Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

One of the most despised provisions of the Social Security regulations is known as the WEP – an acronym for the “Windfall Elimination Provision.”  This provision is poorly named, poorly designed, and poorly understood.  But that does not mean it should be eliminated.  While the Social Security Administration does a truly horrible job of communicating it, the WEP (or something like it) has a legitimate reason for existing.

What is the WEP?  It is a provision in the law that alters the way Social Security benefits are calculated for individuals who work for state and local employers who do not participate in the U.S. Social Security system.  For example, the earnings of employees of public universities and public schools in Illinois – who participate in Illinois SURS and Illinois TRS – are not covered by Social Security. 

Illinois is not alone.  Approximately one fourth of all public employees in the U.S. do not pay Social Security taxes on the earnings from their government job according to the U.S. Government Accountability Office (GAO).  This includes approximately 5.25 million state and local workers, as well as approximately 1 million federal employees hired before 1984. 

However, many of these public employees – including the author of this blog – will still qualify for Social Security benefits, either as a result of switching between covered and uncovered employment at some point in their career or because they simultaneously work two or more jobs that span both covered and uncovered employment.  For example, a teacher in the State of Illinois may spend his summers working in covered employment.  Alternatively, a professor may spend part of her career working at a private university covered by Social Security, and part of her career working for a state university that is not covered. 

If Social Security benefits were calculated as a simple “linear” function of lifetime earnings, this would not present any problems.  If you earned 50% of your lifetime income in Social Security, you would just get 50% of the benefit that you would have earned had all your earnings been covered.  The only thing Social Security would need to know is how much you paid into Social Security.  Whether you have other “uncovered” earnings would be irrelevant.

But Social Security does not have a “linear” benefit formula.  Rather, it is explicitly designed to offer a higher ratio of benefits-to-taxes-paid for low income workers than it offers to higher income workers.  It is designed this way in an attempt to redistribute income from the rich to the poor.

And therein lies the problem.  If Social Security only observes part of a person’s total earnings (e.g., they know someone’s earnings from a summer job, but not their university salary), then they might mistakenly classify this person as a low-income individual, even though they might be a high income individual who just had a small part of their earnings covered by Social Security.  As a result, blindly applying the same benefit formula to this person gives them a benefit that is too high relative to other individuals who have the same total lifetime earnings!  In essence, we would be paying too much to people who only worked a small part of their career under Social Security.      

In order to adjust for this, the Windfall Elimination Provision (WEP) was enacted as part of the 1983 Social Security Amendments.  This provision is meant to downward-adjust the Social Security benefits of affected workers in order to eliminate the “windfall” (a poor choice of words, I am the first to admit!) that arises when, for example, an individual with high lifetime earnings (based on both covered and uncovered earnings) would appear as if he or she were a low earner when evaluated solely based on covered earnings. 

It is easiest to see the problem that would be created if there were no WEP provision in place through an example.  Consider the three individuals shown in the table below.  “Larry” is a very low income worker who works his entire life under Social Security, with an average lifetime monthly earnings of only $500 per month.  Using the 2008 benefit formula, Larry would have a full benefit $450, or 90% of his pre-retirement income.  “Mo” is a higher income worker with all of his earnings covered under Social Security, thus having an average monthly income while working of $5,000.  Under the benefit rules, Mo would have a full benefit of $1891.34, or a 38% of their working life income.  Thus far, this example simply illustrates the “redistributive” nature of the benefit formula, as Larry receives a higher replacement rate than does Mo, owing to the fact that Larry has lower lifetime earnings.

Social Security Primary Insurance Amount If No WEP Adjustment Applied

Now consider Curly, a public employee.  Curly’s total lifetime earnings of $5000 are identical to Mo’s.  Had all of Curly’s earnings been covered by Social Security, Curly would have the same 38%replacement rate as Mo.  However, only 1/10^th of Curly’s earnings were in employment covered by Social Security; the rest were in non-covered public employment.  If Social Security applied the standard benefit formula to Curly’s covered earnings without any WEP adjustment, Curly would receive a monthly benefit of $450, equivalent to Larry.  This provides Curly with a ratio of benefits to (covered) earnings of 90%, which is substantially more generous than the 38% ratio provided to Mo, even though Mo and Curly have identical lifetime earnings.  To use the language of the provision designed to address this issue, Curly would receive a “windfall.”  The WEP adjustment is designed to calculate Curly’s benefits differently, so that they end up looking more like Mo’s, since they both have similar lifetime incomes.    

