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Social Security: A Primer September 2001

Any strategy to prepare the United States for an aging population must deal with a key fact: the goods and services that retirees consume in the future will have to be produced at that time by the U.S. economy or imported from abroad. From that perspective, what matters is not the financial structure of the Social Security program but the capacity of the economy. Various options for reform will have different effects on the economy and on the division of resources between the elderly and other people. To the extent that those options boost the future size of the economy and increase the nation's accumulation of assets, they can lessen the burden on future workers of making payments to the elderly.

How can the federal government expand the economy? Possible ways include running budget surpluses or promoting private saving, which can provide more funds for investment in business equipment, structures, and other types of capital; changing tax and regulatory policies to make the economy more efficient or give people greater incentives to work or improve their skills; and increasing government spending on programs that are geared toward investment rather than current consumption. In addition, changing some of the rules of the Social Security program could promote economic growth. In most cases, increasing the size of the economy requires policy actions that cause people to consume less or work more. Thus, policymakers should weigh the benefits of a larger economy in the future against the costs of those policy actions today.

This chapter looks at three strategies that have been at the heart of the public debate about preparing for the nation's future needs. Those strategies are saving budget surpluses and using them to pay down federal debt, using the surpluses to create private retirement accounts, and changing the rules of the current Social Security program. Those options are not mutually exclusive; they could be combined in any number of ways.
 

Preserving Budget Surpluses

With the federal government running a budget surplus each year, many people argue that those surpluses should be saved and used to pay down federal debt. Federal debt held by the public has already declined in recent years--from about 50 percent of the nation's gross domestic product in 1995 to about 35 percent last year (see Figure 13).⁽¹⁾ Continuing to pay down that debt could provide economic and budgetary benefits. By expanding the nation's saving, that policy could boost the stock of private capital and increase the size of GDP. As a result, future workers might be better prepared to bear the burden of making payments to an aging population. In addition, lower levels of debt would reduce the government's interest payments on the debt, which could give future policymakers more flexibility for dealing with unexpected developments.
 

Figure 13. Federal Debt Held by the Public as a Percentage of GNP, 1790-2000

SOURCE: Congressional Budget Office.

NOTE: This figure compares debt with gross national product (GNP) rather than the more familiar gross domestic product (GDP) because GNP is the measure used in the historical data. GNP measures the total income of all U.S. residents (including net payments for capital and labor income earned in other countries). GDP measures the income produced on U.S. soil. The difference between the two was about $12 billion in 2000.

The Mechanics of Federal Budget Surpluses

Whenever the federal government's total yearly spending exceeds its total yearly revenues, the government runs a budget deficit. If the Treasury does not finance that deficit by drawing down its holdings of cash, gold, or other assets, the government has to borrow funds from the public by selling Treasury securities (bonds, notes, and bills). That additional borrowing increases the government's debt held by the public.

The situation is not unlike what happens when a family borrows on a credit card. The balance on the card is a debt, which carries finance or interest charges as long as the debt is outstanding. The family can reduce its debt by paying off more than it spends (including finance charges) each month.

Since 1998, the government has been running budget surpluses and repaying debt. Looking forward, the Congressional Budget Office projects that if current policies do not change, budget surpluses will grow and, over the coming decade, provide enough money to pay off all of the publicly held debt available for redemption by 2010.⁽²⁾

CBO does not expect the Treasury to redeem (buy back) all of the outstanding debt. Many of the outstanding bonds will not mature for many years, and the government does not have the right to redeem them before maturity. Thus, the only way it could pay off those bonds early would be to buy them on the open market. But as the stock of debt dwindled, debt holders might demand a premium to surrender their bonds. At some point, that premium could grow so high as to make it impractical to pay off any more debt. Budget surpluses would then have to be invested in other assets. CBO calls those assets "uncommitted funds," reflecting the fact that the Treasury does not now have the legal authority to invest in most types of nonfederal assets, such as stocks and bonds of private corporations. Under current law, the federal government would have to hold its uncommitted funds as cash, gold, or deposits at the Federal Reserve or commercial banks.

Managing those holdings within the constraints of current law would be difficult for the federal government; thus, the Treasury would probably seek authority to invest in other assets, including stocks and debt of U.S. or foreign companies and securities issued by foreign governments. However, government ownership of private assets would raise significant questions about the government's role in the economy (discussed below). It would also raise questions about how such securities should be treated in the federal budget (see Box 4).
 

The Economic Effects of Saving Surpluses

Using budget surpluses to pay down debt would probably raise national saving and expand the pool of funds available for investing at home and abroad. Over time, the U.S. capital stock could grow larger, and the nation could accumulate more net assets in other countries. As investment in businesses' structures and equipment increased, workers would become more productive, real wages would rise, and the United States could produce more goods and services. In addition, the income from the extra net foreign assets could supplement the income produced domestically. In October 2000, CBO estimated that real income per person could be about 10 percent higher in 2040 if the off-budget surpluses projected through 2010 were saved rather than used for more government spending that consumed goods and services (see Figure 14).⁽³⁾
 

Figure 14. Real Income per Person Under Different Assumptions About Saving Surpluses

SOURCE: Congressional Budget Office.

NOTES: All of these projections use midrange long-term assumptions that are explained in Congressional Budget Office, The Long-Term Budget Outlook (October 2000).

Off-budget surpluses consist of the surpluses of the Social Security trust funds and the Postal Service. Under the "save off-budget surpluses" assumption, on-budget surpluses in 2000 through 2010 are zero, and off-budget surpluses match CBO's 10-year baseline for the off-budget accounts published in July 2000. Although CBO published a new 10-year baseline in August 2001, its projection of the off-budget surplus did not change by much.

Under the "save no surpluses" assumption, the total surplus in each year from 2000 through 2010 is zero (an on-budget deficit offsets the off-budget surplus). Revising the assumptions to reflect CBO's 10-year baseline projections published in August 2001 would not significantly affect projections of debt under this assumption about surpluses.

