Yet if proposals for the government to invest the trust fund in the stock market were scored on Diamond and Orszag’s risk‐adjusted basis, this would be wholly untrue: even if the trust fund diversified from bonds to stocks, it would be treated as if still held only bonds and thus actuarial balance would be unaffected.
Diamond and Orszag’s risk adjustment renders any private investment, whether undertaken centrally by government or de‐centrally by individual workers, superfluous to enhancing the solvency of the Social Security program. This would be a radical departure from mainstream Social Security analysis over the past decade or so.
Third, if benefits from personal accounts are to be adjusted for risk, benefits from the current program should be similarly risk‐adjusted. This concept applies in two ways. First, the current program is insolvent over the long‐term, promising future retirees benefits 50 percent higher than can be paid under current law financing. Hence, there is not simply a risk but a certainty that current tax or benefit schedules will be altered. Assuming that legislated tax rates are not changed, the common sense “risk adjusted” benefit baseline would be what the current program can afford to pay — that is, the payable level of benefits utilized for analysis by the Commission. By this standard, the comprehensive Commission Models pay substantially higher benefits to all retirees than the current program, with low‐wage individuals receiving the largest increases.
Moreover, benefit promises under the current program are clearly not as secure as explicit government obligations such as Treasury bonds. A worker with a personal account holding bonds backed by the full faith and credit of the government would unquestionably have a stronger claim on future government resources than a worker promised the same sum under the current Social Security program, which grants individuals no legal right to their benefits and which, as the 1977 and 1983 reforms attest, can change the rules of the game at relatively short notice. Risk adjusting current program benefits could involve estimating the risk of the current system and adjusting promised benefit levels downward until risk was comparable to that of government bonds.21
Subsidies to personal accounts
Under Commission Model 2, workers opting for personal accounts give up their traditional benefits equal to their account contributions compounded at a 2 percent real interest rate, called the “offset interest rate.“22 Diamond and Orszag argue that “Model 2 subsidizes the accounts by charging an interest rate projected to be one percent below the [3 percent real interest] rate on Treasury bonds.” The traditional program, they argue, loses money on the deal and reform therefore subsidizes personal account holders at the expense of non‐account holding taxpayers and retirees.
This argument relies on a confusion between the interest rate earned by the Social Security trust fund — which is set in legislation, and can be changed at any time — and the (generally lower) rate of return Social Security pays to individuals. In this context, several points are worth making:
1. Account holders as a group do not receive a subsidy under Commission Model 2. If a worker choosing an account gives up less traditional benefits than his account contributions would have “bought” him from the current program, he has effectively been subsidized. On average, future retirees will receive an approximately 2 percent real return from Social Security, the same as the offset interest rate under Model 2. At a 2 percent offset interest rate, most workers would give up traditional benefits worth roughly what their account contributions would have bought them. At an offset interest rate of 3 percent, which Diamond and Orszag imply would eliminate the “subsidy,” most workers would give up substantially more in traditional benefits than their account contributions would have bought from the current program.23 Hence, there is no overall subsidy to the individuals holding accounts.
Illustration: A worker earns a 2 percent return under the current program, entitling him to $1,000 per month in retirement. If he put all his payroll taxes into an account (not just part, as under the Commission plans) subject to an offset interest rate of 2 percent, he would give up all his traditional benefits — $1,000 per month. At a 3 percent offset interest rate, he would not only have to give up the entire $1,000 per month but pay an additional $200 per month back to the government. In short, Diamond and Orszag argue that to eliminate Model 2’s account “subsidies” account holders should owe the traditional system more than they would have received from it, a highly counterintuitive argument.
2. Subsidies within the group of account holders tend to flow toward lower‐wage individuals. An account‐holder entitled to a current‐program return exceeding the 2 percent offset interest rate gives up less in traditional benefits than his account contributions would have bought him in the current system. In effect, he receives a subsidy. An account holder entitled to a current‐program return below the 2 percent offset interest rate effectively pays an “exit tax”: he must give up more traditional benefits than his account contributions would have bought him.
While future retirees will receive approximately 2 percent returns on average, low‐wage workers tend to be entitled to returns above 2 percent and high‐wage workers to returns below 2 percent. Hence, while account holders as a group do not receive a subsidy, within the group low‐wage account holders effectively receive a subsidy from high‐wage account holders.24
3. Diamond and Orszag’s contention that 100 percent of eligible workers would opt for accounts means we would be “subsidizing ourselves.” Even if we accept that a general subsidy to account holders exists, Diamond and Orszag argue that participation under Commission Model 2 would be 100 percent (not 67 percent as assumed by the Commission and Social Security’s actuaries).25 If every eligible worker would become an account holder, what exists is a general tax subsidy to personal account holders with, as point 2 shows, the largest subsidies relative to wages flowing to low‐wage workers.
4. Charges of “subsidies” assume the trust fund can effectively save cash today to pay benefits tomorrow. Many believe this not to be the case. Many argue that Social Security surpluses have historically been used to hide deficits elsewhere in the budget, enabling the non‐Social Security portion of the government to tax less or spend more than in otherwise would have. If this is the case — and many on both sides of the personal accounts debate believe it is26 — then Social Security funds are effectively subsidizing the rest of the budget, not being saved to pay future retirement benefits. Saving Social Security funds in accounts that cannot be “raided” to pay for other programs simply reduces these subsidies to the rest of the budget and ensures that funds dedicated to Social Security can, in a meaningful economic sense, help pay benefits in the future.
It is true, of course, that a worker holding a personal account could increase his total benefits simply by investing in guaranteed, risk‐free government bonds. What that shows is that today’s workers effectively subsidize the system, since they receive lower returns than their contributions would earn in Social Security’s trust fund and could earn higher returns with ownership and absolute security by holding even the safest, lowest‐returning private investments. That says very little for the value‐for‐money the current Social Security program renders to the public.
The Commission’s recommendation in Model to move from the “wage indexation” to the “price indexation” of initial Social Security benefits has generated controversy, at lies at the root of charges of “benefit cuts.” At present, the initial benefits received by each annual cohort of new retirees rises by the rate of wage growth. If wage growth were 2 percent, for instance, an average‐wage worker retiring in any given year should receive benefits 2 percent higher in real terms than an average‐wage worker retiring the previous year. Under price indexing, the two retirees would receive the same benefit from the government, adjusted for inflation.27 (Total benefits under Model 2 would continue to rise, however, due to rising personal account balances.)28
Wage indexing’s principal merit is that it maintains replacement rates over time, such that Social Security benefits would comprise a relatively constant share of a worker’s retirement income. But wage indexing has several downsides as well.
The first, of course, is dramatically rising costs. The math is simple: today, the average benefit paid by Social Security equals roughly 36 percent of the average wage; since there are 3.4 workers per retiree, the required tax rate is approximately 10.6 percent (36/3.4=10.6). As the payroll tax rate is 12.4 percent, Social Security is currently running surpluses. When the worker‐to‐retiree ratio falls to 2‐to‐1, the cost to each worker to maintain that 36 percent replacement rate rises from 10.6 percent to around 18 percent of each worker’s wages (36/2 = 18). Under a wage‐indexed benefit formula, rising costs are simply inescapable.
Wage indexing means that in 2075 a maximum‐wage earner will be entitled to a monthly retirement benefit of $3,250 (in today’s dollars), yet the program will require a 19.8 percent payroll tax rate to pay such benefits. Is such a growth in both taxes and benefits truly necessary? As chairman of the 1978–79 Advisory Council on Social Security, Henry Aaron of the Brookings Institution argued for price indexing on just such a basis: