How to Fix Social Security's Financing Problem
The recent debt compromise calls for Congress to set up a bi-partisan committee to review entitlements, including Social Security, and to make recommendations by Thanksgiving. As a result, we'll probably hear more impassioned debates about so-called "raids" by politicians on the Social Security trust fund. Here I'll suggest two possible fixes that would prevent such raids, and we'll look at the implications.
To understand these potential solutions, we'll need to first review Social Security financing. The Social Security trust fund stood at about $2.6 trillion as of January 1, 2011, according to the 2011 Social Security trust fund report. The fund has been growing since the early 1980s because Social Security collected tax money from workers during the 1980s, 1990s, and 2000s that was substantially greater than the total benefit payments being made during this same period. This surplus resulted from changes to Social Security that were enacted in 1983 under the Reagan administration, and were intended to boost the funding of the trust fund to pay for Social Security benefits owed to the baby boom generation.
For the first time in decades, benefits paid last year exceeded the Social Security taxes collected, primarily attributable to reduced tax collections and increases in early retirement applications due to the poor economy. From now until about 2023, benefits will be paid from the Social Security taxes collected each year plus the interest on the trust fund. Thereafter, we'll start dipping into the principal of the trust fund; by 2036, the trust fund assets are projected to be exhausted. At that time, only about 77 percent of the Social Security benefits owed will be able to be paid from taxes collected.
The Social Security trust fund is invested in special U.S. treasury bonds. The pictures above show Social Security's "Fort Knox" -- a file cabinet with notebooks containing the $2.6 trillion in these special bonds. These bonds are part of the total U.S. federal debt, which is estimated to be $14.3 trillion as of August 3, 2011. These special bonds are used to finance all the various operations of the U.S. government, including the military, foreign aid, and entitlement programs.
But in reality, there's been no raiding of these bonds going on. The word "raid" implies that greedy politicians in a smoke-filled room have been stealing our money for their pet pork projects. In reality, these special bonds are being used in accordance with the laws passed in 1983 by a Republican Senate and a Democratic House, and signed by a Republican President -- in plain sight of everybody. The proceeds of these bonds became part of the total financial machinery that funds the U.S. government -- they weren't spent on any specific government projects.
This is not to say there aren't any problems with the way Social Security is being financed. In the future, when we dip into the Social Security trust fund to pay benefits, the special U.S. treasury bonds must be converted into cash, and there will be only two sources of this cash: (1) future taxes in addition to Social Security taxes or (2) new federal borrowing.
The recent brouhaha over the debt ceiling arose because of concerns that our federal debt is getting too large, and that eventually we'll be unable to make payments on this debt. If that happens, then part of the debt that won't get paid are the assets in the Social Security trust fund, thereby jeopardizing the security of future benefit payments.
And while I don't agree with use of the word "raid," I do share the concern about the growth in the federal debt. If the total federal debt is manageable, then there's no doubt that the special U.S. treasury bonds in the Social Security trust fund will be repaid. But the concern is that the federal debt is growing to unmanageable levels.
One obvious solution to the problem is to bring the total federal debt down to manageable levels, so that once again, there's no doubt that the special treasury bonds in the Social Security trust fund will be safe. The obvious difficulty with this solution is that it requires running a surplus each year, through some combination of tax increases and reduced federal spending -- and you know that's easier said than done.
The other possibility is to set up Social Security financing such that future benefits aren't dependent on future borrowing or future taxes other than Social Security taxes. And that brings us to our two possible fixes.
Next: Pay-as-you-go financing
Pay-As-You-Go Financing
For decades, Social Security operated roughly on a "pay-as-you-go" basis, in which the Social Security taxes collected each year paid for the benefits due to retirees. This was feasible long ago when the number of workers paying Social Security taxes was many times larger than the number of retirees collecting benefits. In the decades to come, with the impending retirement of the baby boom generation, there will be under three workers paying Social Security taxes for every retiree collecting benefits.