Under the "save total surpluses" assumption, total surpluses (both on- and off-budget) in 2000 through 2010 match CBO's 10-year baseline for the total surplus published in July 2000. Using CBO's August 2001 baseline would increase the projected level of federal debt and reduce the gap between the projected levels of real income per person under the "save total surpluses" and "save off-budget surpluses" assumptions.

National saving would not rise dollar for dollar with an increase in federal budget surpluses because private savers would probably reduce their saving. There are three reasons for such a response. First, higher budget surpluses would lower interest rates, which would reduce people's incentive to save. Second, budget surpluses arise because the government is collecting more income from households than it is spending; as a result, households have less after-tax disposable income than they would otherwise, which reduces both their current consumption and their personal saving. Third, higher budget surpluses imply lower tax liabilities in the future, which lessens people's incentive to save to pay future tax bills.⁽⁴⁾ Despite those considerations, it is unlikely that the decrease in private saving would completely offset the increase in budget surpluses.

Government Accumulation of Assets

One of the potential problems with saving surpluses is that the government could accumulate a large amount of assets and possibly own a significant number of shares in private companies. Although asset accumulation can increase the funds available for capital investment and boost economic growth, it would be unprecedented for the federal government to hold a large quantity of private assets. The possibility of such holdings raises broad philosophical questions (would it be appropriate for the government to own shares in and possibly control private companies?) as well as economic questions (could the government's involvement distort market signals and corporate decisionmaking?).⁽⁵⁾

Answers to those questions would depend on how the investments were chosen, the portfolio managed, and the asset-purchase program overseen. Economic theory and the experience of other governments provide some insights. In principle, the government could reduce the impact of its investments on the economy by investing in index funds, maintaining a passive stance, and letting private shareholders determine corporate behavior. In addition, the investments could be managed by a board that was subject to strict rules. According to economic theory, if financial markets were efficient and government investments in any particular stock were not too large, the government would not significantly affect the prices of stocks selected for its portfolio or alter the allocation of capital among firms.

However, financial markets may not behave exactly as economic models predict, and putting a company's stock in the government's portfolio might influence stock prices and capital flows. For example, the price of a stock often rises when the stock is listed in the Standard & Poor's (S&P) 500 index.⁽⁶⁾ A similar situation might occur when the government put a company on its list of stocks to buy.

Many state pension funds invest in stocks and bonds. Those funds held almost $1.7 trillion in corporate stocks and bonds in the fourth quarter of 2000 (see Table 2). The states have a mixed track record in insulating their investment decisions from politics: in some cases, investment policies bent to political pressure, and the performance of the portfolios suffered.⁽⁷⁾ However, the overall returns on investments in state and local pension funds are similar to those on investments in private funds (adjusted for differences in the size and composition of the portfolios), which suggests that political influence may not have greatly interfered with the pursuit of market returns for many state funds.⁽⁸⁾
 

Some countries have also built up large holdings of government-owned private assets.⁽⁹⁾ Norway, for example, has accumulated net assets (primarily foreign stocks and bonds) totaling almost half of its GDP. It reduces political interference by having the country's central bank manage those investments. However, its decision to invest mainly in foreign securities limits its potential scope for distorting the activities of its private sector. Moreover, Norway is a relatively small country whose actions would not be expected to affect world financial markets to any appreciable extent.

The U.S. government has been successful in managing the Thrift Savings Plan (TSP), which invests in stock and bond markets through broad-based indexes and pays retirement benefits to federal workers through a system of individual accounts. A crucial feature of the TSP is that its assets are owned by federal workers, not the government. The board that oversees the program has a fiduciary responsibility to manage those assets for the sole benefit of the owners of the individual accounts.⁽¹⁰⁾

If lawmakers decided that the federal government should not invest in private assets, they would need to cut taxes or increase spending at some point to eliminate budget surpluses. Making those changes smoothly over time would be desirable because sudden shifts in policy run the risk of causing economic disruptions.

Economic Efficiency

Saving surpluses and accumulating nonfederal assets would have an uncertain effect on the efficiency of the U.S. economy. If surpluses were not saved and current spending policies did not change, future taxpayers could face much higher tax rates to cover the growing costs of Social Security, Medicare, Medicaid, and interest on the federal debt. Thus, saving surpluses could help reduce the pressure to raise future taxes and possibly avoid large variations in marginal tax rates over time. (A marginal tax rate is the rate that applies to an additional dollar of taxable income.) Rising marginal tax rates can be particularly harmful to economic efficiency because they reduce people's incentives to work and save, and the resulting losses in efficiency tend to increase by much more than the tax rate does.⁽¹¹⁾ Paying down debt lessens the pressure to raise tax rates in the future by reducing interest payments on the debt. (Slowing the growth rate of federal spending could have similar effects.)

However, government investments in private assets could interfere with the efficient operation of the nation's capital markets. The size of that interference is difficult to gauge for reasons discussed earlier. Some people also argue that if investors were not able to buy Treasury securities, efficiency in capital markets could suffer, but it is doubtful that such a change would have much effect (see Box 5).
 

Creating Private Retirement Accounts

A second strategy that might help the nation prepare for an aging population is to use budget surpluses to pay for the creation of private retirement accounts. During the previous Congress, lawmakers introduced a host of proposals for such accounts (for a list of those proposals, see Appendix B). Although the proposals differed in significant ways, they shared a common feature: the income that would be available from an account at someone's retirement would depend on the contributions made to the account and the rate of return on the account's assets during the person's working life. In addition, most proposals would let workers invest part of their accounts in corporate stocks (see Box 6 for a discussion of the economic effects of such investments).
 

Private accounts have drawn widespread interest for several reasons:

• They would give workers some freedom and responsibility for choosing investments and planning their retirement;
  
  
• They could expand people's access to financial markets and improve their understanding of the value of saving;
  
  
• They might help protect budget surpluses from being used for increased government spending or for tax cuts; and
  
  
• They could be used to shift control of those surpluses from the government to the private sector and thus avoid the potential drawbacks of having the government own private assets.

