Social Security: Will There Be Anything Left?

Social Security is a broad term that includes multiple government programs. The largest of these is the Old Age and Survivors' Insurance Program (OASI). This is the pension system set up for retirees and their families. There is also Disability Insurance (DI), benefits paid to those with legal disabilities; Medicare, health care for the elderly; and Supplemental Security Income (SSI), income payments made to needy aged, blind, and disabled individuals. When we speak of "Social Security," we typically mean OASI, the retirement and survivors program. This is how we define Social Security in this module. 

Social Security is currently a hot topic of debate in the United States. Older Americans are concerned that their level of funding will be cut back. Younger Americans are concerned that they will not get anything at all. Politicians are afraid to touch the issue despite indications that the Social Security Trust Fund will be broke in the year 2037.  Here examine the history of Social Security, how it differs from traditional private pension systems, and how benefits are calculated. We discuss the fiscal projections for revenues and expenditures, and the likelihood that future generations will receive benefits. We discuss recent proposals to overhaul or modify the system, and we examine Social Security's impacts on saving and work. 

For official information, visit the Social Security Administration Web Site. 

The History of Social Security

The Social Security Administration has a succinct review of the system entitled Social Security: A Brief History. 

The Social Security Act was signed into law by President Roosevelt on August 14, 1935. The economy was in the midst of the Great Depression, and there was concern about the large number of elderly people living in desparate poverty. Under the 1935 law, Social Security only paid retirement benefits to the primary worker. A 1939 change in the law added survivors benefits, and benefits for the retiree's spouse and children. 

As the years went by and the economy boomed, Social Security benefits and coverage were broadened. Disability insurance (1954), Medicare (1965), and SSI (1972) were added. Social Security taxes were first paid in January, 1937, and benefits were initially distributed as a one-time lump-sum payment. Workers were taxed 1 percent of wages. In 1940, monthly payment of benefits began. The scope of the program has widened exponentially through the years. In 1937, there were just over 53 thousand beneficiaries receiving $1.3 million in benefits. In 1996, there were nearly 44 million beneficiaries receiving just over $341 billion in pension payments. 

If the intention of Social Security was to reduce poverty among the elderly, the program has been successful. Today the elderly poverty rate is lower than the national average, and those over 65 are the only group in the US that have guaranteed access to health care. No program is perfect, but the Social Security system has certainly managed to assure most senior citizens of a reasonable safety net. 

Social Security versus Private Pensions

Social Security was never intended to be, and never has been equivalent to a private pension system. There are elements of the system that are consistent with private pensions, but there is also a strong safety net. These objectives sometimes conflict with one another, and create tension in the Program. 

There are four main differences between Social Security and private pensions: 

  1. Participation in private insurance plans is voluntary; participation in Social Security is mandatory. FICA taxes are taken from workers' wages each month. There are very few ways to "opt out" of the system. 
  2. Private insurance is fully-funded, while Social Security is primarily a "pay as you go" system. If a system is fully funded, it has enough interest income from its assets to cover its expenses. A pay as you go system, on the other hand, does not have enough interest income to cover its expenses. This means that current Social Security recipients are being paid by current contributions to the fund. When the next generation retires, it must rely on the previous generation to fund its pensions. 
  3. Private insurance typically pays an individual retirement benefits based solely on the person's individual contribution. The funds put in by a particular individual are earmarked to return to that individual with an interest return. Social Security mixes individual contribution principles with social income redistribution goals. Social Security not only provides a pension for the primary worker, but the spouse as well as any dependent children are also eligible to receive benefits regardless of whether or not they have paid into the system. 
  4. Private pension payments are not typically adjusted for inflation. Social Security payments do increase with inflation, as measured by the CPI. Moreover, income from Social Security is not fully taxable. At most, only one-half of Social Security earnings may be taxed.

