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Some people say that Social Security overall is earning very low returns (such as 1 or 2 %), and some people are even getting negative returns. Therefore, wouldn't we be better off investing the Social Security revenues in corporate stocks and bonds, and other private sector investments? Particularly since stocks have historically earned an average 7.5% real (after-inflation) return since 1926. And for balance and less volatility, some can be invested in corporate bonds. While corporate bonds have not historically been as profitable as stocks, they still have done much better than a 2% return.
What follows discusses the "low return" myth of Social Security (it's true, but SS is not an investment program!), and discusses some of the very heavy transition costs of changing SS from a pay-as-you-go program to an investment program.
A common myth is that the Social Security (SS) program is mismanaged, that the SS surpluses have been invested poorly, and that it is earning a very low rate of return. I've even heard that the SS investments have been earning a negative rate of return, or are projected to earn a negative rate of return. This is all a gross simplification of some complex issues. In particular, the SS program is not an "investment" program, but instead, it is a "pass-through" program where current SS taxes pay benefits to current retirees. It also pays benefits to disabled as well as retirees. And the SS "surplus", rather than being invested, is used to pay for the current costs of other federal programs.
However, the fundamental truth is that after 2013, the general taxpayer will have to pay higher taxes or make some other fiscal sacrifices in order to shore up the SS system. (This statement assumes that the SS Trustees' Intermediate forecast occurs).
Here is an example of a statement about how broken the Social Security system is, and how the current SS investments are earning diminutive and even negative returns. This is from some SS reform legislation Senator Rod Grams of Minnesota introduced in October 1998. See http://thomas.loc.gov/cgi-bin/query/C?c105:./temp/~c105hS2xhf. One can find more commentary by Rod Grams at http://www.senate.gov/~grams/ssintro.html
[Begin Excerpts from Grams' SS Reform Legislation. All emphasis is mine:]
{2} The social security retirement system based on a pay-as-you-go model has failed to meet the challenge of the demographic changes undergoing this Nation, has produced a diminishing return for today's workers, and is projected to go bankrupt, causing financial hardship for millions of baby boomers and destroying the American dream for future generations.
{3} A traditional approach of raising taxes or reducing benefits to fix the social security retirement system will not work because the magnitude of the current crisis makes these bailout plans impossible, and fundamental reform is needed to preserve social security.
{9} Social security reform must replace the current pay-as-you-go financing scheme with a fully funded system that will not only reduce inequality among generations, but also will greatly increase our Nation's savings and investment rates, and therefore produce prosperity.
{14} The return on current social security investment is quite disappointing for today's workers, and almost all workers in 2-earner families receive real returns under social security of approximately 1 percent, with some actually receiving negative returns.
{15} Over the 70-year period from 1926 through 1996, the average real return on the Standard & Poors 500 stocks was 7.56 percent, and the historical data supports the conclusion that a market-based, personalized retirement system will produce overall positive returns.
[End excerpts from Grams' SS Reform Legislation]
O.K. There you have it. For most workers in 2-earner families, Social Security investments are earning a diminuitive real return of 1%, with some even receiving a negative return.
Well, the above is a bit simplistic.
First of all, a defender of the current SS system will tell you that the SS surpluses in the Social Security Trust Fund (SSTF) are invested in government bonds. These government bond investments earned 7.2% in calendar year 1998, per TR99 p. 2 {18}, and considerably more in prior years when interest rates were higher. (The earnings are likely to decline somewhat in the next year or two at least, as the average interest rate on new securities purchased by the trust funds during CY 1998 was a considerably lower 5.6 percent).
On the other hand, these interest earnings -- being a book-keeping transfer from one Treasury Department account to another, are fictitious for all practical purposes. This will be discussed later, in section non102.
What Rod Grams is referring to when he talks about a return on SS investment is based on what a worker receives in benefits after retirement, compared to what the worker paid into the system during his/her working life as SS payroll taxes. For example, if the worker receives in benefits after retirement the same amount as he paid in as SS payroll taxes during his working life, then we say he has received a zero return. I call this definition of return an apparent return.