Some analysts also argue that private accounts offer the opportunity for higher rates of return than the traditional Social Security system does, but that argument can be misleading (see Box 7).
 

Proposals for private accounts can help prepare the nation for an aging population only to the extent that they increase national saving. However, private accounts are not necessary, or by themselves sufficient, to boost national saving. As discussed in the previous section, the government might be able to increase such saving by preserving budget surpluses and paying down federal debt. However, national saving would not rise if the government simply financed the creation of private accounts by borrowing. In that case, every dollar saved in a private account would be offset by a dollar borrowed by the government.

In setting up a system of private accounts, policymakers would also have to confront various questions. Would participation be mandatory or voluntary? Would people be given a limited choice of assets (as in the government's Thrift Savings Plan for federal workers) or would they have the freedom to choose from a wide range of investments (as with individual retirement accounts, or IRAs)? At retirement, would people have to convert the assets in their private accounts into an annuity (a series of regular payments that continues until the person and his or her spouse dies), and if so, under what conditions? How would the accounts affect people's exposure to various sources of risk? Would individuals be guaranteed a minimum benefit if the markets performed poorly, and if so, who would pay for the guarantee? How much would administering a system of private accounts cost? How would the accounts be financed and integrated into the current Social Security program? And how would a system of private accounts handle nonworking spouses, people with disabilities, low-income workers, and people with intermittent work histories?

The Basic Structure of a Privatization Plan

Many proposals for private accounts would combine a cut in the Social Security benefits specified in current law with the establishment of mandatory private accounts that were owned and directed by individual workers. Such proposals--often referred to as privatization--would give workers control over how their money was invested. Most privatization plans have five elements in common:

• They would provide income at retirement that would depend partly on the contributions made into an account and the rate of return on the account's assets during the person's working life;
  
  
• They would reduce Social Security benefits from the amounts specified under current law;
  
  
• They would require (or at least give a strong financial incentive for) workers to put a certain percentage of their earnings into individual investment accounts;
  
  
• They would generally allow workers to decide for themselves how to allocate their accounts among the qualified investments available; and
  
  
• They would prohibit withdrawals from those accounts until workers reached a certain age.

The budgetary cost of setting up a system of private accounts would depend on the details of the proposal, but the amount could be large. For example, creating a system of accounts based on 2 percent of workers' earnings could cost about $1 trillion over 10 years.⁽¹²⁾

The Effects on National Saving

Private accounts could increase national saving if they preserved some of the budget surpluses as private saving. The size of that increase is hard to estimate, however, because it would depend on the specific details of the proposal and on how the government and the private sector responded. Moreover, raising national saving is not costless: it requires people to reduce their current consumption (see Box 8).
 

In analyzing the impact of private accounts on government saving, the major issue is the extent to which using surpluses for such accounts would prevent policymakers from using them for some other purpose, such as additional government spending or tax cuts.

In analyzing the impact on saving in the private sector, the major issue is how the accounts would influence people's decisions about saving. Under many proposals, the government would offer a tax credit that gave people some or all of the funds they would need to set up a private account. Because many low-income people have few assets, an account would probably represent new savings for them. Indeed, past experience with 401(k) plans suggests that low-income people increase their saving in response to tax incentives, although the size of that response is hard to gauge.⁽¹³⁾ Similar responses might occur under a system of private accounts.

Experience also suggests that most high-income people respond to tax incentives by shifting their assets from other accounts into their 401(k) plan rather than by increasing their total saving. However, that experience may not be directly applicable to some proposals for private accounts. Combining a tax credit with a cut in future Social Security benefits could limit the risk that people would reduce their other saving dollar for dollar; those who did could have less income in retirement. With that combination, high-income people might increase their total personal saving, including saving in the accounts.

Despite those areas of uncertainty, using budget surpluses for private accounts would probably increase national saving more than using surpluses for additional government spending or tax cuts would. Most types of government spending consume resources, and many types of tax cuts simply stimulate private consumption.⁽¹⁴⁾ By contrast, a substantial portion of the resources transferred to private accounts would probably be saved, for the reasons discussed above.

The Effects on the Labor Market

What effects private accounts would have on the labor market is uncertain. Both the current Social Security system and a private-account system could distort people's decisions about work. Comparing the labor-market effects of the two systems would require examining the specifics of the proposal for private accounts. Without knowing those specifics, no firm conclusions can be drawn.

On one hand, private accounts could reduce distortions in the labor market and encourage people to work more because those accounts would tighten the link between workers' contributions and their retirement benefits. On the other hand, a proposal for private accounts might include provisions (such as subsidies for contributions by low-income workers or guarantees of minimum benefits) that could distort incentives to work.

If low-income workers received subsidies for their contributions, the subsidies might encourage some people to join the labor force. However, if those subsidies were phased out as people's income rose, they would also impose an implicit tax on work for people whose income was in the phaseout range (because those people would receive less subsidy for each additional dollar of income). The size of that implicit tax would depend on the size of the subsidy and the rate at which it was phased out. Other labor-market distortions could arise from the fact that subsidies or guarantees of minimum benefits would have to be paid for in some way. If they were funded through increases in payroll or income tax rates, they could lessen people's incentives to work.

Administrative Costs

Any pension system costs something to administer. Staff must perform such tasks as collecting funds, keeping records, managing assets, calculating and paying benefits, overseeing and enforcing rules, and (in some cases) marketing and selling the plans.

Some lessons can be learned by looking at the administrative costs of a range of institutions that offer retirement savings accounts or that manage programs to provide income in retirement. Those institutions include mutual funds, defined-contribution pension plans, Social Security, and private-account plans in other countries. The experience of those institutions suggests that the administrative costs of a system of private accounts would depend greatly on the structure of the program. Under some proposals, administrative costs would be modest; but those costs could be high if an account system provided many services to investors and gave them a wide choice of investments.⁽¹⁵⁾

Of course, administrative costs may pay for services that people value. Some people may want to choose whether to participate in the program, how much to contribute, the mix of assets in their portfolio, and the frequency with which they adjust their portfolio. When they are at or near retirement, they may want choices about whether and when to convert their assets into an annuity and the kinds of annuities to buy. Restricting the freedom to make financial choices reduces administrative costs, but it may also reduce the value that people place on their accounts.

