65 andsignificantly higher than payable benefits.
Americans Understand the Tradeoffs
Our citizens sense these tradeoffs, risks, uncertainties, andthe fundamental differences in providing retirement income from atax system versus a saving and investment system. This is why, butonly part of why, they want the option, the freedom to choose.
If they could acquire this freedom they also would have personalproperty rights over their accumulated wealth. They have no suchrights to Social Security benefits. They also could bequeath someor all of their retirement assets. They cannot under SocialSecurity. They would benefit from the direct relationship betweeneffort, their saving, and reward, their accumulating wealth. Theywould have the dignity that comes with being personally responsiblefor their future. They would no longer be tethered to thegovernment. They would no longer be subject to politicians’preferences over when they can retire, how much they can get, howtheir spouses are treated, how much they’re going to pay, and allof the rules and regulations that have evolved to the point ofbeing incomprehensible. They would be free.
It’s been eleven years since I had the opportunity to speakbefore this Committee. Although much of what I am saying today iswhat I said then, I hope that we are closer to fundamental reform.If we are not, and the two powerful forces that I mentioned abovein fact collide, we will edge closer to the wrenching difficultiesthat Europe is now facing.
You, Congress, are the Hope
But should we grasp the extraordinary opportunity that thischallenge offers, we will forever strengthen our nation, oureconomy, our freedoms, and our ability to finance the many needsthat the future will undoubtedly require. It is a matter of willand political leadership in seeing the benefits of greater personalfreedom and acting to ensure them. You, as Members of Congress,have the unique opportunity to offer, once and for all, a lastingsolution for which all Americans will be forever thankful.
William G. Shipman