One resason that the apparent return of the SS is small is because not all of the SS benefit payments go to pay SS retirement benefits. In FY 1998, 87% of SS revenues went to pay SS retirement benefits. The other 13% went to disabled workers. So it is not just a retirement program. It is a retirement program (87%) plus a disability program (13%). Source: TR99 Table II.C7.
That 13% that doesn't go to paying retirement benefits might not sound like that huge of a deal. But how would your mutual fund investments have performed if 13% of the fund balance each year went to pay, for example, fees and expenses?
Another reason that apparent return is small is because SS is not a pre-funded retirement program where money is saved and invested. Rather, almost all payroll tax revenues collected today are spent later today on beneficiaries. That is, today's workers are supporting today's retirees and disabled.
A worker is currently benefiting from the SS system because he/she does not have to provide much or any support to his parents. That is because his SS and Medicare payroll tax deductions are supporting his parents. This is another benefit that is not considered in the apparent rate of return calculations. If we were to transition to an entirely pre-funded system, as many privatizers want, then we would have to find some other source of revenue to pay benefits to current SS beneficiaries. This is a huge amount of money that must come from somewhere -- for example, in 1999 payments to beneficiaries (and administrative expenses) is expected to be $394 Billion. And this is expected to increase rapidly in the coming years, for example reaching $1,405 Billion in 2020. See Table T103.1 below (non103) for figures for some other years.
Currently, (and for most of the program's life, but especially since 1984), annual SS taxes collected exceeds the annual SS program expenditures. The difference between these two is the annual SS surplus. The annual SS surpluses end up in the Social Security Trust Fund (SSTF). However, the SSTF then immediately loans all of this money to the Treasury general fund in exchange for Special Issue Treasury obligations. (I'll refer to them as SIT obligations or just "government bonds".) The loaning of the SS surplus to the Treasury general fund is the only facet of the SS program that can be considered somewhat of a savings or investment plan.
The Treasury general fund spends the money it borrowed from the SS program right away on current general federal programs.
Looking at the Treasury department as a whole, or if you prefer, the federal government as a whole, the SS surpluses are simply spent on current general federal programs. So nothing is really saved or invested. (This topic is exhaustively discussed in section non77 and touched on in many other places on this web site).
Another factor that the apparent rate of return concept leaves out is that the money the SSTF loans to the Treasury general fund helps pay the federal government's current bills. Over the last 20 or so years, the Treasury general fund has borrowed almost $800 Billion of SS surpluses from the SSTF and spent it.
Some critics of the current SS program, such as those favoring privatization, say that if only we had been investing the SS surpluses in private-sector bonds and stocks, then everything would be O.K. Well, that is true when just looking at the SSTF picture -- in fact, the SSTF would be in really great shape. It would be a real retirement account with real assets -- private-sector bonds and stocks. Rather than the present situation, where the SSTF "assets" are only claims against future general taxpayers.
But if the $800 Billion of SS surpluses over the past years had been invested in private-sector securities, then where would the Treasury general fund have gotten an additional $800 Billion from all these years?
Were it not for this borrowing, nearly $800 Billion would have had to be raised through higher taxes, or other fiscal sacrifices would have had to be made, such as cutting other federal government programs, or selling bonds to the public (which amounts to raising taxes on a deferred basis). This is a consideration that the privatizers often don't mention or try to bury.
As for the future, there are projected to be only about 14 more years when there are SS surpluses (from 2000 to the end of 2013). The surpluses that can be saved and invested during this short 14 year period will not come close to being enough to finance the deficits that the program will incur in the decades that follow. This is true even if the surpluses were invested in private sector stocks and bonds, and even if they earned good historic private - sector returns. The SS surpluses in the 14 surplus years are simply too small to do more than finance the SS deficits in the 13 or so years that follow.
Footnote: The cash surpluses in the 14 surplus years 2000 thru the end of 2013 add up to $801 Billion. (See the Operating (Cash) Net Income column (D) of Table T80.1 in section non80). The cash deficits in the first 13 deficit years, from 2014 thru the end of 2026 add up to $2796 Billion.Footnote continued: However, when surpluses and deficits are present-worthed (to the year 2000), the cash surpluses in the 14 surplus years 2000 thru the end of 2013 add up to $667 Billion. The cash deficits in the first 13 deficit years, from 2014 thru the end of 2026 add up to $718 Billion. Thus, assuming the rate of return on investment equals the 6.3% that I used to present-worth, the 14 surplus years will almost finance the following 13 deficit years. Should returns be higher than 6.3%, as one would expect for private-sector investments, then the 14 surplus years should be able to finance more than 13 deficit years. However, realize that demographics will be much less favorable to stock market investments after 2010 than they have been in the 1980s and 1990s).