Another issue for policymakers to consider is how administrative costs would be allocated among participants. Two concerns arise. First, if people do not face the marginal costs of their transactions, they may take actions--such as churning (short-term buying and selling) of assets in their portfolios--that raise administrative costs. Second, if some of the fixed administrative costs are not spread among accounts, they could absorb much of the income of people who have small accounts (because of low incomes or intermittent work histories).

Risks and Guarantees

All public and private pension systems carry risks. How those risks are distributed can have significant effects on economic well-being. This section compares two types of public pension systems--a defined-contribution plan and a defined-benefit plan--to show how risk might be allocated in a private-account system. Those two public systems have counterparts in the private sector. Participation in private defined-contribution plans was about half the level of participation in private defined-benefit plans in the late 1970s, but the opposite is true today (see Figure 15).
 

Figure 15. Number of Active Participants in Private Pension Plans, 1977-1997

SOURCE: Department of Labor, Pension and Welfare Benefits Administration, "Abstract of 1997 Form 5500 Annual Reports," Private Pension Plan Bulletin, no. 10 (Winter 2001), available at www.dol.gov/dol/pwba/public/programs/opr/bullet97/cover.htm.

A public defined-contribution plan resembles a 401(k) plan in that a defined amount of a worker's salary is contributed to an account and invested in assets such as stocks and bonds. At retirement, the worker's income depends on the size of the contributions and the rate of return on the assets. In such a system, each individual bears the risk of certain unexpected changes, such as an increase in life spans (which creates the need for more money in retirement), a drop in wages, or a decline in the stock market.

With a public defined-contribution system, variations in the value of stocks can create large differences in the retirement income of workers who retire in different years. The riskiness of stock investments can be dramatically reduced by requiring that workers invest in a stock market index (such as the S&P 500) composed of many companies. Even so, the risks cannot be eliminated. For example, workers with average wages who invested 6 percent of those wages in the S&P 500 index over 40 years and then bought an annuity at retirement would have replaced almost 100 percent of their peak wage if they had retired at age 62 in 1969 (see Figure 16). But if they had retired just six years later (in 1975)--shortly after the oil price shocks of 1973 and the recession of 1974-1975, which knocked down the stock market--they would have replaced just 42 percent of their peak wage.⁽¹⁶⁾ Those two years present an extreme example, but they show some of the potential for large year-to-year fluctuations in the income of retired workers who retire at different times. Such an analysis also shows that those fluctuations could be reduced by requiring people to hold portfolios of both stocks and bonds.
 

Figure 16. How the Year of Retirement Affects Income-Replacement Rates in a System of Private Accounts Invested in Stocks or Bonds

SOURCE: Gary Burtless, Social Security Privatization and Financial Market Risk, Working Paper No. 10 (Washington, D.C.: Center on Social and Economic Dynamics, February 2000).

NOTES: The estimates are based on average male workers who are assumed to work for 40 years and save 6 percent of their earnings. Dividends and interest are reinvested. On their 62nd birthday, workers retire and convert their accumulations into a single-life annuity.

"Replacement rate" is the workers' initial annuity divided by their average real annual earnings when they were 54 to 58 years old.

In a public defined-benefit plan (such as Social Security), by contrast, workers' income in retirement depends on their history of wages and a formula that relates those wages to benefits. The formula can be set up to redistribute income from people who had high wages to those who had low wages, providing a type of insurance for low-income people.

Many of the risks that individuals face in a public defined-contribution system do not disappear in a defined-benefit system. For example, if people live longer than expected, public defined-benefit programs may become financially strained, creating the political risk that policymakers will change the benefit formulas or tax rates. If average wages grow more slowly, average benefits at retirement will be lower (although a progressive defined-benefit formula will help reduce some of the variation in wages among individual workers). In such a program, however, risks can be shifted to different people and across time, thus providing a form of social insurance.⁽¹⁷⁾

The risks of any private-account proposal depend on the proposal's specific provisions. Many proposals are not for pure defined-contribution plans; instead, they contain provisions that could pool risks among generations under certain conditions. For example, many private-account proposals guarantee a minimum level of retirement income; some may also tax earnings on withdrawals from the accounts. If the stock market does poorly, a minimum-benefit guarantee can shift the risks onto future generations. In principle, the government can transform any defined-contribution system into a defined-benefit system by using a set of guarantees and taxes to pool risks among generations.

Guarantees can create other problems, however. By insuring people against losses in their investment portfolio, the government could unintentionally encourage investors to put money into risky assets. If such gambles were successful, investors would pocket handsome returns; but if they failed, the losses would be covered by the government. That type of "moral hazard" is a problem inherent in many insurance contracts. It can be reduced by restricting people's choice of assets, but it cannot be eliminated.

Annuities

Most of the public discussion of private accounts has focused on questions about contributions, rates of return, and the accumulation of assets in the accounts. Much less attention has been paid to how people would draw down their accumulated funds in old age, but that issue is equally important.

Today, most retirees receive a life annuity from Social Security that is indexed to inflation. If the retiree is married or has dependent children, Social Security also pays benefits to his or her survivors. In addition, many people receive annuity payments from private pensions.

Annuities like Social Security provide insurance against the risk of longevity--that is, the risk of outliving one's resources. A life annuity protects against longevity risk by providing a stream of payments for as long as the annuitant (or his or her spouse if the contract provides survivor benefits) is alive. The insurer (an insurance company or the government) absorbs the uncertainty about longevity and pools that uncertainty among many annuitants. Since some annuitants live longer than expected and others die earlier than expected, the insurer can protect each individual against life-span uncertainty but itself be subject only to uncertainty about the average life span of the population.