One solution is to return to pay-as-you-go financing, so that the Social Security taxes collected each year from workers pay for the benefits due retirees each year. Under this solution, there would be no need for a substantial Social Security trust fund. To make this solution work, however, we'd need some combination of increased Social Security taxes or reduced benefits, so there's a rough balance between the two. The basic "deal" is that the current working generation pays for the benefits of the current retired generation, with the expectation that the following generation will agree to the same deal.
With this solution, we couldn't do away with the trust fund altogether, because it is impossible to exactly balance taxes collected with benefits paid each year, and we'd need a trust fund to provide a cushion.
What kind of benefit reductions might be necessary, if we didn't raise Social Security taxes? Based on a read of the 2011 Social Security trust fund report, I'm guessing that benefits would need to be reduced to roughly 80 percent of current levels. This would come about through some combination of reducing the amount of monthly income, increasing retirement ages, and reducing future cost-of-living adjustments.
On the other hand, if we agreed to increased Social Security taxes, then we could get by with smaller benefit reductions. A return to pay-as-you-go financing would require some tough choices, but it is one way to go.
Next: A Real Trust Fund
A Real Trust Fund
Normally, when people think of a trust fund, they think of money that's been dedicated for a specific purpose and can be converted into cash fairly readily to meet payment obligations. Using this definition for Social Security, we could operate the Social Security trust fund like the pension trust funds of corporations and state and local governments, where assets are invested in stocks, bonds, and real estate.
One problem with this solution is that government ownership of businesses and real estate could be considered socialism, and politicians might be tempted to influence corporations to achieve social goals. One way to mitigate the undesirable effects of this solution would be to require that the Social Security trust fund be invested in broad-based equity, bond, and real estate index funds, with no voting powers or investment selection powers given to politicians.
Is it even feasible to invest the Social Security trust fund in this manner? That is, could our capital markets absorb the necessary investments? It's not easy to get a handle on the total capitalization of U.S. equity, bond and real estate markets, but let's give it a try. Based on a brief search of the Internet, it appears that the total capitalization of the U.S. stock market is roughly $12 trillion so far this year. The total capitalization of the U.S. debt market other than the federal government appears to have been about $25 trillion in 2009, and the total value of U.S. real estate is about $25 trillion. Add this up, and you have a total value of more than $60 trillion that would need to absorb a Social Security trust fund of about $2.6 trillion. So the idea isn't out of the question.
One big problem with this solution is the transition: We'd need to sell the $2.6 trillion in special U.S. treasury bonds to raise the cash to buy stocks, bonds, and real estate of this amount. More likely, we'd phase in the sale of these bonds and the resulting asset purchases over several years, to minimize the disruption.
This solution might give a boost to stock, bond, and real estate markets, and could give us all a collective stake in the business of our country. We'd collectively invest in America through the private sector. On the other hand, it could create a drag on stock, bond and real estate values in years to come, when these assets might need to be sold to pay for benefits that come due. At that time, the government would need to decide which assets to sell. No doubt there are consequences with this solution that I can't foresee, but I wish our leaders would explore creative solutions to the Social Security funding challenges.
As you can see, there are no easy answers here. The eventual solution may be some combination of these ideas. And I'm sure many readers have ideas of their own that might help. (Feel free to add your comments below.)
My hope is that our leaders can put our country's interests ahead of their political parties and their ideologies. I'd like them to conduct honest, reasonable debates about solutions that will work, and come to reasonable compromises that balance tax increases and entitlement reductions. We expect our leaders to address the tough challenges facing our country. I really don't care about the success of any political party, and workable solutions are the ideologies that I care most about. Leaders who agree by their actions will get my votes.
More on MoneyWatch:
- 3 Big Myths About Social Security
- Is Social Security a Ponzi Scheme?
- Debt Deal: What Changes Are in Store for Social Security?
- Debt Deal: What Changes Are in Store for Medicare?
