February 2005
With the coming blitz of media coverage on the proposed changes to our Social Security system, we thought a primer on the main challenges surrounding this important program was especially timely. Politically, this could not be a more divisive issue, but beyond the rhetoric are real, substantive choices to make.
With President Bush's State of the Union address just completed, it is now clear that Social Security reform sits firmly atop his very ambitious agenda. In his speech he said that by 2042 - without changes - the Social Security system will be "entirely exhausted and bankrupt".
These types of declarations send shivers up the spines of both current workers and today's retirees who are dependent on the system. According to a recent study on the plan, for about 2/3rd of the elderly, Social Security provides the most of their income. Even more importantly, for 20% of the poorest retirees in our country, it is all they have.
The reform debate pivots on a few basic facts about the current health of the system. First, with the looming retirement of the Baby Boom generation about 77 million more people will soon start getting monthly payments. This is in addition to the current 50 million already receiving monthly benefits.
The actuaries working for the Social Security Administration have the tough job of providing best-guess projections on the state of the system. They have made calculations that show that by 2018, the inflow of payroll tax collections will not be enough to pay for all of the promised retiree benefits. The system will need to then dip into its reserves - the trust fund. According to some estimates, by 2042, the trust fund would then be depleted entirely. At that point, without any changes to the system, taxes collected from workers - almost 40 years from now - would only be able to afford to pay 70% of benefits.
With some slightly changed assumptions and a combination of moderate reforms, the exhaustion date extends even further out. It's important to realize that a huge number of very hard to predict items go into making these types of long-range projections. In the words of one former Social Security commissioner, "In 1928, there was no way to forecast the Depression, World War II, or the birth-control pill. We have to stop acting as if our 75-year estimates were absolute."
Demographic shifts are a big reason we have this issue at all. But we've known the Baby Boomer generation was coming since - well - since they were born. During the last major reform of the Social Security in 1983 headed by now Fed Chairman Alan Greenspan, our system has taken into account the demographic challenge that we will soon face. The poor health of the system back then was very real and through a tough combination of tax increases and benefit cuts a more solidly funded system was put in place. Nothing has drastically changed since then. But our perceptions and political environment has changed.
Behind the sense of an impending crisis is a broader political concept. President Bush has adopted the vision of an "Ownership Society" into which fundamental Social Security reform fits very nicely. Which brings up the current administration's most controversial proposal - one which we, as money managers, feel particularly capable of addressing - private investment accounts.
Creating private accounts will allow a portion of each worker's payroll tax contribution to be diverted into individual accounts rather than into the collective Social Security trust fund. With these private accounts, workers will be free to choose from a limited number of investment funds in an effort to get a bigger return on their money. The main point here is that they will own the account - for better or worse. But what are younger workers giving up to own these private accounts? And will they fix the system financially?
The plans under construction will likely give younger workers private accounts in return for accepting lower Social Security benefits at their retirement. Even with historical investment returns in stocks and bonds, some projections show that for middle-income retirees, the combined total of income from private accounts and Social Security benefits will be less than the current system's promised benefits. Fortunately, those same projections show lower-income workers will just about break even under the proposed new structure.
But if introducing private accounts results in the same or even less benefit to future retirees, what is the actual point of having them at all? The right marketing of private accounts may make a benefit cut politically feasible.
Almost everyone agrees that the economic benefits of private accounts could be easily captured if the trust fund instead invested a portion of its money in diversified index funds. Doing so would avoid the creation of 150 million separate private accounts. But it also limits the ownership concept. The battle over private accounts is going to be huge but in isolation their existence is not an economic fix.
The big fix comes with benefit cuts for future retirees. And the proposals out there are not easily understood. Currently, the promised benefit amount that future retirees get is based on their wage level when they retire. This is referred to as a "wage-indexed" benefit. The proposed change is to adopt an "inflation-indexed" system. This change produces large savings for the government.
For generations wages have increased faster than the inflation rate. In other words, we all live better in "real" terms than previous generations did. Under the current system, benefits are designed to replace a set percentage of each retiree's pre-retirement wages. Switching to an inflation-indexed system will effectively result in every successive generation of retirees getting a lower and lower wage replacement percentage from Social Security. The big question is will timely investment moves between the five broadly diversified investment funds make up for the benefit cuts?
Since current retirees and workers over age 55 will still get their promised benefits, the government will be forced to borrow up to $2 trillion dollars before future benefit cuts kick in. That's the projected price tag of implementing private accounts. Can our indebted nation afford this much reform this quick? Are we prepared for the economic issues that might come of this borrowing? Have we prepared our future retirees for what these changes mean to them? Are there other moderate reforms that we could or should adopt first?
The questions go on and on and the answers need to be thoughtfully debated. Social Security is complicated - but it is also a slow changing system - is it fair to ask if this is a legitimate crisis today?
Jason P. Tank, CFA
jason@frontstreet.com