Without access to annuities, people must divide their resources according to their expectations about how long they will live after retirement. They may find themselves without enough money if their actual life span exceeds what they had expected. For example, someone who retires at age 65 with assets of $100,000 and who expects to live 10 more years may choose to spend those savings in 10 equal installments. But if the retiree lives to age 76, he or she could end up without any assets.

One key issue for any system of private accounts is how people would be protected from outliving their resources. Would the system rely on private markets to provide annuities or would the government carry out that task? If the former, would people be able to buy annuities at fair prices and would private markets offer the same level of protection against longevity risk during retirement that Social Security does now?

Although private insurance companies currently sell life annuities to retirees, the market is very small. The reasons include competition from Social Security (which provides a similar product), people's desire to leave assets to heirs, and problems in the market that raise prices. An analysis by CBO concluded that private annuities are 15 percent to 25 percent more expensive than average mortality rates would suggest.⁽¹⁸⁾ That higher price reflects a combination of overhead costs and the fact that people who expect to have longer-than-average life spans are more likely than other people to purchase annuities (a phenomenon known as adverse selection).

If a system of private accounts was created and private insurance companies supplied the annuities, the prices of those annuities would probably fall. The system would put more people into the annuities market, which could lower both overhead costs and the share of annuitants with longer-than-average life expectancy. Furthermore, a growing market for annuities could increase the variety of annuity products and better adjust those products to meet consumers' demand.

Nonetheless, some factors could hinder the functioning of the private annuities market: adverse selection, high marketing costs, shortsighted behavior by consumers, and the existence of a social safety net. Government oversight of the annuities market and private retirement accounts could address some of those problems and reduce the cost of annuities to society. But policymakers would face a trade-off between balancing the gains from reducing overall costs and the losses from restricting individual choice.

The government could sharply limit adverse selection in the annuities market by requiring everyone with a private account to convert that account into an annuity at retirement. Such a requirement would increase the pool of people participating in the market and reduce the costs of adverse selection. However, it would also reduce people's choices and might not allow many retirees to pass the assets in their account to their children. (Life annuities end at the death of the owner, unless a joint annuity has been purchased, in which case it ends at the death of the spouse.)⁽¹⁹⁾

In requiring account holders to buy annuities, policymakers would also have to confront some difficult questions. Would insurers be forbidden to separate annuitants into risk classes on the basis of sex, marital status, income, health, and forebears' longevity? Prohibiting the separation of annuitants into risk classes results in a redistribution of resources among different people. If a low-income retiree with shorter life expectancy pays the same price for an annuity as a high-income person with above-average life expectancy, wealth will be redistributed from the low-income person to the high-income one. If unisex annuities are required, resources will be implicitly redistributed from men to women (since women live longer, on average, than men). Both types of redistribution could have substantial effects on the welfare of certain groups. Those redistributions also occur in the current Social Security system, but they are masked by the complexity of the system.

Other Considerations

Creating a system of private accounts would require policymakers to address several other practical issues. First, how would the system handle benefits for nonworking spouses, people with intermittent work histories, workers with low income, and people with disabilities? The current Social Security system provides benefits for those people. Would it continue to do so? If so, how would the provision of such benefits be integrated into the system of private accounts?

Second, the success of private accounts will depend partly on people's knowledge about financial markets and the quality of their financial decisions. That is an important issue because in 1998 (the most recent year for which data are available) roughly half of all U.S. families did not own stock either directly or indirectly (through mutual funds, retirement accounts, and other managed assets). Moreover, large percentages of U.S. families in their prime saving years did not own stock in 1998: 41 percent of families headed by someone ages 45 to 54, and 44 percent of families headed by someone ages 55 to 64 (see Table 3).⁽²⁰⁾ Of course, that may not be a permanent state of affairs: stock holdings could become more widespread over time and people more knowledgeable about financial markets.
 

In addition, some people may have trouble making wise financial decisions. Evidence suggests that some people spend their retirement accounts early when they have the freedom to do so. For example, in 1990, nearly $50 billion in pension assets were distributed to people before they reached age 59½, and roughly half of those distributions were spent rather than rolled over into another qualified account.⁽²¹⁾ In addition, some married workers might not pick annuities that provide coverage for their spouse without government regulations. The General Accounting Office found that the share of retired married men selecting joint and survivor annuities (which provide coverage for their spouse) increased by 15 percentage points after passage of the Retirement Equity Act of 1984, which required workers to get written approval from their spouse before choosing an annuity that did not provide such coverage.⁽²²⁾

Third, policymakers would have to set up a regulatory structure to oversee any system of private accounts. Regulations could be aimed at protecting investors from fraud and incompetence, ensuring that investment funds had enough capital, and preventing people from investing in overly risky assets during their working life or from spending down their assets too fast in retirement and then relying on public assistance programs if they ran out of resources. Dealing with that last issue might require having retirees annuitize part of their wealth so they would not outlive their resources.

The experience of private retirement accounts in the United Kingdom illustrates some of the potential risks of inadequate oversight and regulation. The U.K. instituted a reform that allowed workers to switch funds from their occupation-based pension plans to personal accounts. In the so-called misselling scandal, representatives of financial firms used high-pressure sales tactics to persuade some people to switch from favorable occupational pensions to personal pensions that provided lower returns.⁽²³⁾
 

Changing the Rules of the Current Social Security System

Policymakers have discussed a third approach for addressing the budgetary challenges of an aging population: phasing in cuts in future Social Security benefits so as to slow the growth of the program's spending. In addition, some people have proposed increasing the rate of the Social Security payroll tax. Cutting benefits and raising taxes represent different choices about how to divide economic resources between workers and retirees and between current and future generations. Although tax increases could improve the solvency of the Social Security trust funds and the balance of the federal budget, they might not address the broader economic challenges created by an aging population.