In short, because Social Security is a redistributive program, there is a real need for something like the WEP.  Most people affected by it, however, hate it.  And who can blame them given that SSA does a terrible job of explaining it?  In essence, instead of telling a retiree that “your benefit will be $800,” SSA tells them “your benefit would be $1100, but because of the WEP, it is only $800.”  But for the individual in question, the $1100 benefit is a red herring.  In no way, shape or form is the $1100 benefit a relevant amount to start with.  So SSA’s poor communication and negative framing raises a lot of hackles unnecessarily.  As a result, thousands of letters are written to elected officials every year demanding that it be repealed.  And, every year, bills are introduced in Congress to eliminate it.  And every year, those bills fail as they should.

This is not to say that the WEP is perfect.  Far from it.  I have written more extensively elsewhere that the WEP calculation may be close to correct on average, but it is almost certainly wrong for each individual.  Sadly, it hits lower income individuals harder than it should, and does not hit most high income individuals hard enough.  There is a “right” way to calculate the WEP, but implementing it requires that SSA have a full history of both covered and uncovered earnings, but they did not collect the uncovered earnings in a systematic way until the early 1980s.  As such, we probably have to wait another 10 years before they can implement the fix.  In the meantime, SSA could do themselves and a lot of elected officials a huge favor by taking the time to adequately educate affected individuals on the rationale for this program.

This coming Saturday, August 14, marks the 75^th 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. 

The Social Security Disability Insurance (SSDI) program is an important part of the social safety net in the U.S.  If ever there were a risk that ought to be insured, it is the possibility of experiencing a physical or mental disability that brings one’s working-life to an end.  Those of us that have loved ones who rely on the SSDI program as a major source of household income understand how important it can be to financially sustaining those who are unable to continue working.

But the program can also be criticized in many ways.  First, the backlog of cases is very high – meaning that those who are disabled must often a very long time – sometimes even years – before they receive their first check.  There has also been a tremendous rise in the SSDI program caseload, which is placing enormous financial strain on the program as well as on the Social Security Administration’s already stretched field offices.

Nearly all of these problems trace to one root cause – that there is no simple test for determining who is truly disabled, and who is just trying to pass themselves off as disabled so that they can receive monthly checks for the rest of their lives without working. 

I know, some of you are going to say, “who would possibly do that?”  Indeed, some are offended by the notion that any undeserving individual would attempt to “act” disabled when they are not. 

But let’s be honest.  If it were easy to determine who was disabled and who was not – if there were some simple and fool-proof blood test or lie-detector test – then there would be no need for a huge bureaucracy of SSA claims reps, no need for 50+ state disability determination units, no complex layers of case reconsiderations and appeals, no need for hundreds of Administrative Law Judges, and no delays in processing checks.  There would be no backlog of cases.  And, frankly, there would probably be a lot more willingness among the general public and elected officials to generously support the program. 

But it is not that easy.  When a person argues that their back pain or mental condition means that they will no longer be able to work, the law requires that Social Security determine whether the person is indeed unable to earn more than the “Substantial Gainful Activity” amount each month – not just in their prior job, but in any job.  They must also determine whether the disability is permanent and/or likely to result in their death.  No easy task.

Ultimately, however, it is an empirical question whether there are people who apply for benefits but do not truly qualify.  And economists have researched this topic for years.

One recent paper by researchers at Columbia University, the Social Security Administration and the Congressional Budget Office (http://www.columbia.edu/~vw2112/papers/dissa_vwjsjm_final.pdf) finds that “younger rejected mail applicants to the Disability Insurance (DI) program exhibit substantial labor force attachment.  Similarly, a significant fraction of rejected applicants with low-mortality impairments such as back pain and mental health problems is employed.” 

In other words, there are a lot of people who apply for SSDI benefits, thus explicitly claiming that they have a work-ending disability, who return to work after being rejected.  Pretty clear evidence that they were not actually disabled, at least according to the SSDI definition.  But they applied for benefits anyway.  Maybe they really are hurt, maybe they really think they deserve the benefits.  But the fact that they can work after being rejected indicates that they did not suffer a work-ending disability. 

