Republican National Hispanic Assembly

Social Security: A Tale of Two Problems.

Pedro Celis, Ph.D.
March 30, 2005

Those with a vested interest in the current setup of the Social Security system are holding to the tune of “Confusion is the best defense”.

But our social security crisis can be best understood by ignoring all the confusing “fixes” and focusing on the two distinct problems at its core.

The first problem is that the federal government collects more, a lot more, contributions to social security than what it needs to pay the current retirees. The excess contributions are spent on other government programs and not really saved to pay for the retirement of the workers who are making the contributions.

The second problem is that demographics are such that, in the future, the federal government will collect less, a lot less, contributions than what it will need to pay the retirees of that day.

Spending your retirement fund.

All tax receipts go into the same pot in the Treasury. Every year, far more money gets collected as Social Security payroll taxes than what the program pays out. Congress simply spends it all – on top of what’s reported as “the deficit”.

As the system is now, the surplus that has been paid into Social Security over the past 20 years has been treated as part of the general budget and has already been spent by the U.S. Treasury

Over the past 20 years $1.7 trillion surplus Social Security tax payments have been used to pay for other programs. It is estimated that in the next 10 years another $2.2 trillion will be similarly spent.

That is a lot of money, even by Washington standards. Of those $3.9 trillion, nothing will be saved to pay for the retirement of those making the contributions. Zilch, zero, nada, niente.

What about the trust fund?

The Social Security “trust fund”, currently at $1.7 trillion, contains no hard assets. It represents money the Federal Government owes to itself. Congress has spent the surplus money and promised to pay it back someday.

This situation is equivalent to you using your retirement savings to buy a car, and then writing in a piece a paper an IOU to yourself and filing that in a folder called “Retirement Fund” in a safety deposit box at the bank. The following year you do the same to pay for your vacation. You pay for your kids’ college education the same way. And every year you reassure your spouse that your joint retirement fund is growing, safe and secure in a lock-box. If you tear up those pieces of paper, it has no economic impact.

Former Chrysler Chairman Lee Iacoca once declared that any CEO who tried this with a firm’s pension fund would be thrown in jail.

David Walker, Comptroller of the Government Accounting Office (GAO) explained recently: “The left hand owes the right hand, and that has legal, political and moral significance. But it doesn’t have any economic significance whatsoever. There are no stocks or bonds or real estate in the trust fund. It has nothing of real value to draw down.”

Until recently, these IOUs existed only as entries in a record book. Now, when a new bond is issued, it is printed on a laser printer located at the Bureau of the Public Debt office in Parkersburg, West Virginia. The bond is then carried across the room and put in a fireproof filing cabinet. That filing cabinet is your Social Security trust fund. If you tear up those pieces of paper, it has no economic impact.

According to the Office of Management and Budget (OMB), there are only three ways that Congress can repay these bonds: raise other taxes, authorize the Treasury to borrow the needed funds from the public, or reduce spending on other federal programs.

The end of the Baby Boomers.

The second problem with social security is that demographics are such that the big surplus will turn into a big deficit.

The current social security system is structured like those infamous “pyramid systems”. Workers don’t pay for their own retirement; those coming behind will pay for it. As long as the ratio of workers to retirees remains constant (and large) it is cheaper than saving for your own retirement. By cheaper we mean that you get a better rate of return than alternative forms of saving.

But Americans are living longer and having fewer children, and this alters the ratio between the number of workers and retirees. In 1937, 42 workers paid into the program about a 2% payroll tax for every retiree. In 1950 16 workers paid a 3% tax for each beneficiary. Today around 3.3 workers pay a 12.4% payroll tax for each person receiving benefits. By 2025 there will be two workers per retiree and by 2050 1.3 workers per recipient.

Other changes have occurred in addition to the tax rate workers are paying. The retirement age has been slowly pushed out, meaning that you contribute more money for a longer period, further eroding the rate of return.

Social Security has become a poor deal for workers. When the program was created in 1935, the rate of return on a 40-year worker’s investment was about 8%. Today someone that age can expect a dismal 1%. Our children’s rate of return will be negative if the program remains the same. But it can’t stay the same, it can only get worse.

Elected officials are currently proposing many confusing “fixes” to deal with this crisis. Raise the payroll taxes, increase the amount of income subject to payroll taxes including a “doughnut” version, decrease the rate of indexing of benefits, tax the benefits, increase the retirement age, are some of the examples.

These changes fix nothing fundamental. They do nothing to address the first problem; they simply delay the inevitable with regards to the second problem, and they further erode the rate of return on retirement contributions.

Back to the future.

Private saving accounts are the only solution being discussed that goes to the core of the problems. It proposes to fix the second problem by fixing the first.

Private accounts, in essence, move some of the burden of supporting the future excess retirees to the current excess workers (to the future retirees themselves) and go to the core of the problem (change the ratio).

Instead of completely supporting future retirees with payroll taxes collected when they have retired, use some of the excess payroll taxes being collected now to pay for that retirement.

The Federal government has no mechanism to save these huge amounts of money. The surplus funds cannot be simply put in a mattress. They have to be put back into the economy. Today they are put back into the economy by paying for some other government programs. With private accounts they will be put back into the economy by buying real assets that belong to the future retirees.

So what’s the hitch?

If this is such a good idea, why are so many opposed to it?

The biggest reason is that we have gotten used to spending our retirement funds now. If congress stops writing IOUs to itself and instead put the money into private accounts owned by the future retirees, how is it going to pay for all the other programs it has gotten used to financing with the excess social security contributions?

Remember that the OMB says there are only three ways that Congress could, in the future, repay the bonds in the “trust fund”: raise other taxes, authorize the Treasury to borrow the needed funds from the public, or reduce spending on other federal program.

Well, those are also the only three options in the present to stop writing those IOUs.

The status quo means Congress will spend the surplus $2.2 trillion of the next ten years, keep writing those IOUs and reassuring us that our trust fund is safe in that file cabinet in West Virginia. Personal accounts, on the other hand, are the way to make sure our retirement funds are worth more than an empty promise in a lock box.