Ten Myths About Social Security (Part 1)

Posted by Jeffrey Brown on Nov 15, 2010

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy)

The Social Security Administration was established during the Great Depression by President Roosevelt and has been an enormously successful safety net for the people of the United States.  It has undoubtedly kept millions from poverty in the event of retirement, disability or death of the primary breadwinner.  In the 75 years since the program’s inception, however, times and circumstances have changed, and the system’s financial structure has become unsustainable.  Under the current system, there are two primary options for closing the large financing gap that exists: either increase the revenue dedicated to the system (i.e., increase taxes) or reduce expenditures from it (i.e., cut benefits).  Beginning today, I will bring to the CBPP blog what I consider to be the top ten myths (in no particular order) of Social Security reform, in my best attempt to add some clarity to this debate.  These myths are adapted from a paper I wrote along with Kevin Hassett and Kent Smetters that appeared in the Elder Law Journal.  I will begin by looking at whether the system really needs to be reformed at all.

Myth 1:  Social Security is Financially Sound for “Decades to Come”

A leading argument against reform of the Social Security system is that “Social Security is financially strong and will remain strong for decades to come.” Implicit in this statement is that it is okay to follow a “do nothing” approach to reform Social Security.  Defenders of the “do nothing” approach point to the fact that the Social Security Trust Fund[1] is projected to have sufficient resources to pay full retirement benefits through the year 2037 (according to the Social Security Trustees) or the year 2039 (according to the Congressional Budget Office). While it is true that the data of Trust Fund exhaustion is several decades away, this fact is not a particularly salient one when it comes to analyzing the broader economic or budget implications of the Social Security system.

To understand this debate from a broad economic perspective, it is important to understand how the Social Security system is financed.  For most of its history, Social Security has been financed primarily on a “pay-as-you-go” basis.  What this means is that in a given year, the taxes paid by workers in that year are immediately spent to provide benefits to individuals who are receiving benefit payments in that year. In other words, Social Security is primarily an income transfer system, not a savings program.

One implication of this financing structure is that the required balance between tax rates and benefit payments is sensitive to the ratio of the number of workers, who pay the taxes, to the number of beneficiaries, to whom payments are made.  To put this relation in very simple mathematical terms, the following relation will hold in an annually balanced, pure pay-as-you go system:

For example, in 2006, the average Social Security benefit was approximately 36% of the average worker’s wage.  In that year, there were 3.3 workers paying into Social Security system for each beneficiary.  Thus, the cost to each worker to support each beneficiary was around 10.9% of earnings (36 / 3.3 » 10.9).  Because the payroll tax rate is set at 12.4% of covered earnings, Social Security ran a surplus in that year.  Indeed, if the ratio of workers-to-beneficiaries were projected to stay constant at 3.3 for the indefinite future, then we would have the pleasant option of reducing payroll taxes from 12.4% to 10.9%, or increasing benefits from 36% of an average worker’s earnings to 42%.

Unfortunately, the worker-to-beneficiary ratio is not constant.  Back in 1950, there were over 16 workers per beneficiary.  Today we are down to a ratio of about 3.0.  By the year 2030, as a result of lengthening life expectancies and declining fertility rates, this ratio will decline to only 2.1.  To put this into perspective, with a worker-to-beneficiary ratio of only 2, then a Social Security program that pays benefits equal to 36% of the average worker’s earnings would require a payroll tax rate of 18%, or 45% ((18-12.4)/12.4) higher than today’s rate.  Alternatively, to live within the existing 12.4% payroll tax, benefits would need to decline to under 25% (a 30% reduction) of the average worker’s earnings.  In short, the pay-as-you-go structure of the existing Social Security system, when combined with a declining ratio of workers-to-beneficiaries, requires either that tax rates rise or that benefits fall by a substantial amount over time.

This stylized example closely mirrors actual cash flow projections prepared by both the non-partisan Social Security actuaries as well as the Congressional Budget Office (CBO).  Although we have been running Social Security surpluses in recent decades, in a few years these surpluses will changes to deficits, and the deficits will grow every year thereafter.  Indeed, by the time today’s college senior reaches their normal retirement age of 67 in the year 2055, the annual cash flow deficits will amount to 3.14% of covered wages (according to intermediate projections by the Social Security trustees).  This means that in order for the system to be in annual cash flow balance, taxes would have to be quite a bit higher, or benefits substantially lower, than scheduled under current law.