Reducing Benefits

Slowing the growth of Social Security spending by reducing benefits to future retirees could be one way to lessen future pressures on the federal budget and expand the economy in the long run.⁽²⁴⁾ Indeed, economic models suggest that many types of benefit cuts could increase GDP in the long run, although those long-term gains could take a couple of decades to appear fully.⁽²⁵⁾ How benefit cuts would affect the economy in the near term is uncertain.

Reducing benefits would probably increase national saving, although the size of the effect--and its path over time--is very uncertain. The results would depend on how much workers anticipated and responded to the cuts in benefits. Workers who were forward looking would probably reduce their current consumption and increase their saving in anticipation of receiving smaller benefits. However, some people might not be so forward looking. They would also have to lower their consumption, but that would probably occur in retirement when they received smaller benefit checks.

The effect on the labor supply of cutting future benefits would depend on the precise nature of the cuts. Some reductions in benefits might encourage people to work more. For example, raising the age for early retirement could cause some workers to delay their retirement. The size of that impact is uncertain, but an analysis of retirement behavior around the world suggests that there is a strong link between the earliest age at which workers can claim public pension benefits and the age at which they retire.⁽²⁶⁾ In the United States, the number of men retiring at age 62 rose significantly after policymakers added a provision to Social Security in 1961 that allowed early retirement at that age (see Figure 17). Benefit cuts might also encourage work by reducing expected lifetime income, causing people to work more to make up some of the difference. Conversely, benefit cuts could discourage work by reducing the amount by which expected future benefits rise with each additional hour of work.
 

Figure 17. The Probability of Retirement for Men at Various Ages in Different Years

SOURCE: Jonathan Gruber and David Wise, eds., Social Security Retirement Around the World (Chicago: University of Chicago Press, 1999).

NOTE: Early retirement benefits were introduced for men in 1961. (They were introduced for women in 1956.)

Slowing the growth of Social Security spending by cutting benefits would probably reduce the lifetime resources of some transitional generations. Later generations, however, would most likely have higher real wages and pay lower taxes, for two reasons: the additional national saving that would result from lower spending would boost the capital stock and raise their wages, and the cuts in benefits would lessen the chance that taxes would be raised in the future.

Because Social Security benefits are a major source of income for many people, it would be important to announce any benefit cuts well in advance so people would have enough time to respond by adjusting their plans for saving and retirement. Moreover, if the changes were made in a way that preserved the benefits of low-income people, then larger cuts would be necessary in the benefits received by other retired workers.

Some of the major issues involved in reducing benefits can be seen by looking at three options: speeding up the increase in the retirement age, lengthening the number of years of employment for which Social Security benefits are calculated, and reducing annual cost-of-living adjustments.

Accelerate the Increase in the Retirement Age. Under current law, workers born before 1938 become eligible for full Social Security retirement benefits at age 65. That normal retirement age increases in two-month increments for people born thereafter, reaching 66 for workers born in 1943. It remains at 66 for workers born between 1944 and 1954 and then begins to rise again in two-month steps, reaching 67 for people born in 1960 or later. Workers will still be able to start collecting reduced benefits at age 62. But as the NRA increases and moves further away from age 62, the size of that reduction will grow.

Members of Congress and others have recommended speeding up the change to a normal retirement age of 67. One option would steadily increase the NRA by two months per year until it reached 67 for workers born in 1949. Under that option, the first people to face a normal retirement age of 67 would become eligible for reduced benefits (at age 62) in 2011, which is 11 years sooner than under current law.

The savings from that change would begin as workers in the first affected age group (people born in 1944) reached age 62 in 2006. Each year after that, the savings would grow as more beneficiaries were affected, with each successive group incurring larger reductions in benefits. Workers in the first group who began collecting benefits at 62 would receive about 1 percent less than they would under current law. Workers who turned 62 in 2011 would receive about 7 percent less than they would under current law. Some Social Security beneficiaries with low income would qualify for federal means-tested programs, such as Supplemental Security Income and Food Stamps, so part of the savings in Social Security benefits might be offset by greater spending for other programs.

Proponents of raising the normal retirement age point out that, on average, people are healthier and live longer today than was the case in the early days of Social Security, and thus they may be able to work for a longer part of their lives. Opponents argue that raising the normal retirement age is nothing more than another way to cut future monthly Social Security benefits.

Lengthen the Computation Period for Benefits. Social Security retirement benefits are based on the average indexed monthly earnings of workers in jobs covered by the system. The current formula computes those earnings on the basis of a worker's 35 highest-earning years of employment. Lengthening that averaging period would generally lower benefits slightly by requiring more years of lower earnings to be factored into the benefit computation.

One argument for lengthening the computation period is that it would encourage people, who are now living longer, to stay in the labor force longer as well. It would also reduce the advantage that workers who postpone entering the labor force sometimes have over people who get jobs at a younger age. Because the AIME calculation is based on 35 years of employment and thus can ignore many years of low or no earnings, people who enter the labor force later suffer little or no loss of benefits for their additional years spent not working and not paying Social Security taxes.

Opponents argue that this option would hurt beneficiaries who retire early because of poor health or unemployment--the people who would be least able to continue working. It would also disproportionately affect people who spent significant time outside the Social Security system--such as parents (usually women) who interrupted their career to raise children--and workers who were unemployed for long periods.

Reduce Cost-of-Living Adjustments. Each year, the Social Security Administration must adjust recipients' monthly Social Security benefits for inflation. To do so, it raises benefit payments by the percentage increase in the consumer price index. Some policymakers suggest that the law be changed so that the yearly COLA equals the increase in the CPI minus a specified amount, such as 0.5 percentage points.

