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?