And as long as it remains the case that non-disabled people apply for disability benefits, the disability determination process will continue to be difficult, complex, long and extremely frustrating for everyone involved.  Those who suffer the most are those who truly are disabled.

A few days ago, AFL-CIO President Richard Trumka testified before the federal budget deficit commission.  In his remarks, he essentially argued (among other points) that we should try to grow our way out our problems.  Similarly, Edward Coyle, executive director of the Alliance for Retired Americans (an organization very closely affiliated with the union movement), objected to any discussion of raising the retirement age or reducing benefits.            

Sounds pretty good, right?  If we can just stimulate economic growth, we can avoid hard choices? 

Unfortunately, as with most “no pain” solutions to our nation’s fiscal problems, this one is too good to be true.  (In the name of bipartisanship, let me be clear that both Democrats and Republicans have their own version of the free lunch when it comes to Social Security – many free lunch Democrats argue we can grow out of the problem we have, and many free lunch Republicans believe that private accounts can solve the problem without benefit cuts.  Both are wrong – I will post about the flaws of the Republican form of free lunch at some other time.)

Let me be clear – growth is undoubtedly a good thing.  Of course I am pro growth.  Faster economic growth enlarges the economic pie, increases average wages, and thus provides more revenue for the same level of tax rates.  And there is no question that faster economic growth is a net positive for Social Security’s finances.

Unfortunately, faster growth is not sufficient to solve Social Security’s financial problems.  Let me point out two of the many reasons for this:

First, let’s remember that projections of Social Security’s long-term fiscal situation already assume that our economy will grow.  It is not as if Social Security’s trustees had not thought of this possibility.  So for growth to save us, it needs to be growth in excess of the baseline assumption.

Second, while it is true that faster growth and resultant higher wages increase payroll tax revenues to Social Security, this same wage growth also increases the benefits that Social Security must pay out in the future!  This is because the Social Security benefit formula is directly indexed to growth in the “average wage index.”  You may recall that the 2001 reform commission – and, in 2005, the Bush Administration itself – came out in favor of switching from a wage-indexed system to a price-indexed system.  Part of the rationale was to break this link and allow for us to get more of a fiscal “bang-for-the-buck” out of economic growth. 

There have been a lot of analyses to back up this analysis.  Of them all, the one that is most accessible to the non-PhD economist is probably the one written in 2003 by Rudolph Penner of the Urban Institute.  Hs conclusion: “Given the pending demographic pressures on the federal budget, we face a serious problem.  Increased growth cannot save us from breaking strong historical precedent.”  And that was back in 2003.  Sadly, the situation has gotten worse, not better …

So the short answer to the question posed in the title is “no.”

Paul Krugman wrote last week that Zombies have killed President Obama’s Deficit Commission. He refers to a “Zombie lie” having to do with exactly when Social Security will begin its financial problems. It is the typical Krugman approach – rather than have a serious discussion about economics, he instead resorts to name-calling.

So let me try to explain the economics behind this debate (for an interesting view of the politics, check out Keith Hennessy’s post on the topic). Back in 1983, a Social Security reform commission (now referred to as the Greenspan Commission, after Alan Greenspan who served as its chair) made substantial changes to Social Security taxes and benefits. One effect of these changes was to put Social Security on a path in which it would run cash surpluses for several decades. These surpluses were to be “saved” in a “trust fund” (actually, there is more than one trust fund, but we can safely ignore that distinction for now and treat them as one) that could then be drawn down once the demographic shift resulted in benefit payments exceeding annual tax revenue and Social Security starts running deficits (note – we are now virtually there).

On paper, this is exactly what has happened. Since 1983, we have collected several trillion dollars worth of taxes in excess of Social Security benefits paid. And those surpluses have been credited to a Social Security trust fund. When people say that politicians have raided the trust fund, they are not correct - at least technically. This is because every dollar of surplus has been credited to Social Security’s trust fund in the government’s official ledgers.

But that is all just government accounting. And accounting can be gamed and gimmicked. Most importantly, these accounting games tell us nothing about the economic impact. To understand that, we have to understand what these surpluses have to do with national saving.

Suppose, for example, that Congress simply decided to transfer $10 trillion on paper into the Social Security trust funds (such as by retroactively increase the interest rate paid on the trust funds to a very high rate). Suddenly, the trust funds would have much more money in them, and Social Security would appear solvent. Great solution, right?

