Social Security Financing

1. Social Security Financing October 16, 2006

2. By the end of today you should be able to: • Explain how Social Security’s “pay as you go” financing works • Describe the long-run financial problems facing the system • Describe the factors that are responsible • Describe the “hard facts” of what is required to fix the problem

3. What Do You Believe?

4. What Do Others Believe?

5. Discussion • What do you think is the problem with Social Security? • Do you believe it can be fixed? • What benefits, if any, do expect from it?

6. Summary of 2005 Trust Fund Financial Operations (Table II.B1)

7. So What is the Problem? • In 2005, we are ran a large surplus • So what is the problem? Why does Social Security need “saved?” • “Pay-As-You-Go”: Taxes paid by today’s workers are used to finance today’s retirees

9. How Big is the Financing Gap? • Present value of the shortfall over next 75 years = $4.6 trillion • Present value of shortfall as % of taxable payroll over next 75 years = 2.02% • Annual deficit in 2080 = 5.38% of payroll • Program costs 4.3% of GDP today, and will rise to 6.3% of GDP by 2080 • Over an infinite horizon, shortfall is $13.4 trillion

10. Sources of the Problem • Demographics • Rising Life Expectancies • Declining Birthrates • Declining ratio of workers to retirees • Structure of the Current System • Inability to “grow our way out”

11. People Are Living Longer • Generation born in 1875 • Only 40% of males reached age 65 in 1940 • Those that did lived another 12.7 years • Generation born in 1935 • 69% of males reached age 65 in 2000 • Those that did expected to live 16.2 years • Generation born in 1985 • 84% of males will reach age 65 in 2050 • Those that do can expect to live 19.1 years

12. And Having Fewer Children • Total U.S. fertility rate • 2.2 children per woman in 1940 • 3.2 in 1947 • 3.7 in 1957 • 1.8 in mid-1970s • Now approximately 2.0

14. Is the Problem Real? • There are some who assert that economic growth will save us … • NY Times’ Paul Krugram refers to the “bonanza” of tax revenue that higher growth would bring • Baker & Weisbrot’s book “The Phony Crisis” also downplays the problem • Some politicians have said that Social Security is just fine for another 4-5 decades • What to believe?

15. Is the Problem Real? • It is not a “crisis” • But it is a serious long-term problem • Demographic changes are definitely coming – we know that the ratio of workers to retirees is declining • In a pay-as-you go system, either benefits must fall or taxes must rise

16. Will Growth Save Us? • Baseline SSA assumptions include economic growth • But are economic growth assumptions too pessimistic? • Productivity assumptions seem reasonable • Low economic growth assumptions stem from slower growth in labor force

17. Technical Panel Findings • Social Security Advisory Board appoints a Technical Panel on Methods and Assumptions to review Trustees Report • In 2003, report made recommendations about immigration, mortality, labor force, wages and inflation • What did they find?

18. Effect of Technical Panel Changes on SS Finance Status • Net effect of: • Increase immigration • Increasing rate of mortality decline • Eliminating rise in labor force participation rates of older persons • Increasing projected real growth rate • Decreasing projected inflation • Only changed 75-year actuarial balance by 0.01 percent of payroll

19. So, What Do We Do About It? • Option 1: Ignore the problem • Option 2: Raise taxes • Option 3: Cut other spending • Option 4: Reduce scheduled benefits • Option 5: Generate higher returns • Option 6: • Let’s examine each option in turn to see what will and what will not work …

20. Option 1: Ignore the Problem • “Do nothing” appears to be the default policy position • Problem will grow worse each year • With each passing year, we have one fewer surplus year ahead of us, and one more deficit year ahead of us • And we will have fewer options • Will become harder to protect older cohorts • Will require larger sacrifices

21. Option 2: Raise Taxes • This certainly helps to balance the books • How big a tax increase is required? • By 2080, the 12.4% payroll tax would need to be over 18% • At the same time that burden from Medicare and Medicaid will grow even faster • Possibly deleterious effects of high taxation • Reduced labor supply incentives • Reduced economic growth • Note: Borrowing is just a future tax increase!

22. Option 3: Cut Other Spending • We could divert spending from other programs • But numbers are mind-boggling • In 30 years, the annual shortfalls (adjusted for inflation) are over $300 billion • Would require crowding out huge proportion of non-defense discretionary spending

23. Option 4: Reduce Benefits • Social Security is not a super-generous program to start with • “Unfair” to cut benefits to those already retired  no time to adjust • What about future cohorts? • If slowed the rate of growth of benefits by about 1% per year (roughly difference between wages and prices), deficits disappear in long run • But replacement rates from SS would be sharply reduced

24. Option 5: Higher returns • Popular idea: invest in stocks to generate higher returns • Central government investment of Trust Fund • Personal accounts • Problems with this logic • Stock returns higher than bonds because of compensation for risk – no free lunch • Social Security return also low because of “debt overhang” – this won’t go away • More on pros and cons next time …

25. Key Issues in the Reform Debate • How restore solvency? • New revenue vs. changes to benefits • Individual accounts (IA’s) or not? • How to structure IA’s? • The accumulation phase • “Add-on” vs. “carve-out” • Investment options, vendors, costs • Access restrictions • Payout phase • Annuitization • Risk vs. return • Paying for the transition / savings