Mend it Or End It? Kenneth Freije & Joseph Hernandez • Reforming Social Security Winter 2004

The Point - Kenneth Frieje (click here for counterpoint)

A Remnant of FDR's New Deal, the U.S. Social Security Program looks like a brilliant government policy. By providing an insurance policy for retirees, essentially a safety net ensuring the financial ability to maintain a basic standard of living, Social Security helps remove the burden of an aged underclass. Yet this system is the best example of a ‘great in theory, terrible in practice’ social program. FDR adopted the Pay-As- You-Go (PAYG) method of instituting his New Deal. Relying on the taxes of today’s workers to pay the retirement benefits of current retirees, the PAYG system offered exactly the benefits that the U.S. economy needed in the 1930s.

The system has a huge flaw, however, and this flaw is at the heart of the solvency crunch the U.S. currently faces. Only President Bush’s plan offers any hope for a sustainable Social Security program to replace the slowly dying PAYG system.

A PAYG funding scheme works perfectly when there are a large number of workers for each retiree. Young workers pay taxes, which go directly to older retirees. This seems like a good idea until we take a closer look at the actual mechanics. Although tax burdens are quite high, they do not comprise anywhere close to 100 percent of a worker’s salary; in fact, the Social Security contribution is often less than 10 percent of a worker’s total wage. The current system immediately pays out the Social Security taxes as benefits to current retirees, leaving no time for this 10 percent contribution to grow and cover each retiree solely through a single worker’s contributions. The PAYG system must thus rely on the tax payments of several workers to cover the benefits of a single retiree.

In the 1930s, this was not a problem; the population satisfied these demographic requirements. Since then, demographics have changed, and with them the burden on current workers. Through a combination of lower birthrates and increasingly long life expectancy, the ratio of workers to retirees has fallen from over 5-1 in 1960 to 4-1 in the year 2000. This ratio is expected to fall to 3-1 by the year 2040. Something has to give: either smaller benefits to retirees or higher contribution burdens on workers. Ideally, the U.S. would hold a surplus of funds from the time when the worker/pensioner ratio was higher, but as is just as true of individuals as of governments, excess funds tend to be consumed for current needs. Moreover, because a surplus is a fixed sum of money, the fundamental funding problem of the PAYG system will persist if the demographic trends that cause the surplus to fall do not reverse.

There is a better way, known in economic circles as the Fully Funded (FF) method. Here, a worker’s taxes flow into a government-held but personally owned account. The idea is similar to that of a bank account: the bank holds the money for individuals and allows them to allocate the funds, but the money will always be there when they need to withdraw funds. The funds in a FF system remain essentially untouched by the government until the worker retires. This frees the Social Security system from demographic dependence; each worker funds his or her own retirement benefits regardless of the U.S. pensioner ratio.

The first steps toward a Fully Funded Social Security system emerged in the campaign rhetoric of 2004. President Bush’s private retirement accounts—far from just another IRA or glorified savings account—are government-held but individually owned and controlled retirement accounts. Though an incomplete solution, this plan is nevertheless an important step toward a Fully Funded system.

Young people will contribute to these government-owned plans and gain partial control over the investment decisions of their Social Security funds. Today, even the most conservative investment strategies return significantly greater yields when compared with the abysmal twopercent returns of the Social Security trust fund. More importantly, current workers can rest assured that their Social Security checks will come in the mail by the time they retire. Their funds will always be available because they will never be used to pay current retirees; the money will remain in the individual worker’s chosen investment vehicles.

Any system the U.S. chooses will incur increased costs at some point. The advantage of the FF system is that the populace only feels the pain in the short term. Once the government absorbs the immediate cost of funding the current retirees and instituting individual accounts for current workers, the Fully Funded system will be in place, free of the demographic factors that plague a PAYG system.

Compare this with the increased taxes or increased retirement age (most likely both) that will be necessary to sustain the current Social Security scheme. Even if the U.S. government institutes these stopgap measures to solve the current liquidity crunch, the underlying dependence of the PAYG system on demographic trends will remain. Should the worker/pensioner ratio fall even lower, the pressure to keep the system solvent would once again force the government to increase the tax burden on current workers.