The obvious problem is that every dollar in the trust fund - which represents a dollar of assets to Social Security - also represents a one-dollar liability to the federal treasury. Thus, if we simply decreed that there were now an extra $10 trillion in the trust funds, all we have done is transfer from one government agency (treasury) to another (Social Security). But ultimately, we still have to find the $10 trillion to make good on this promise.

Where does that $10 trillion come from? Out of the productive capacity of the U.S. economy in the form of higher current or higher future taxes.

Now, you might say, there is a big difference between simply decreeing the existence of money, and having actually saved the money through past surpluses. This is correct. If those past surpluses added to national saving, then presumably the higher saving rate spurred investment, and the economy is larger today than it otherwise would have been.

Here is an analogy. Suppose I divide my household expenditures into “mine” and “my wife’s.” Suppose that in the “mine” account, my income exceeds my expenditures by $10,000 per year. In “my wife’s” account, her income falls short of expenditures by $15,000 per year. So rather than me sticking my $10k in a bank, I loan it to her. This means I am running a $5k surplus in the “min” account, she is running a $15k deficit in her account, and our combined household is running a “unified deficit” of $5k.

Suppose we do this every year. So by the time I reach retirement, I have “saved” $250,000 in accumulated surpluses and interest in the form of I.O.U.’s from my wife. I call this my trust fund. But this means my wife owes me $250,000 (in addition to the $125,000 she would owe to other creditors.)

It might make me feel good to say that I have a quarter million in savings. But my wife and I are not exactly well-prepared for retirement, are we?

The question becomes, am I better off having saved $10k per year? Well, it depends. If my wife would have run $15k deficits whether I saved or not, then, yes, we are better off. But if the fact that I was saving $10k per year means she ran deficits of $15k per year instead of $5k per year, then we are no better off.

And, either way, we still have to come up with money to pay off our debt and feed ourselves in retirement. That money has to come from somewhere …

So it is with the government. Social Security saved all this money for the past 25-30 years. The rest of government spent it. Now the treasury owes Social Security trillions of dollars. It is fine to say that the treasury must pay it. But where does Treasury get the money?

Empirically, nobody can say for sure whether those Social Security surpluses were saved in an economically meaningful way. Republicans tend to argue that none of it was saved – that every dollar of Social Security surplus was spent on massive deficits elsewhere in the government. Democrats say those “on budget” deficits would have existed whether or not Social Security ran a surplus, and therefore the Social Security surpluses still increased national saving (or reduced dis-saving.)

Ultimately, it is an empirical question whether the surpluses added to saving or not, but unfortunately it is an empirical question we cannot really answer because we never get to observe the counter-factual world in which we hold everything constant except the size of the Social Security surpluses. This has not stopped researchers from trying, and they have found mixed results with some saying it has contributed a bit, other saying not at all. Nobody has claimed empirically that it was all saved.

Bringing this back to Krugman. He is clearly taking one side in this debate. By arguing that the only date that matters is when the trust funds are exhausted, he is implicitly arguing either that (a) 100% of the surpluses were saved, or (b) that he does not care about the broader economic impact, but only about government accounting rules. Either way, it is rather strange to take such a view and then claim that the other side is thinking like a Zombie …

I am a member of the National Academy of Social Insurance (NASI).  But I am beginning to think it should rename itself the National Academy of Spending Irresponsibly.  Their latest idea?  At a time when the single biggest threat to our long-term economic health is our burgeoning debt burden, they issue a new brief (see here) calling for extending Social Security benefits for students.  Why, exactly, is now a good time to be expanding entitlement programs?

While the Goldman Sachs testimony yesterday made all the political headlines yesterday, there was a second event occurring simultaneously that is much more important for our long-term economic security.  You see, despite all the rhetoric about financial regulatory reform, the Goldman Sachs hearings are really all about the past. 

The bigger story is about our future.  President Obama formally kicked-off of the “National Commission on Fiscal Responsibility.”

