In June 1999, The New Yorker magazine carried a cartoon of a man stranded on an island telling his potential rescuer to focus instead on saving Social Security. The trustees for Social Security just released their 2018 report and, scarily, the plea is as appropriate today as it was 20 years ago.
In short, Social Security is a slow-moving train wreck. In 2034, the combined trust fund (currently at $2.9 trillion) — where excess revenues over payments have been maintained — will be exhausted. The trustees suggest Congress needs to act quickly because otherwise:
- a) Social Security taxes will need to be raised to 16.65% in 2035 and 17.6% in 2075, from 12.4% today;
- b) benefits would need to be cut by about a fourth; or
- c) some combination of both.
Let's not kid ourselves — no sensible politician would dare suggest option b, so the only result of inaction will be higher taxes for our children.
In 2004, the late Professor Franco Modigliani (Nobel laureate) and I wrote a book ("Rethinking Pension Reform," Cambridge University Press) arguing Social Security needed to be reformed immediately because it was a ticking time bomb and delays would only increase the cost. In 2004, the Social Security Trust Fund was projected to be depleted in 2042 — so inaction, and even detrimental decisions during the Obama administration, have moved up the depletion date by eight years, meaning higher Social Security taxes eight years earlier. One would hope that inaction today is not an option given we can see this wreck taking place in front of our eyes.
This begs the following key questions: What is the problem with Social Security? Why does it need to be reformed? Is there a sensible reform option? If so, is it feasible and how do we transition to the new Social Security.
Unsustainable funding principle
Social Security is a mandatory (with some exceptions) defined benefit pension plan and pays citizens, who participate for a minimum number of years, a pension through death with some survivor benefits, based on average lifetime income. It is one-part pension system and one-part wealth redistribution, as low-income earners get a slightly higher pension replacement rate than higher earners. It also has a disability insurance component. The first generation of retirees were paid a pension without ever having contributed, which is where the Social Security financial problem originates. The funding principle underlying Social Security is termed "pay-as-you-go" or PAYGO. For such a system to work efficiently, the commitment every future generation is making to the previous generation is to produce more children (so that more folks are taxed) and/or grow the economy, especially as life expectancy increases.
Social Security is not a pure PAYGO because in the 1980s, Alan Greenspan headed a commission that recognized that this social contract was being violated, raised the payroll tax to the current rate of 12.4%, and all excess contributions over payments were placed in the trust fund that would earn an artificial rate of interest. In 2017, this rate was 3% nominal, which is close to the yield on a 30-year Treasury bond.
In 1997, Mr. Modigliani and I started to evaluate Social Security. We argued the system was headed for a crisis because PAYGO was not a sustainable funding approach given the future demographic imbalance (low population growth and increasing longevity) and low projections for economic growth. In short, for small and reasonable changes in these parameters, future Social Security taxes would be very volatile and potentially much higher than current levels. Instead, we recommended the U.S. convert Social Security into a partially funded pension system — much like traditional pension funds — and have assets invested in the market under the oversight of a blue-ribbon board — much like the Canada Pension Plan — and with a clear target return (in 2004 we set the target at 5.2% per annum real). Further, clear rules were articulated to adjust taxes/benefits if the realized returns were above or below the target. For simplicity, call this the "MM model."
Our key point was that the simplest way to express the Social Security contract with citizens was to express a DB plan as nothing more than a guaranteed rate of return on contributions — in this case 5.2% per annum. Since a portfolio invested in financial assets would have volatile returns, the guaranteed return on contributions would be achieved via a swap between the U.S. Treasury and the Social Security Administration.
Even these changes were not sufficient back in 2004 to save Social Security, because Social Security's finances already were severely impaired. Additional contributions/taxes were needed to ensure financial stability even under the MM model. By our estimates, a one-time permanent increase in taxes by 1.1 percentage points (to 13.5% from 12.4%) would stabilize contributions permanently at that level (as opposed to forecasts of Social Security taxes approaching 19% by 2075). The rationale with the one-time increase in contributions was to ensure intergenerational sharing of the burden (as opposed to passing the buck to our kids) and to ensure the lowest possible impact on all citizens.
Alternatively, if the country ran budget surpluses (briefly during the Clinton administration), those resources could be used to get the partially funded MM model going. Interestingly, had the U.S. adopted the MM model or even invested the trust fund in financial assets, a simple 60% stock/40% bond portfolio would have earned 8.5% nominal per annum from January 2004 to June 2018 — in excess of our projected 5.2% per annum real.
Is the MM model feasible in 2018 given the latest trustee report, and if so, what additional contributions would it take given the generally low expected return on assets?
It is still possible for Congress to convert Social Security to a partially funded system, and invest the trust fund in a diversified portfolio of assets (much like the Canadians and Japanese), under the supervision of a blue-ribbon board, with a clear target return. The Social Security Administration could similarly enter into the swap with the U.S. Treasury. One unanticipated benefit of inaction by Congress is that the cost ratio (i.e., projected benefits divided by the total payroll) is no longer projected to reach 19%, but rather flatten out around 17.75%. This result follows because of higher projected labor force increases and replacing baby boomers with lower-birth-rate generations and slightly lower projected growth of wages than in 2004. This drop in the cost ratio permits the U.S. to potentially still save Social Security 20 years after we first proposed the MM model. If we assume the trust fund earns 5.2% per annum real (alternatively, 4% per annum real), then the additional one-time permanent increase in Social Security taxes would be 1.45% (or alternatively, 2.3%). Moreover, the trust fund in steady state would be just 85% of total payrolls, ensuring this portfolio is not so large as to overwhelm global financial markets.
Clearly, delaying reform, even with the beneficial impact of a lower long-term cost ratio, has raised the cost to future generations from a 0.7% increase under the Clinton administration, to 1.1% under the Bush administration to a 1.5% to 2.25% increase in 2018 (depending on one's forecast of expected returns). However, this one-time increase is far better than either having future contributions jump 4.3% or trying to maintain PAYGO (which could be maintained alternatively with a one-time permanent increase in Social Security taxes of 2.78%). Leaving Social Security as a PAYGO system would unnecessarily leave future generations with a pension plan with highly volatile contributions for small changes in productivity or demographic changes. More significantly, the delay has prevented Social Security from earning a much higher return on assets than the current 3% it earns from the U.S. Treasury, and these higher returns could have been used to pay pensions thereby reducing the pressure on Social Security taxes to pay current beneficiaries.
The U.S. might have just lucked out in that the MM model is still feasible, but the time to act is now. Hopefully, Congress will have the courage to say, "Forget about me – save Social Security!"
Arun Muralidhar is co-founder of Mcube Investment Technologies LLC, in Great Falls, Va. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.