The tradeoff is simple. Continue with a system dependent on demographic trends far outside the government’s control, requiring constant adjustments and changes to maintain solvency, or make a shortterm sacrifice for the sake of instituting a stable system free from demographic shifts, ensuring a guaranteed source of retirement funds for each worker. To neutralize the third rail of U.S. politics, we must adopt a Fully Funded system.

Kenneth Freije is a senior in Branford College and Layout & Business Manager of The Yale Free Press.

Counterpoint: Joseph Hernandez (click here for the point)

President Bush plans to spend his political capital in the coming year on a bitter fight in Congress over the partial privatization of Social Security. Democrats and lobby groups, including the powerful AARP, promise to stop the president’s initiative, but the debate lacks an alternative liberal proposal. This is not because the Democrats lack a plan; rather, it is because Republicans will never allow them to bring it to the floor of the House and Senate. As proposals emerge, President Bush and the Republican Congress will already have won the image war of selling public policy, making Democrats appear obstructionist.

Both sides agree that Social Security faces serious financial hurdles, but are they serious enough to warrant undercutting the basic structure of the program? By 2042, Social Security will not be able to pay out full benefits with its current financial system. President Bush and his congressional allies present this scenario to push for partial privatization. They argue that allowing younger workers to take a portion of their payroll taxes and invest in securities (such as stocks, mutual funds, and bonds) with taxfree personal accounts will assure the system’s longevity; by producing a higher rate of return than the present system, it will empower people to secure a more steady retirement. They point to the fact that over the course of the twentieth century, the U.S. securities market always grew in inflation-adjusted dollars over the long run, even during the Great Depression.

Endorsing President Bush is the 2004 Noble Laureate economist Edward Prescott, who recently visited Yale and expressed his enthusiastic support for privatization of Social Security, but both are misguided.

First, personal accounts subject people to the risks and rewards of the stock market, thereby providing them no promise for a guaranteed retirement income. Market investments from private accounts might pay higher returns, but many individuals could easily lose all or part of their nest egg in a stroke of bad luck.

Second, privatization is not the most effective method of securing the long-term strength of the program. There is little evidence for a corollary rise between individual portfolios and financial markets, so it is unclear whether personal portfolios will rise with time. Unlike Social Security, individual portfolios do not account for rises in inflation.

Third, the deficit will pile upon the trillions already accrued under Bush’s watch. To finance the transition to private accounts, economists from Brookings to CATO agree that the U.S. Treasury would have to pay 1 to 2 trillion dollars to cover current benefits. Borrowing the money is the only likely option, since President Bush has already stated he would not raise taxes to pay for the transition. Privatization would therefore significantly increase the deficit, creating greater uncertainty in our financial and securities markets.

To assure the long-term health of Social Security and personal retirement, the administration should adjust current payroll tax laws, create another revenue source for Social Security, strengthen private investment options, and adjust the benefit structure by age.

Since the Right has turned Social Security into a debate over securing personal retirement—shifting it away from the original principle of securing a guaranteed level of income—lawmakers should discuss reforms of private-sector retirement accounts. Federal augmentation of personal 401(k)s will increase the number of people invested in securities markets without exposing Social Security to the risks associated with open markets.

Too many people are unaware of how to utilize traditional and Roth IRAs, both highly useful forms of personal retirement saving. According to dinkytown.net, a financial calculator webpage, an individual who opens an IRA at age 30, contributes $3,000 annually from a $40,000 to $80,000 salary until age 65, and earns a 6 percent return on investments would earn $300,000 for retirement (assuming a retirement tax rate of 15 percent). Individuals already have sufficient options for securities investments to assist in their personal retirement, and Social Security must not be jeopardized just to duplicate those choices.

Lastly, Congress should raise the maximum amount of taxable income for payroll taxes. When the $87,900 cap was instituted back in 1983, only 10 percent of the workforce earned that level of income. Today, 15 percent earn above that level, according to the Treasury Department. In addition, a new national sales tax of 0.5 percent to 1 percent would sustain the Social Security trust fund. A tax at this level will not hurt overall consumer spending and will build a nest egg for the entire program.

With these adjustments, Social Security and private investments can together secure and sustain the future of personal retirement.

Joseph Hernandez is a freshman in Davenport College.