This Commission has the most difficult and important jobs in Washington – to figure out how to restore U.S. fiscal policy to something akin to a sustainable course.  It won’t be easy.  After 50+ years of total government spending comprising about 1/5 of the U.S. economy, the three entitlement programs - Medicare, Medicaid and Social Security - are projected – all by themselves – to exceed this share of the economy in the lifetime our today’s schoolchildren.  Throw in continued expenditures on all other functions of government – national defense, homeland security, environmental protection, education, the court system, and more – government spending is projected to consume an ever larger share of our economy.  This, in turn, has the potential to raise interest rates, crowd-out private investment, and thus reduce our rate of economic growth.

The President was careful not to take anything off the table yesterday.  That is important because this is not going to be an easy problem to solve.  At the end of the day, there are only two solutions to our fiscal problem. 

Solution 1: Raise more revenue.  In political terms, this means raising taxes.  I doubt that the Republican members of the Commission will be fond of this.

Solution 2: Cut spending.  In political terms, this means reducing the growth rate and/or level of benefits from “sacred cow” programs with vocal constituencies – such as seniors.  Democrats proved in 2005 that they are unwilling to cut benefits.  And many Republican members of the House sought to “solve” the problem through free lunch gimmickry, arguing that personal accounts (which I support, albeit for different reasons) would generate high enough returns that no benefit cuts would be needed. 

Where does that leave the Commission?  I see it most likely pursuing one of three possible outcomes.

Outcome 1:  The D’s and R’s on the Commission are unable to find enough common ground, and thus the Commission issues a final report that offers a series of options, each with proponents and dissenters.  In other words, partisanship.

Outcome 2: The Commission agrees they need to have at least some options that most members agree to.  And, caving to political pressure, they throw intellectual honesty out the window, and use a combination of both time-tested and brand new gimmicks to make it seem like the problem can be fixed without serious revenue increases or spending cuts.

Outcome 3:  The Commission takes a brave political stand by pointing out the extraordinarily difficult fiscal challenges ahead of us, proposes politically earth-shattering reforms, and then disbands and watches its proposals wither and die in the backrooms of Congressional committees.

Given the composition of the committee (see list here), I am optimistic that option 2 will be discarded.  But I think 1 and 3 are equally likely.

If there is hope for real reform coming out of this Commission, it will be because the Commission actually includes many sitting members of Congress who control the key committees.  In this important sense, this Commission has more in common with the 1983 Greenspan Commission, which led to politically difficult Social Security reforms being passed by Congress, than with the 2001 President’s Commission to Strengthen Social Security, which had no members of Congress and which saw its recommendations soundly ignored.

I hope my skepticism is mis-placed.  I sincerely hope this Commission comes up with good options, and that those in power listen.  If this happens, the long-term implications for “good” are far greater than 99% of all other economic news …

On February 18, the President Obama signed an Executive Order establishing the “National Commission on Fiscal Responsibility and Reform.”  The Commission will consist of 18 members.  Of these, 6 will be appointed by President Obama (with no more than 4 of the 6 being Democrats).  The remaining 18 will be divided up “3 each” among Democratic and Republican House members and Democratic and Republican Senators. 

The stated mission of this Commission is to identify “policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run.”

The mission is a critical one.  As I have noted in other posts (see, for example, my post from 2/2/10 on the 2011 budget or my post on 1/14/10 about why deficits matter), the long-term fiscal outlook is dire.   While the short-term deficits are being driven by a combination of recession-induced revenue declines, aggressive spending policies targeted at averting an even worse credit crunch and/or recession (e.g., TARP, stimulus, etc), as well as high levels of spending on Iraq and Afghanistan, the most serious long-term fiscal problems arise as a result of the runaway growth of entitlement programs.  Social Security, Medicare, and Medicaid are growing faster than the economy as a result of an aging population, rising health care costs, and the important interaction of these two factors. 

Commissions have a long history in the U.S., some of them successful in terms of leading to real changes (e.g., the Greenspan Commission in 1983) and some of them not (e.g., the President’s Commission to Strengthen Social Security in 2001 on whose staff I served.)  One of the features of this new commission is that it will be dominated by sitting members of Congress.  IF (1) these members are ones with real power (e.g., chairs and ranking minority members of the key committees like Senate Finance and House Ways and Means) and IF (2) these members can somehow move beyond ideological bickering and election-year politics and come to some meaningful compromises, THEN such a Commission could have an extraordinarily meaningful and positive impact on our fiscal future.  If, however, they simply resort to their political safe zones - with Republicans calling for balancing budgets solely through spending cuts and Democrats calling for balancing budgets solely through tax increases - then I would not expect much to come out of it.   

