Happy 75th Birthday Social Security. But What Now?

Posted by Jeffrey Brown on Aug 9, 2010

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy)

This coming Saturday, August 14, marks the 75th birthday of the U.S. Social Security system. Specifically, it marks the date that President Roosevelt signed the Act into law, famously stating:

“We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life, but we have tried to frame a law which will give some measure of protection to the average citizen and to his family …”

The original Act specified that benefits were to be paid only to primary workers when they retired at age 65.  The Act established that benefits would be based on payroll tax contributions made during the working years.  Of course, the program has been modified many times over the years (e.g., allowing benefits to be taken at 62, expanding coverage to spouses, disabled workers, and others, dramatic increases in tax rates, changes in benefits, etc). 

Initially, benefits were paid as a lump-sum.  While Ida May Fuller is best known as the first recipient of Social Security benefits, SSA’s historian indicates that the first benefits were paid as a lump-sum, and that:

“The earliest reported applicant for a lump-sum benefit was a retired Cleveland motorman named Ernest Ackerman, who retired one day after the Social Security program began. During his one day of participation in the program, a nickel was withheld from Mr. Ackerman’s pay for Social Security, and, upon retiring, he received a lump-sum payment of 17 cents.”

It was not uncommon for early recipients to receive much more than they put in.  Indeed, it has been estimated that the net transfers to early generations of recipients is well in excess of $10 trillion.  In other words, for most of the last 75 years, the majority of Social Security recipients received far more in payments than they paid into the system (and, yes, this is true even if one accounts for inflation and implied interest on those contributions.)

How is this possible?  Actually, it is quite simple.  Social Security is not a funded pension system.  It is a “pay-as-you-go” transfer system in which the funds paid out to current beneficiaries are provided by current taxpayers.  Such a system can work quite well so long as we have wage growth and so long as the ratio of workers-to-retirees is stable or growing. 

But therein lies the crux of Social Security’s financing problems.  Unlike what many citizens believe, the true problem facing Social Security has very little to do with Congress’ penchant for “spending the Social Security surpluses” of the past 25 years.  It has far more to do with the basic financing structure of the program.

In the 1950s, there were 16 workers paying taxes to support each Social Security beneficiary.  By the time JFK was elected President, it was about 5 workers per beneficiary.  Today we have a bit more than 3 workers for each beneficiary.  In my lifetime, that will fall to 2 workers per beneficiary.

So do the math.  If you want to replace 40% of the average workers income upon retirement, and you have 16 workers supporting each retiree, you only need to collect taxes from each worker equal to 2.5% of their income (2.5 x 16 = 40).  With only 5 workers per retiree, you need to tax them at a rate of 8%.  When there are only 3.3 workers (today’s ratio), you need a tax rate of 12.1%.  (Today’s combined tax rate is about 12.4%).  As the ratio falls to 2-to-1, tax rates need to climb to 20% to keep the system in balance.

(I am simplifying a bit here, but it is remarkable how closely this very simple calculation mirrors the Social Security Trustees’ long-term financial outlook!)

So, as we celebrate the birthday of the Social Security system, we have to ask ourselves some difficult questions.  Can we afford the system we have?  If not, whose benefits do we cut? High income retirees ?  Low income retirees?  Today’s retirees?  Today’s workers?  Alternatively, whose taxes do we raise?  Everyone?  Only high income households?

Just as most members of the human race who are fortunate enough to live to age 75 begin to notice varying degrees of health declines due to aging, so too must we deal with the unhealthy economic consequences of an aging Social Security system. 

3 Responses to “Happy 75th Birthday Social Security. But What Now?”

  • Ryan says:

    Why was social security designed as a “pay-as-you-go” system? Rational thinking would suggest that this would only work if economic conditions remained similar to what they were at the time (16 workers to 1 beneficiary). I realize hindsight is 20/20, but I feel like FDR and the masterminds behind social security would have at least considered a mandatory funded pension system as a more sustainable way for people to save for their own retirement and not have their money put into a pool for the government to use as needed.

  • Ying Cui says:

    This article is very good in proposing a thoughtful point with regard to long-term development of social security.

    There is a trend of imbalance of the ratio of workers-to-retirees. Given that 77 million baby boomers are at the point of retirement, plus all startling numbers the author lists in the article, this issue is particularly urgent. Looking for ways to help ourselves afford social security is even important.

    Solving this problem, we cannot get away from one word “redistribution”, what professor Jeff mentioned in his lecture. In my view, the redistribution happens between generations. It also happens that today’s taxpayers support today’s retirees. Also, on the tax raise, if the increase of the tax is not used on benefit improvement, then people might even choose to retire earlier and make things worse.

  • FL says:

    This is a true reflection of an aging population problem. In my opinion, the age of retirement can switch the gear. An earlier retirement is a trend that benefits individual workers, allowing them to enjoy a longer retirement than in the past. Furthermore, if individuals continue to retire earlier, this might increase the demand for younger workers. On the other hand, earlier retirement, combined with increased longevity, exacerbates the problem of economically sustaining an aging population. If the trend toward early retirement continues as the population ages, an even smaller shore of workers will be supporting a larger proportion of retirees.