BY ARUN S. MURALIDHAR · JUNE 13, 2018 12:00 PM
In June 1999, The New Yorker
magazine carried a cartoon of a man stranded on an island telling his potential
rescuer to focus instead on saving Social Security. The trustees for Social
Security just released their 2018 report and,
scarily, the plea is as appropriate today as it was 20 years ago.
In short, Social Security is a
slow-moving train wreck. In 2034, the combined trust fund (currently at $2.9
trillion) — where excess revenues over payments have been maintained — will be
exhausted. The trustees suggest Congress needs to act quickly because
otherwise:
·
a) Social Security taxes will need to be raised to 16.65% in 2035
and 17.6% in 2075, from 12.4% today;
·
b) benefits would need to be cut by about a fourth; or
·
c) some combination of both.
Let's not kid ourselves — no
sensible politician would dare suggest option b, so the only result of inaction
will be higher taxes for our children.
In 2004, the late Professor
Franco Modigliani (Nobel laureate) and I wrote a book ("Rethinking Pension
Reform," Cambridge University Press) arguing Social Security needed to
be reformed
immediately because it was a ticking time bomb and delays would
only increase the cost. In 2004, the Social Security Trust Fund was projected
to be depleted in 2042 — so inaction, and even detrimental decisions during the
Obama administration, have moved up the depletion date by eight years, meaning
higher Social Security taxes eight years earlier. One would hope that inaction
today is not an option given we can see this wreck taking place in front of our
eyes.
This begs the following key
questions: What is the problem with Social Security? Why does it need to be
reformed? Is there a sensible reform option? If so, is it feasible and how do
we transition to the new Social Security.
Unsustainable funding principle
Social Security is a mandatory
(with some exceptions) defined benefit pension plan and pays citizens, who
participate for a minimum number of years, a pension through death with some
survivor benefits, based on average lifetime income. It is one-part pension
system and one-part wealth redistribution, as low-income earners get a slightly
higher pension replacement rate than higher earners. It also has a disability
insurance component. The first generation of retirees were paid a pension
without ever having contributed, which is where the Social Security financial
problem originates. The funding principle underlying Social Security is termed
"pay-as-you-go" or PAYGO. For such a system to work efficiently, the
commitment every future generation is making to the previous generation is to
produce more children (so that more folks are taxed) and/or grow the economy, especially
as life expectancy increases.
Social Security is not a pure
PAYGO because in the 1980s, Alan Greenspan headed a commission that recognized
that this social contract was being violated, raised the payroll tax to the
current rate of 12.4%, and all excess contributions over payments were placed
in the trust fund that would earn an artificial rate of interest. In 2017, this
rate was 3% nominal, which is close to the yield on a 30-year Treasury bond.
In 1997, Mr. Modigliani and I
started to evaluate Social Security. We argued the system was headed for a
crisis because PAYGO was not a sustainable funding approach given the future
demographic imbalance (low population growth and increasing longevity) and low
projections for economic growth. In short, for small and reasonable changes in
these parameters, future Social Security taxes would be very volatile and
potentially much higher than current levels. Instead, we recommended the U.S.
convert Social Security into a partially funded pension system — much like
traditional pension funds — and have assets invested in the market under the
oversight of a blue-ribbon board — much like the Canada Pension Plan — and with
a clear target return (in 2004 we set the target at 5.2% per annum real).
Further, clear rules were articulated to adjust taxes/benefits if the realized
returns were above or below the target. For simplicity, call this the "MM
model."
Our key point was that the
simplest way to express the Social Security contract with citizens was to
express a DB plan as nothing more than a guaranteed rate of return on
contributions — in this case 5.2% per annum. Since a portfolio invested in
financial assets would have volatile returns, the guaranteed return on contributions
would be achieved via a swap between the U.S. Treasury and the Social Security
Administration.
Even these changes were not
sufficient back in 2004 to save Social Security, because Social Security's
finances already were severely impaired. Additional contributions/taxes were
needed to ensure financial stability even under the MM model. By our estimates,
a one-time permanent increase in taxes by 1.1 percentage points (to 13.5% from
12.4%) would stabilize contributions permanently at that level (as opposed to
forecasts of Social Security taxes approaching 19% by 2075). The rationale with
the one-time increase in contributions was to ensure intergenerational sharing
of the burden (as opposed to passing the buck to our kids) and to ensure the
lowest possible impact on all citizens.
Alternatively, if the country
ran budget surpluses (briefly during the Clinton administration), those
resources could be used to get the partially funded MM model going.
Interestingly, had the U.S. adopted the MM model or even invested the trust
fund in financial assets, a simple 60% stock/40% bond portfolio would have
earned 8.5% nominal per annum from January 2004 to June 2018 — in excess of our
projected 5.2% per annum real.
Is the MM model feasible in
2018 given the latest trustee report, and if so, what additional contributions
would it take given the generally low expected return on assets?
Still salvageable
It is still possible for
Congress to convert Social Security to a partially funded system, and invest
the trust fund in a diversified portfolio of assets (much like the Canadians
and Japanese), under the supervision of a blue-ribbon board, with a clear
target return. The Social Security Administration could similarly enter into
the swap with the U.S. Treasury. One unanticipated benefit of inaction by
Congress is that the cost ratio (i.e., projected benefits divided by the total
payroll) is no longer projected to reach 19%, but rather flatten out around
17.75%. This result follows because of higher projected labor force increases
and replacing baby boomers with lower-birth-rate generations and slightly lower
projected growth of wages than in 2004. This drop in the cost ratio permits the
U.S. to potentially still save Social Security 20 years after we first proposed
the MM model. If we assume the trust fund earns 5.2% per annum real
(alternatively, 4% per annum real), then the additional one-time permanent
increase in Social Security taxes would be 1.45% (or alternatively, 2.3%).
Moreover, the trust fund in steady state would be just 85% of total payrolls,
ensuring this portfolio is not so large as to overwhelm global financial
markets.
Clearly, delaying reform, even
with the beneficial impact of a lower long-term cost ratio, has raised the cost
to future generations from a 0.7% increase under the Clinton administration, to
1.1% under the Bush administration to a 1.5% to 2.25% increase in 2018
(depending on one's forecast of expected returns). However, this one-time
increase is far better than either having future contributions jump 4.3% or
trying to maintain PAYGO (which could be maintained alternatively with a
one-time permanent increase in Social Security taxes of 2.78%). Leaving Social
Security as a PAYGO system would unnecessarily leave future generations with a
pension plan with highly volatile contributions for small changes in
productivity or demographic changes. More significantly, the delay has
prevented Social Security from earning a much higher return on assets than the
current 3% it earns from the U.S. Treasury, and these higher returns could have
been used to pay pensions thereby reducing the pressure on Social Security
taxes to pay current beneficiaries.
The U.S. might have just lucked
out in that the MM model is still feasible, but the time to act is now.
Hopefully, Congress will have the courage to say, "Forget about me – save
Social Security!"
Arun Muralidhar is co-founder of Mcube
Investment Technologies LLC, in Great Falls, Va. This content represents the
views of the author. It was submitted and edited under P&I guidelines, but
is not a product of P&I's editorial team.
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