The political outlook is not promising, however.  Recall that only a month or so ago - in January 2010 - the Senate failed to garner the 60 votes needed to pass the “Bipartisan Task Force for Responsible Fiscal Action Act of 2010.”  In a blog on this same subject (click here to see it), Stephen Huth notes that “even before members have been appointed, both liberals and conservatives are dooming the work …”

The economic consequences are real.  As the Financial Times reported in January, the credit rating agency Moody’s announced that the U.S. could be at risk of losing its tripple A credit rating in the future unless it took steps to reduce its long-term deficits.  While Treasury Secretary Geithner says the U.S. will “never lose” its top rating, the very fact that the Treasury Secretary has to engage in such a conversation is an indication of just how serious are the risks posed by long-term deficits.  As noted by CNBC, “even if a downgrade in US credit is not imminent, the underlying conditions that raised such fears are worrying investors about what the future holds.” And even if our credit rating is not at risk, the long-run tax burden required to finance projected levels of spending are so enormous that I am afraid we will risk something far more important - our potential for sustained economic growth.

In short, I am in the “glass half empty” camp when it comes to my political assessment of the Commission’s likely impact.  I hope they prove me wrong …

I happened to spot a USA Today in the coffee shop where I was working today (think of it as practice for my upcoming furlough days) and noticed a headline in the “Money” section entitled “How do we dig out from under $12 trillion in debt?”  It reminds readers of the very salient fact that our national debt-to-GDP ratio (now at 70.4 percent of GDP) is the highest it has been since the post WWII period.  Importantly, this figure substantially under-states the sad state of the U.S. fiscal position because it ignores the massive unfunded obligations facing our “big three” entitlement programs – Medicare, Medicaid and Social Security. 

While this is not good news, I was pleased to see one of the nation’s widely read newspapers addressing the issue.  And I thought it was worth a brief post about why deficits matter. 

There is some public confusion around this issue, not least because neither party seems to do much about it.  Whatever you like or dislike about the Bush Administration (disclosure: I worked for President Bush in 2001-02, participated in the Social Security reform tour with him and 2005, and received a Presidential appointment to the Social Security Advisory Board in 2006), it is near impossible to make a credible case that his Administration took deficit or debt reduction seriously. 

 Thus far, the Obama Administration has an even worse record of fiscal discipline.  Yes, yes, I know – the midst of a deep recession is not the best time to cut federal spending (or increase taxes) in an attempt to close the fiscal gap.  But despite the significant lip service that the Obama Administration gives to deficit reduction, there is so far scant little evidence that they are serious about reducing it even after the economy improves.  Most of their calls for increasing taxes are accompanied by new ideas for growing the size of government, such as paying for health care reform. 

 Leaving politics aside, do deficits matter?  V.P. Cheney famously quipped that they do not.  But most economists agree that they do.  The standard textbook analysis is that deficits reduce national saving and drive up long-term interest rates, thus reducing private investment and thus sacrificing long-term economic growth. 

 There is plenty of empirical evidence to support this.  Indeed, President Obama’s own budget director Peter Orszag, a distinguished economist and fiscal policy expert (another disclosure: Peter is a good friend and co-author of mine, despite our policy disagreements) has an influential paper on this topic.  The full paper (with Bill Gale) appeared in the Brookings Papers on Economic Activity, but a more reader-friendly summary is available from their piece in the Economist’s Voice. 

 Keep in mind that this article was written in 2004, back when annual deficits were projected to run 3.5 percent of GDP.  In contrast, current deficits are running about double that (although, admittedly, no one expects the current level of deficit spending to persist once the economy improves and we stop spending like drunken sailors in an attempt to stem the decline). 

 Here is what Gale and Orszag said then: 

 “Under reasonable projections, the unified budget deficits over the next decade will average 3.5 percent of GDP. Compared to a balanced budget, the unified budget deficits will reduce annual national income a decade hence by 1 to 2 percent (or roughly $1,500 to $3,000 per household per year, on average), and raise average long-term interest rates over the next decade by 80 to 120 basis points. Looking out beyond the next decade, the budget outlook grows steadily worse. Over the next 75 years, if the tax cuts are made permanent, this nation’s fiscal gap amounts to about 7 percent of GDP. The main drivers of this long-term fiscal gap are, in order, the spending growth associated with Medicare and Medicaid, the revenue losses from the 2001 and 2003 tax cuts, and increases in Social Security costs. The nation has never before experienced such large long-term fiscal imbalances. They will gradually impair economic performance and living standards, and carry with them the risk of a severe fiscal crisis.”