Some point out that even though they system will start running cash flow deficits in just a few years, we have nothing to worry about because the Social Security trust funds will not be exhausted for another three decades.  This is technically true from a narrow, government accounting perspective, but it is not true from a broader economic perspective.  While the bonds in the Trust Fund are an asset to the Social Security system, they also represent an equally large liability to the U.S. Treasury.  Thus, from the perspective of the federal government as a whole, the Trust Fund asset is exactly cancelled by a corresponding Treasury liability.  It is roughly akin to an individual borrowing money from himself – because he creates an asset and a liability of equal size, his net worth is unaffected.  As a result, when these bonds are redeemed, the Treasury must come up with the resources to fulfill those obligations.  Ultimately, this money can only come from one of three sources: i) higher taxes, ii) reduced government spending, or iii) issuing additional debt to the public, which simply means higher taxes or reduced spending at some point in the future.

But, you may ask, what happened to those surpluses in the year they were generated?  From an economic perspective, the Social Security surpluses of the past two decades helped to reduce the burden on future generations only to the extent that they increased national saving over this period.  Holding constant the level of private saving as well as all other government revenues and spending, adding one dollar to the Social Security surplus adds one dollar to government saving and thus to national saving.  However, many analysts believe that the very existence of the Social Security surpluses over the past twenty-five years have made it easier for Congress to run larger deficits in the non-Social Security portion of the budget, essentially using the Social Security surpluses to “hide” larger deficits in the rest of government.  To the extent that this is true, the net increment to national saving of the Social Security surpluses is reduced.  Indeed, work by Wharton Professor Kent Smetters has provided empirical time series evidence suggesting that the Social Security surpluses net contribution to national saving has been close to zero. If so, then the balance in the Social Security Trust Fund is little more than an accounting fiction.

For these reasons, it is incorrect to assert that Social Security is “financially strong and will remain strong for decades to come.” To argue that we can ignore the problem for several decades simply because we have an accounting balance in the Trust Fund is fiscally and economically irresponsible.  It is worth noting that two of the leading economists who strongly opposed President Bush’s reform plans – Peter Orszag (who went on to become President Obama’s budget director) and Peter Diamond (who won the 2010 Nobel prize in economics and was nominated by President Obama to become a governor of the Federal Reserve system) agreed that the fiscal problem facing Social Security is quite real, and that acting sooner rather than later is good public policy. A constructive debate about the future of Social Security should accept that a problem exists, and focus on alternative methods of restoring long-run, sustainable fiscal balance to the program.  Simply denying that the problem exists will not make it go away.

[1] Technically, there are separate trust funds for the Old Age, Survivors Insurance program (OASI) and the Disability Insurance program (DI).  For the rest of this blog, I will refer to the combined balances of these funds as the Social Security “Trust Fund.”

11 Responses to “Ten Myths About Social Security (Part 1)”

  • Charles says:

    Given Congress’ unwillingness to raise taxes or decrease benefits for Social Security and the general public’s lack of knowledge on this issue, how do you suggest we go about fixing the program? As I remember you saying in class, education doesn’t do much to change behavior, so is there any way to create a system that automatically adjusts benefits and taxes for the long-term sustainability of Social Security without people balking?

  • Tina H says:

    I can not imagine anyone still believing that myth and how Social Security is Financially Sound for “Decades to Come.” I completely agree that it is socially irresponsible for people to resist to changes. In the generation where people have no problems recycling their water bottles to preserve the environment for future generations, they should also be able to incur higher taxes or lower benefits to preserve social security for future generations as well. This contradiction is blaringly obvious and uncomfortable for me to handle. Wouldn’t you all agree?

  • Amanda Nagode says:

    I agree with Tina that it is hard to imagine people believing that Social Security is financially sound. However, I do not think that it comes down to believing but instead being oblivious to any facts about Social Security funding. The sole reason that we (the ones commenting on blogs like these)are knowledgeable about this problem is because of taking an employee benefits course. Most of our generation has no idea that soon a huge chunk of their paycheck will go towards paying for their parents’ social security income. Perhaps they issues need to be put on Facebook or Twitter to get our attention. I have done some research on this issue having recently read the provisions proposed by the cochairs of the President’s Fiscal Commission. According to the President’s Fiscal Commission report, indexing retirement ages to life expectancy is one way to restore 36% of Social Security’s solvency. Change definitely needs to happen but there seems to be no easy solution. I am personally a little scared for the future of my personal Social Security income.