Many economists believe that the CPI may overstate increases in the cost of living, but they disagree about the size of the overstatement. There are conceptual problems with devising a "true" cost-of-living index, as well as difficulties collecting and compiling data for such an index. For those reasons, economists have had trouble reaching a strong consensus on this issue. In 1996, the Advisory Commission to Study the Consumer Price Index (known as the Boskin Commission) concluded that the CPI probably overstates the change in the cost of living by between 0.8 and 1.6 percentage points a year.⁽²⁷⁾ Since the commission's report was issued, the Bureau of Labor Statistics has made several changes to the way it calculates the CPI and eliminated some of the problems with the index. But some thorny issues remain, including how to measure the cost of living for Social Security beneficiaries.

To the extent that the CPI still overstates increases in the cost of living for those beneficiaries, policymakers could reduce COLAs by a corresponding amount without making Social Security recipients' real benefits lower than they were when the recipients became eligible for the program. Moreover, reducing cost-of-living adjustments by a relatively small amount could save a great deal of money.

The impact of even a small cut in COLAs, however, would be significant for future older beneficiaries, whose benefits would reflect the cumulative effects of a series of smaller COLAs. In the long run, the people whose benefits would be most affected would be the oldest recipients and those who first became eligible for Social Security at an early age on the basis of disability.

The Effects of Raising Payroll Taxes

Another option--which would address the narrow issue that promised Social Security benefits are expected to exceed the revenues dedicated to the program--would be to raise payroll taxes. Because what really matters is the overall budget balance, any tax could be increased to finance future Social Security spending. However, to limit the scope of the analysis, this report focuses on the Social Security payroll tax.

The Social Security trustees project that the gap between the program's income and costs in 2050 will be about 4.6 percent of the nation's taxable payroll.⁽²⁸⁾ Thus, increasing the combined payroll tax on workers and their employers from 12.4 percent to 17.0 percent at that time would be one way of dealing with the shortfall.⁽²⁹⁾

The payroll tax rate has been raised several times since the Social Security system was created in the 1930s (see Figure 18). The total rate (including the shares paid by employers and employees) was only 2 percent when the program began, but it increased in a series of steps over the years to the current rate of 12.4 percent. The wage base to which the tax rate applies also rose during that period. In 1951, the payroll tax was assessed on workers' earnings up to $3,600, which was 148 percent of the average wage at that time (see Table 4). By 1999, the payroll tax applied to earnings up to $72,600, or 251 percent of the average annual wage. This year, the maximum level of earnings for the tax is $80,400.
 

Figure 18. The Payroll Tax Rate for Social Security, 1937-2000

SOURCE: Social Security Administration.

NOTE: The payroll tax rate includes both employee and employer payments.

Although employers nominally pay half of the payroll tax, the burden of the tax largely falls on workers. Both economic theory and empirical studies suggest that most of the tax is shifted to workers in the form of lower wages and less generous fringe benefits.⁽³⁰⁾ Workers would also bear most of the burden of any increase in the tax rate.

Raising the payroll tax rate would reduce the marginal return from working (that is, the return from an additional hour worked). For many workers, raising the payroll tax rate by, say, 5 percentage points could reduce their marginal after-tax compensation by almost 10 percent (compared with what that compensation would be otherwise).⁽³¹⁾ Those workers could include people in families in the 28 percent income tax bracket and some low-income workers who already face high implicit marginal tax rates because the earned income tax credit phases out as they earn more.⁽³²⁾

Increasing the payroll tax rate would probably reduce the labor supply (compared with keeping the tax rate steady). The size of that effect would depend on how workers responded to the increase. Some information can be gleaned by examining how workers responded to earlier changes in their after-tax wages. Based on past observations, the total supply of labor could decline by between zero and 3 percent for each 10 percent drop in after-tax wages, with virtually all of the response coming from second workers in households that already have one worker.⁽³³⁾ However, responses outside that range are not unlikely.⁽³⁴⁾

The effect on GDP of raising the payroll tax rate is less certain; it would depend on what was done with the additional revenues. If the government did not use them for another purpose, those revenues would increase government saving, which could boost national saving. In that case, the impact on GDP would depend on whether the positive effects on economic growth from more national saving outweighed the negative effects on the labor supply. Moreover, the decline in interest costs associated with lower federal debt could allow policymakers to reduce the payroll tax rate in the future, which could have a positive long-term impact on the economy.

By contrast, if the extra payroll tax revenues were used to finance more government consumption spending, national saving would not rise. Further, because the labor supply would probably fall, the policy would most likely reduce GDP. In that case, the tax increase could make it more difficult for the nation to prepare for an aging population.

1. Federal debt held by the public is debt issued by the federal government in the form of Treasury securities and held by nonfederal investors. In this chapter, "debt" refers to debt held by the public.

2. Congressional Budget Office, The Budget and Economic Outlook: An Update (August 2001).

3. That estimate is based on CBO's midrange assumptions for population, productivity, and medical costs. For details, see Congressional Budget Office, The Long-Term Budget Outlook (October 2000).

4. Robert J. Barro, "Are Government Bonds Net Wealth?" Journal of Political Economy, vol. 82, no. 6 (December 1994), pp. 1095-1117. For an evaluation, see Douglas W. Elmendorf and N. Gregory Mankiw, "Government Debt," in John B. Taylor and Michael Woodford, eds., Handbook of Macroeconomics, vol. 1C (Amsterdam: Elsevier Science, 1999).

5. For views on those topics, see the statement of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Senate Budget Committee, January 25, 2001, and the statement of David M. Walker, Comptroller General of the United States, before the Senate Budget Committee, published as General Accounting Office, Long-Term Budget Issues: Moving from Balancing the Budget to Balancing Fiscal Risk, GAO-01-385T (February 6, 2001).

6. Statement of Kevin Hassett, Resident Scholar, American Enterprise Institute, before the House Ways and Means Committee, February 13, 2001.

7. Olivia Mitchell and Ping-Lung Hsin, "Public Pension Governance and Performance," in Salvador Valdés-Prieto, ed., The Economics of Pensions: Principles, Policies, and International Experience (Cambridge: Cambridge University Press, 1997); Alicia Munnell, "The Pitfalls of Social Investing by Public Pension Plans," New England Economic Review (September/October 1983), pp. 20-37; John Nofsinger, "Why Targeted Investing Does Not Make Sense," Financial Management, vol. 27, no. 3 (Autumn 1998), pp. 87-96; and Roberta Romano, "Public Pension Fund Activism in Corporate Governance Reconsidered," Columbia Law Review, vol. 93, no. 4 (May 1993), pp. 795-853.