And if the surpluses are invested in the private sector, then the surpluses will not be available to the Treasury general fund. Currently, with the "rest of the budget" (the budget excluding the SS surplus) being nearly in balance, most of the money that is loaned by the SSTF to the general fund is used to reduce the publicly - held debt. Reducing the publicly - held debt is like a tax cut on a deferred basis. The reduction in the amount of publicly - held debt also eases interest rates throughout the economy.
I'm not against privatization of some portion of Social Security in the future, in fact I favor it. But what upsets me is that it is never explained, or never well explained, that there isn't some pot of money in the SSTF somewhere that could be invested in the stock market.
See section non106 for a short discussion of privatization.
The SSTF earns interest on the money it loans to the Treasury general fund. This interest is set at the same rate as the market rate for Treasury securities that are sold to the public at auctions. In CY 1998 for example, the SSTF earned 7.2% (source: TR99 p. 2 {18}). This is well over the 1% real return or negative return that Rod Grams talks about. But...
The Treasury general fund pays interest to the SSTF in the form of SIT obligations. This payment of interest is really an internal accounting manuver between two Treasury Department accounts. The SIT obligations in the SSTF are not an asset or store of value that will help the federal government or future taxpayers to pay future beneficiaries. Nor do the SSTF's SIT obligations affect the legal obligation of the government to pay promised benefits. The government is obliged to pay all benefits set by law even if the SSTF is empty. (See section non131 and surrounding sections for official government quotes that the SIT obligations in the trust fund do not affect the ability or obligation of the government to pay benefits.)
So although the SSTF earns a market rate of interest (the market rate of Treasury securities), the interest is meaningless.
Rod Grams is comparing apples and oranges. There are many differences between a real retirement fund and Social Security. Comparing SS's apparent return to the return of a real pre-funded retirement fund is erroneous and misleading. However, he isn't being too pessimistic when he talks gloomily about the program's future. The fact that the SS program will require additional taxes after 2013 makes academic the debate about the real return of the SS program.
Currently we have annual SS cash surpluses because annual SS taxes exceed annual SS expenditures. For example, in calendar year 1999 the SS tax income is projected to be $464 Billion, the SS program outgo is $394 Billion, and so the SS cash surplus is $70 Billion (464-394 = 70). As a percent of outgo, this $70 Billion surplus is 70/394 = 17.8%. (See Table T103.1 below for figures for this and other selected years). But after 2013, SS taxes are projected to be less than SS expenditures. The general taxpayer will have to pay higher taxes or make some other fiscal sacrifice in order to keep SS benefits from being cut a little bit. (If SS taxes aren't raised, and if the general taxpayer does not aid the SS program, benefits will have to be cut by 1.3% in 2014, by 14.2% in 2020, and so on as shown in the last column of the table below).
Table T103.1
Operation Of the OASDI (Social Security) Trust Funds and the
Social Security Program
Income Net Income
(excludes Net As % Of
Calendar interest) Outgo Income Outgo
Year $ Billions $ Billions = B - C = D/C * 100%
-------- ---------- ---------- ------- ------------
A B C D E
1999 464 394 70 17.8%
2013 875 867 8 0.9
2014 917 929 -12 -1.3
2020 1205 1405 -200 -14.2
2030 1876 2542 -666 -26.2
2034 2241 3101 -860 -27.7
2040 2921 4037 -1116 -27.6
2050 4498 6230 -1732 -27.8
2060 6886 9888 -3002 -30.4
2075 13020 19415 -6395 -32.9
Source: Table T80.1 in section non80.
The OASDI Trust Funds Are Also Known As the Social Security Trust Fund or SSTF.
In Table T103.1, only certain selected years are shown. 1999 is the curent year. 2013 is the last year when there is a cash surplus. 2014 is the first year when there is a cash deficit. 2034 is the year in which the SSTF runs dry (a meaningless event). And 2075 is the end of the 75-year projection period.