 I am heartened that OMB Director Orszag understands the serious long-term consequences of our nation’s fiscal imbalance.  Of course, Peter and I will likely disagree on how to fix the problem (he will want to rely primarily on taxes, whereas I would prefer to first go after spending).  But future generations had better hope that our elected officials find a way to compromise, do some of both, and get this nation back on a sustainable fiscal path.   

The past year has not been good for 401(k)s and other retirement plans.  Among many implications of the financial crisis and deep recession, we have seen the dramatic, correlated losses across nearly every major asset class underscore the fragility of a 401(k) system that is focused predominantly on wealth accumulation rather than secure retirement income.  In essence, the 401(k) system was exposed for what it truly is – a promising supplemental savings plan, but an inadequate vehicle for ensuring a secure retirement.  

I’m not alone in this view.  I spend much of my time interacting with people who specialize in thinking about retirement income security – academic researchers, policymakers on both sides of the political aisle, insurance companies, financial advisors, consultants and consumers.  Over the past 12 months I have noticed a striking degree of commonality in their thinking around the fact that we need a better retirement system in the U.S.  This is not to say there are not still important areas of disagreement - for example, I find proposals to increase Social Security benefits, to return to a defined benefit system, and/or to have the government guarantee retirement income to be a combination of naive, reckless and fiscally irresponsible.  But when it comes to the future of private sector retirement plans, I believe there are a number of common themes emerging that make very good sense.

Yesterday, I had the opportunity to speak at the annual conference of the American Council of Life Insurers (www.acli.com) about my proposal for encouraging plan sponsors to use guaranteed lifetime income products as the default distribution option.  Before my session, I had the privilege of hearing Dr. Roger Ferguson, President and CEO of TIAA-CREF – one of the largest providers of retirement income in the world – speak on this issue.  (In the interest of full disclosure, I should note that I am a trustee of TIAA). 

Dr. Ferguson outlined 5 areas that need improvement in our system.  (I should note that I am paraphrasing here and including some of my own thoughts – so please do not interpret this as an exact representation of his remarks!)

1. We need to return to a focus on providing guaranteed income.  During the shift from Defined Benefit (DB) pension plans to Defined Contribution (DC) pension plans like the 401(k) and 403(b), we somehow lost sight of the fact that the point of saving for retirement is to provide income security.  We need to get the focus back on annuitized, lifetime income.  This does not mean a return to the old style DB systems.  It does mean looking for innovative ways to convert 401(k) and 403(b) wealth into income before, during, and after retirement.
2. We need to broaden coverage.  Millions of households do not have access to any employer sponsored retirement plan.  Somehow, someway, we need to fix this.  While it is true that individuals can save on their own, the evidence is overwhelming that “employers matter” in promoting saving.  Social Security alone is sufficient to replace adequate income for only a minority of households.  Indeed, given the poor fiscal trajectory of the program, the rising normal retirement age that will reduce benefits for those who claim at earlier ages, and rising Medicare premiums, its adequacy will only diminish further.    
3. We need to ensure that individuals are broadly diversified.  I, personally, would love to see us put together individualized retirement plans that include a life cycle portfolio trajectory that gradually converts into annuitized income the closer one gets to retirement.  The investment options need to include not just stocks and bonds, but also real estate and other asset classes.  
4. We need to ensure that individuals have access to good information and advice.  Our current regulatory structure – designed to protect consumers from tainted advice by those who might have a conflict of interest – has had the unfortunate effect of making plan sponsors go through a torturous and administratively complex route to provide good advice to participants.  We need to find sensible ways to streamline this process. 
5. We need to provide vehicles for individuals to be able to save for retiree health care expenses.  Health Savings Accounts and other similar tools have a useful role to play here.

To get there from here, we do need some regulatory and policy changes.  I suspect that we may see this discussion rise closer to the top of the agenda after health care reform is behind us …