Calculation of Benefits for a Retiree

Average monthly benefits for January, 1997 were $745 for retired workers, $704 for disabled workers, and $707 for nondisabled widows and widowers. Calculation of benefits for a retiree is very complex, and the amount that each person gets will be slightly different because of the amount put in, and family conditions upon retirement. There are a few general rules, however, that determine benefits. 
  • The more that retirees have put in during their working years, the more they get out. Benefits are partially determined by the contribution that you put in, so the more you put in the pot, the more you can take out upon retirement. 
  • The return on the retiree's contributions falls with higher levels of income. That is, while low-wage earners earn less Social Security than higher wage earners, the low wage earners receive a higher benefit relative to the amount of income they have contributed. The SSA provides data for low, medium, and high wage earners who worked since the age of 22, and retired at age 65 in the year 1997. This chart is provided below.
    • Type of earner
    Monthly Benefit
    Low wage earner
    $566
    Average wage earner
    $933
    High wage earner
    $1,202
    Maximum earnings
    $1,326
    As the chart indicates, someone who earned a low wage all through her lifetime will earn about half of someone who earned a high wage. The gross replacement rate, the ratio of monthly Social Security benefits to monthly earnings, declines with an increase in earnings. Moreover, the real rate of return to Social Security can be extremely low relative to other financial investments. For example, it is not uncommon for real rates of return in the stock market to equal six or seven percent. However, the return for a two-earner couple ranges from around 2.5 percent in the low wage category to 1.2 percent for a high wage couple. Therefore, it is likely that many people currently paying into Social Security will receive a rate of return of between 1 and 2 percent. 
  • Retirement benefits are the highest if a person retires at the age of 70, and they drop by five-ninths of one percent for each month you begin retirement before age 65. 
  • Retirement benefits increase by 50 percent for a retiree with a spouse, provided that the spouse does not qualify for a larger payment on his or her own earnings record. If each spouse has worked and paid Social Security for more than ten years, then it is likely that each spouse will receive benefits based on his/her own earnings. 
  • Retirement benefits increase with the number of dependents the retiree has. 
To calculate expected rates of return based on your demographic type, click here. (This is really depressing) 

To obtain information about the contributions you've already made, visit the Social Security Administration.

You can also download the Benefit Estimate Software, which lets you estimate future benefits. 

The Fiscal Projections: Surplus and Deficit 

The Social Security Trust Fund consists of the assets of OASDI (Old Age Survivors and Disability Insurance Programs). If Social Security tax revenues in a given year exceed expenditures, the Program generates a surplus, and the surplus adds to the balance in the Trust Fund. But if revenues fall short of expenditures, the Program is in deficit and the amount in the Trust Fund decreases. The Social Security Trust Fund surpluses are used to purchase government bonds which, of course, finances the national debt. 

In the early 1980s, the Social Security Trust Fund was in crisis, nearing bankruptcy. In 1982 the fund had only $24.8 billion, and large yearly losses had been sustained since 1975. In 1983, an amendment to the Social Security Act moved forward scheduled tax rate increases, made income that used to be exempt from Social Security subject to taxation, and increased the age of eligibility for full benefits from 65 to age 67 by the year 2027.   These changes resulted in large annual surpluses. The idea was to build up a large surplus in anticipation of the retirement of the baby boomers. In 1986 the Trust Fund had a surplus of over $46 billion and it was growing quickly. Today the surplus in the Trust Fund is some $550 billion. 

The Social Security Administration's Report on the future of Social Security highlights concerns about the program's continued existence. The main problem is that the dependency ratio, the ratio of Social Security recipients to the number of workers, is projected to rise from .29 today to .50 in the year 2030. In other words, by the year 2030, for every two working people, there will be one on Social Security. Today there are nearly four workers for each Social Security recipient. Starting in 2015, Social Security Benefit expenditures will exceed tax collections. The OASIDI Trust Fund will continue to grow until the year 2022. This chart (from the Social Security Administration) shows the status of the Trust Fund over time. Due to the rapid increase in retirees, the Fund will be depleted by the year 2,037 (the latest projection). Hence there is a very real and legitimate concern that the members of Generation X will not have significant Social Security benefits. The entire program could collapse, or more likely, benefits will be reduced while tax contributions are increased. 

Solutions to Fixing Social Security

Recently, an advisory council convened to address the problems of Social Security. They recently issued their findings and solutions in the Report of the 1994-1996 Advisory Council on Social Security. They offered three suggestions which ranged from minor adjustments in the current system to a fairly radical switch to a system more closely modeling private pension plans. The notes below summarize these suggestions. The source for this information is "Different Approaches for Dealing with Social Security," by Edward M. Gramlich, Journal of Economic Perspectives, Summer 1996, v. 10, no. 3. 

Solution #1: Maintain Benefits

This solution is the least controversial, and it attempts to maintain the Program with only two significant modifications. First, taxes on Social Security benefits would be raised. All Social Security benefits in excess of previously taxed employee contributions would be taxable. The second modification is that 40 percent of the Social Security fund's assets would be invested in the stock market. This is expected to raise the overall return by nearly half. The combination of higher taxes and higher return on investment would make the Trust Fund solvent for a much longer period of time. 

Solution #2: Individual Accounts

The second approach also has two key elements. First, benefits would be scaled back by gradually raising the retirement age throughout the next century, and by lowering the replacement rates of high wage earners. In other words, those who put the most into the pie while working, will get slightly less upon retirement. The second element is the creation of mandatory individual accounts. Workers could decide from five or ten investment options for their individual accounts. The funds would be annuitized and added to their normal Social Security pension upon retirement. The Social Security system as set up now is a defined benefits system. The benefits that a retiree receives is based upon a formula that has nothing to do with the performance of the fund's assets. But the individual accounts would be a defined contributions system. The amount one receives upon retirement depends upon how much was put in to the account, and upon the return of those assets. 