8. Alicia Munnell and Annika Sunden, "Investment Practices of State and Local Pension Funds: Implications for Social Security Reform" (paper presented at the Pension Research Council conference at the Wharton School, University of Pennsylvania, April 26-27, 1999).

9. General Accounting Office, Budget Surpluses: Experiences of Other Nations and Implications for the United States, GAO/AIMD-00-23 (November 2, 1999).

10. Under certain circumstances, the Secretary of the Treasury is authorized to reduce the holdings of the TSP fund. For instance, when negotiations to increase the legal limit on federal debt deadlocked in 1995, Treasury Secretary Robert Rubin sold holdings of the TSP's Government Securities Investment Fund to create room under the debt limit and ensure that the government would be able to meet its November 15 quarterly payment to bondholders. Those holdings were later replenished in full with interest, as required by law.

11. Those losses increase by roughly the square of the tax rate. For a nontechnical discussion of this issue, see Harvey Rosen, Public Finance, 5th ed. (Homewood, Ill.: Richard D. Irwin, 1999).

12. That estimated cost excludes any additional interest payments that the government would have to make if it financed the accounts by increasing federal debt.

13. Eric M. Engen and William G. Gale, The Effects of 401(k) Plans on Household Wealth: Differences Across Earnings Groups, Working Paper No. 8032 (Cambridge, Mass.: National Bureau of Economic Research, December 2000).

14. Tax cuts or government spending may have other economic effects besides their impact on national saving. For example, cuts in marginal tax rates may increase the labor supply. In addition, some types of government spending may increase productivity.

15. For more information, see John B. Shoven, ed., Administrative Aspects of Investment-Based Social Security Reform (Chicago: University of Chicago Press, 2000).

16. Gary Burtless, Social Security Privatization and Financial Market Risk, Working Paper No. 10 (Washington, D.C.: Center on Social and Economic Dynamics, February 2000). The replacement rate for similar workers retiring at age 62 in 2000 would have been more than 100 percent of their peak wage.

17. Peter Diamond, "The Economics of Social Security Reform," in R. Douglas Arnold, Michael J. Graetz, and Alicia H. Munnell, eds., Framing the Social Security Debate: Values, Politics, and Economics (Washington, D.C.: National Academy of Social Insurance, 1998).

18. Congressional Budget Office, Social Security Privatization and the Annuities Market, CBO Paper (February 1998).

19. Some countries have addressed that problem by requiring only that people annuitize enough of their accounts to provide a minimum level of income in retirement. The rest of an account could be used for any other purpose, including being passed to children as a bequest. In Chile, for example, people are not allowed to withdraw funds from their account unless they have an annuity that provides income of more than 70 percent of their taxable earnings over the past 10 years and at least 120 percent of the minimum pension. See Congressional Budget Office, Social Security Privatization and the Annuities Market, p. 31.

20. Many of those families do not own stock because they have low income and do not save; however, stocks also account for a disproportionately small fraction of the portfolios of low-income people who have assets.

21. Andrew Samwick and Jonathan Skinner, "Abandoning the Nest Egg? 401(k) Plans and Inadequate Pension Saving," in Sylvester Schieber and John Shoven, eds., Public Policy Toward Pensions (Cambridge, Mass.: MIT Press, 1997).

22. General Accounting Office, Pension Plans: Survivor Benefit Coverage for Wives Increased After 1984 Pension Law, GAO/HRD-92-49 (February 1992).

23. For more details, see Congressional Budget Office, Social Security Privatization: Experiences Abroad, CBO Paper (January 1999).

24. See Congressional Budget Office, Long-Term Budgetary Pressures and Policy Options (May 1998), Chapter 3.

25. Laurence Kotlikoff, Kent Smetters, and Jan Walliser, "Privatizing Social Security in the U.S.--Comparing the Options," Review of Economic Dynamics, vol. 2, no. 3 (July 1999).

26. Jonathan Gruber and David Wise, eds., Social Security and Retirement Around the World (Chicago: University of Chicago Press, 1999).

27. Advisory Commission to Study the Consumer Price Index, Toward a More Accurate Measure of the Cost of Living, final report submitted to the Senate Finance Committee (December 4, 1996).

28. Social Security Administration, The 2001 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (March 19, 2001).

29. Another option for raising revenues would be to increase the maximum level of earnings subject to the payroll tax.

30. For new evidence and review of the literature, see Jonathan Gruber, "The Incidence of Payroll Taxation: Evidence from Chile," Journal of Labor Economics, vol. 15, no. 3, part 2 (July 1997), pp. S72-S101.

31. That would be true for anyone facing a total marginal tax rate on labor compensation of almost 50 percent (such as a federal income tax rate of 28 percent and a state income tax rate of 5 percent, in addition to the 12.4 percent payroll tax for Social Security and the 2.9 percent tax for Medicare).

32. This year, the earned income tax credit (EITC) phases out at a 21 percent rate for workers with two or more children and earnings between $13,090 and $32,121. For each additional dollar they earn, workers in that income range lose 21 cents of EITC benefits. Thus, the phaseout imposes a marginal tax of 21 percent on those workers.

33. Congressional Budget Office, Labor Supply and Taxes, CBO Memorandum (January 1996).

34. Raising the payroll tax rate could increase hours of work or intensity of work among people who earn more than the maximum level of taxable earnings. The tax increase would reduce their income but not their marginal incentive to earn an extra dollar. As a result, they would have an incentive to work a little more to make up for the lost income. In addition, increases in the payroll tax would have a smaller effect on the supply of labor than the estimate cited in the text if they increased workers' expectations of future benefits.

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