To pick one year, in 2020, SS tax revenue is $1205 B and SS expenditure is $1405 B, resulting in a $200 B shortfall (1405-1205 = 200). Thus, assuming no help from the general taxpayer, benefits must be cut by $200 B, which is a cut in benefits of 14.2%. (200/1405 = 0.142). (This analysis is a little bit inaccurate because outgo also includes administrative expenses).
In 2030, benefits will have to be cut by 26.2%. In years after 2030, benefits will have to be cut by amounts ranging between 26.2% and 32.9%.
(To see a similar table for the more optimistic SS Trustees' "Low Cost" scenario, see section non168. Even in this most optimistic of the three Trustees' scenarios, benefits will have to be cut unless the general taxpayer provides additional funds).
Of course, it is almost certain that the general taxpayer will come forward to meet some or all of the Social Security shortfall, and thus benefits won't be cut so drastically. But pity the general taxpayer after 2013.
One can argue that the general taxpayer should come to the aid of the SS program, since the general taxpayer in effect borrowed from the SSTF during the surplus SS years, and therefore owes the SSTF the amount borrowed plus interest. That is true, but this fact won't make life for the future (after 2013) general taxpayer any easier. Nor will the future general taxpayer appreciate being asked to pay back what the general taxpayers in earlier decades borrowed.
In the above heading, I was a little loose in characterizing generations. More accurately, its been mostly the general taxpayers of the boomer and previous generations that have benefited from the Treasury general fund borrowing from the SSTF. And it is mostly the general taxpayers of the Gen-X and later generations who are expected to make the fiscal sacrifices to pay back the SSTF.
One of this web site's main purposes is to alert people to the projected future large tax burdens, and not to try to argue whether one group owes another group anything. But many Gen Xers and Yers do see themselves getting the short end of the stick, and this web site gives them a lot of reasons to think so.
* It is a disability program for currently disabled, (about $48 Billion in FY 1998)
* It pays benefits to current SS retirees (about $324 Billion in FY 1998)
* SS Surpluses fund general federal programs ($70 Billion in FY 1999)
* It has no savings or investments and thus earns no return
Source of the $48 Billion and $324 Billion numbers: TR99 Table II.C7. Source of the $70 Billion number is TR99 Table III.B3 p. 179 {195} -- it is "income excluding interest" minus "outgo".
Section non95 above discussed the Negative Returns Oversimplification. That section went on to describe in detail the ways in which the current SS program is not a pre-funded retirement program. The key differences between the current pay-as-you-go SS program and a pre-funded retirement program are:
* It is a disability program for currently disabled, (about $48 Billion in FY 1998)
* It pays benefits to current SS retirees (about $324 Billion in FY 1998)
* SS Surpluses fund general federal programs ($70 Billion in FY 1999)
* It has no savings or investments and thus earns no return
Source of the $48 Billion and $324 Billion numbers: TR99 Table II.C7. Source of the $70 Billion number is TR99 Table III.B3 p. 179 {195} -- it is "income excluding interest" minus "outgo".
Since the SSTF is not a pot of money or other sale-able assets that can be invested in the stock market, there is nothing with which to begin a pre-funded retirement program. We must start from scratch.
If we start saving the SS tax revenues in a pre-funded retirement account so that they can be invested, then we must find a way to {1} pay disability benefits to SS disability beneficiaries {2} pay retirement benefits to current SS retirees, and {3} raise general taxes or make some other fiscal sacrifice to replace the SS surpluses that have been funding general federal programs.
The fact is, all of the SS taxes being collected -- for example $464 Billion in 1999 -- is being put to use. Should this be diverted into a new pre-funded retirement program, then we will have to find $464 Billion from somewhere else to pay current SS beneficiaries and to fund the general federal programs that the SS surpluses are currently funding.
That of course is the Cadillac solution -- raising taxes to the point where we are both completely funding current beneficiaries and funding our own future retirements. That is too much of a financial burden to undertake in a year or two, or even a decade or two. It would be less drastic to phase in a mixed solution -- where some of the SS taxes and surpluses starts to finance a pre-funded program. And where most of the SS taxes continue to fund the present pay-as-you-go program.
(hits since Sept 16, 1999)
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