  • YW says:

    I think that any projections out more than 10 years are not reliable and practical due to the fact that the social security system, the operation and its financial health condition tie to other major areas and functions. Probably, we need to make some serious changes in our tax structure, entitlement structure and federal budget, so, only time will tell.

  • SE says:

    I think it is pretty easy to see how people can still believe arguments such as Social Security being financially sound. There is a lot of punditry in the media and a lot of people follow their opinions. People need to become more educated on topics such as Social Security so they can see what the funding situation is actually like instead of just repeating what they hear on tv or read on blogs. If this happens, then I think we will be able to move towards viable solutions.

  • Meghan says:

    What is disconcerting is that these supposed “expert” financial leaders possess the ignorant belief that Social Security is not only financially sound, but that is will remain strong in decades to come. I would hope that those controlling our nation’s fiscal health would be fiscally responsible: they would see the extreme futility of the “do nothing approach” and protect us from its devastating effects. It is unfortunate that the only two options that would solve this Social Security crisis, raising payroll taxes or cutting benefits, are politically adverse, but right now they seem to be the only resolutions. Hesitation to invoke any policy due to political criticism is both cowardly and reckless – we need to fix this problem and now.

  • John Keady says:

    I believe that the American people have realized that Social Security is going to fail in the very near future. With the rise of the Tea Party and TV personalities such as Glenn Beck, our country has begun to take note of the dire US debt situation. The only problem is that the general public, Tea Party politicians, and pundits demand that the problem be solved, but they would never support a rise in taxes or cut in benefits. Somehow, there is growing disconnect between what people want, and the reality of what they need to do to get it.

    People want the Social Security problem to be solved, and there are real solutions that have been proposed. The only problem is that no one in Washington can solve the problem without getting thrown out in the next election for raising taxes or cutting benefits. The American people need to grow up and realize that for us to solve Social Security and the underlying US debt crises, that everyone is going to have to make sacrifices. End of story.

  • Matt W. says:

    Most Americans would say that Social Security is not financially sound but the problem is that veiw is too black and white. Indentifying the “true” solution to SS is different from individual to individual. As a result any debate on changing Social Security will essentially be an arguement on unrelated issues.
    Amanda suggested changing retirement age. Another person may suggested raising taxes. These leads to the possibility that even if some social security reform does pass, even before results can be seen another debate will start saying it needs to be reformed again, or changed back.

  • Rohan Sahasrabudhe says:

    As cynical as this view is, I do not believe that the situation will be solved, or even sufficiently approached, within the next decade. Since the only real approaches are either to increase taxes or decrease benefits (disregarding the floating of additional debt, as the “full faith and credit” idea loses meaning over time, and may even cause a credit crisis should China decide to ever cash in as a political move), people in reality care little about future generations.

    Aside from the people’s unwillingness to clamp down, there is also the fact that politicians are in the job not to represent the will of the people, but to get re-elected. Neither choice is politically tenable, and thus will get ignored due to fear of devastating campaign ads. In addition, we have seen from past precedent that large reforms are generally delayed-effect or staggered. Thus, should Congress even squeeze through a piece of reform, deficits will likely continue to accrue for a couple of years, all the while being vulnerable to repeal.

    Should anything ever come of the debate, I believe that the most tenable reform would be a rescaling of the Social Security benefit to only provide benefits for low-income individuals. Though the Republicans are likely to cry foul about socialism and redistribution of wealth, it would be less abhorrent to voters than a tax increase or blanket decreased benefits.

  • Hillary Haen says:

    It seems to me that pay as-you-go systems are similar to a pyramid scheme in the sense that it always works out well for the people in the beginning, and then bashes the people in the end. Who believes that a pyramid system is the right way to do things? Probably the same people that believe the social security system is in no trouble at all. I am also an accounting major and it seems as if there are major cash flow problems arising for social security. Just because the books say that money is somewhere doesn’t mean that it is easy to get a hold of and use. Social security money is tied into securities and there are economic consequences in that.

  • Lauren Siemienas says:

    The discussion about how either taxes should be raised or benefits should fall really increases my awareness of the proposed tax cut that Obama wants to implement. For those of us that don’t understand the implications of the tax cut, it looks very attractive. However, by reducing taxes we are reducing the amount of money that would contribute to social security, forcing the government to borrow more money to maintain social security at an appropriate amount. I’m not sure what the answer is, but as Hillary posted, just because it “says” we have social security money on the books, I am really curious as to how much will actually be available.