Solution #3: Personal Security Accounts

The third approach is the most radical. Currently, there is a 10 percent payroll tax that funds the Old Age program, half of which (5 percent) is paid by employers, and the other half by employees. Under this proposal, the 5 percent paid by the employer would continue to fund the normal Social Security benefits at about 2/3 of the poverty level. The employees share would go into a Personal Security Account. These accounts could be held by private investment companies, and the contributor would have a large say in how these funds are managed. Funds accumulated by the individual would be available upon retirement. 

The central issue to be dealt with in this approach is transition to the Personal Security system. Today's generation of workers pays for their parent's retirement. Younger workers who join this system their entire working careers, would be paying for their own retirement. The problem is in financing those who are working now and relying on the generation after them to finance their retirement. Some sort of transition tax would have to be raised. Therefore, the transition is likely to be costly in the short term. 

This third suggestion for reform is much less focused on community, and more on individualism. It is much closer to a private Social Security plan that Chile and a few other countries have adopted. Two other factors must be considered in this proposal. First, the contributor gets to decide how his 5 percent payroll contributions are to be invested. What happens if some investment portfolios turn sour and the retired person finds himself living below the poverty line? Second, there may be some retirees who take all the funds from the Personal Security Account and blow them in the first few years of retirement. Does society have an obligation to support those people who have squandered away their savings? In other words, Personal Security Accounts eliminate much of the safety net aspect of Social Security. There is increased opportunity for poverty among the elderly that we as a society may not accept. 

Will There Be Anything Left?

After examining how Social Security works and the shape that it is in, what is the most likely scenario for those of us who retire after 2030? It is right to be concerned because best estimates show that there will not be enough funding beyond 2030 to support the elderly at the current level. However, it is unlikely that the system will collapse altogether. The most likely scenario is that workers today will pay more in taxes than their parents, yet receive less in benefits. Today's retirees are probably getting a good deal relative to future generations. There is one other possibility that is more optimistic. It could be that our economy resumes the high rates of economic growth that we saw in the 1950s and 1960s. If this is the case, people's incomes and wages will rise fast enough that it will be relatively easy to raise the funds necessary to support the retired people in the year 2030. In this case, future retirees will still get the same types of benefits that the current generation enjoys. 

Note that the U.S. is not the only country facing a Social Security Budget problem.  Most developed countries are trying to deal with the problems of an aging population and funding a public pension system.  In fact many countries are aging more quicly than in the U.S. and have more urgent budgetary problems.  Japan is one example.

Impacts on Savings and Work

Social Security has been criticized for its potentially negative incentives on private savings and work. Savings may decrease because people realize that Social Security gives them a guaranteed means of support. Therefore, they can consume more today. If saving decreases, then there are fewer funds available for investment. In other words, the economic growth rate in the economy could slow due to slower rates of capital formation and technological advancement. This result is similar to the crowding out effect from large budget deficits. The real issue is whether or not this disincentive to save is large or small. If it is small, we need not concern ourselves with this issue. But if it is large, we may try to revise Social Security in such a way that it does not lead to such saving disincentives. The leading economist on this issue is Martin Feldstein. Feldstein recently argued that Social Security could reduce private saving by as much as 38 percent! His results are very controversial. Other economists have concluded that the effect is very small. Therefore, the jury is still out. It seems like a good idea, though, to dampen the disincentive to save if and when the Social Security Program is revised. 

Social Security also has negative impacts on the number of hours that individuals choose to work over their lifetimes. There are two reasons why Social Security reduces hours worked: 

  • Payroll taxes that fund Social Security provide a disincentive for current workers to work. One of the reasons that people work is to be compensated financially. Higher taxes lowers the after-tax income that people receive, making an extra hour of work less desirable. 
  • The Social Security system induces people to retire earlier than they otherwise might. Workers today can begin collecting at the age of 62. Indeed, there has been a recent trend among white males to retire earlier than ever before. Social Security is partly responsible for this. 
The problem with these work disincentives is that there are fewer dollars flowing into the economy, and hence fewer dollar flowing into the Social Security Trust Fund. Moreover, those who retire earlier will receive pension benefits longer. Both of these effects puts more pressure on the fiscal solvency of the Social Security Program. One partial solution to the work disincentives is to force people to retire at a later age. Indeed, we have already increased the retirement age to 67 for people retiring after the year 2027. As medical improvements make retirees healthier and able to live longer, it may make sense for them to work longer. 

Links

OECD policy brief on Ageing

*Based on designs by Erick Eschker and Tim Yeager