Sunday, October 31, 2004

How to Reform Social Security, Part II

The last time I wrote for an academic audience about Social Security reform was this paper, which I presented in Sweden two years ago at a conference sponsored by the Foundation for International Studies on Social Security. In that paper, I argued that the most sensible way to restore solvency was by raising the age at which the system pays out full benefits, also called the normal retirement age, or NRA. (The discussion below is similar to the section on "Moving Forward," which starts on page 9 of that paper.)

Arnold Kling recently wrote about the need to reform Social Security on his blog and at TechCentralStation and concluded that, "The retirement age is the most logical and effective policy lever." I think he is exactly right, primarily because it squarely addresses one of the two main reasons why the system is projected to run into cash flow problems in the near future.

The dramatic increase in Social Security's cost rate over the next several decades is mainly due to the increase in the number of beneficiaries relative to covered workers. In 2004, there are 30 beneficiaries per 100 workers. By 2080, there will be 54, an increase of about 80 percent (as shown in this table). Over the same period, the program's cost rate--the ratio of benefits paid to taxable payroll--will increase from 11.07 to 19.39 percent, an increase of about 75 percent (as shown in this table). That the increases are so close shows that the projected deterioration in Social Security's finances is almost entirely the product of demographic shifts.

There are two reasons why there will be about 80 percent more beneficiaries relative to workers in the future: lower fertility rates and lower mortality rates (see this table for the history and this one for the projections). There is probably no easy way to link a reform of the system to changes in fertility rates, but it seems straightforward to base reform on changes in mortality rates.

Failing to index the retirement age to life expectancy implies an increasing portion of adulthood spent collecting benefits. Policy makers could craft a sensible justification for raising these ages. Consider how much easier it is to explain why retirement ages have to increase than it is to make sense of, say, an effective switch from wage indexing to price indexing in the calculation of the benefits (the centerpiece of Commission Model 2). Other reforms could be introduced to compensate for the impact of lower fertility rates on the system's finances, and I would not be against the ones that work by reducing future benefits rather than raising future payroll taxes. I would prefer to just stick with one policy lever to keep things simple.

A rough calculation suggests that the normal retirement age would have to increase to 73 by 2080 in order to restore solvency using only this policy lever. Though it seems to be a large change, it can be phased-in at a rate of about a year of age per decade (if we start now). When fully phased in, a worker who wished to retire at the currently legislated normal retirement age of 67 would face actuarial reductions of about 40 percent of benefits (e.g., the current early retirement reduction factor of 6 2/3 percent per year for 6 years). It would be perfectly reasonable to help people retire earlier than the NRA by facilitating a system of personal accounts, and, as I noted earlier, if any new money is coming into the system, it should be done through personal accounts.

Raising the NRA by this much would create a few complications, which could be easily addressed. Here is a list of the ones I think are most important:

1. The Early Eligibility Age. Workers can first claim benefits at the early eligiblity age (EEA), which is currently 62 and not scheduled to increase. Benefits are reduced at an actuarially fair rate for each year that benefits are taken before the NRA. When the NRA is 67, the total reduction for those 5 years will be 30 percent of benefits. If the NRA goes up, then the EEA should also go up. Otherwise, some people who live for a long time after claiming benefits at age 62 would be at risk for poverty later on in old age.

2. Pressures on the Disability Insurance Program. Workers who become disabled before their normal retirement age are eligible for disability benefits. These benefits are more generous than benefits taken early in the absence of disability. With higher ages for full and early benefits, there is more of an opportunity (and possibly a greater incentive) for workers to claim disability. This will increase program costs and can be addressed by having the normal retirement age increase a bit faster than a year per decade, if necessary.

3. The Bigger Hit to Low-Earners. People with higher incomes over their lifetime tend to live longer. Raising the Normal Retirement Age therefore disadvantages lower income workers more than higher income workers. This impact can be offset by changes in the benefit formula to give higher replacement rates for lower earnings, paid for by lower replacement rates at higher earnings levels.

With the retirement ages linked to projected improvements in life expectancy, personal accounts can serve two purposes. First, their accumulations can facilitate retirement at ages earlier than the legislated early and normal retirement ages. There is nothing wrong with people retiring when they choose--they just should not do so at the public's expense or at the risk of their own poverty later in old age. Second, when confronted with the magnitude of the increase in the NRA required to restore solvency, policy makers may decide that they prefer to bring new revenues into the system rather than rely solely on higher retirement ages. Investing those revenues in personal accounts rather than the Trust Fund helps to ensure that the additional revenues are actually saved for retirement rather than becoming a source of funds for the government to finance the rest of its expenditures.

The reason I like using higher retirement ages to restore solvency is that it simply brings our definition of "Old-Age" in Old-Age, Survivors, and Disability Insurance in line with contemporary (and evolving) notions of life expectancy. It gets Social Security to live within its means and allows the system to continue alleviating poverty among the elderly.

5 comments:

Anonymous said...

Andrew,

Although it is not necessarily in conflict with your recommendations, I have an alternate economic view of unfunded mandates in general, which I have demonstrated in a short example here. -

http://catallarchy.net/blog/archives/2004/10/31/why-unfunded-mandates-cannot-be-effectively-funded-in-advance/

Any comment that you may care to make would be appreciated.

Regards, Don Lloyd dlloyd@catallarchy.net

JG said...

While solvency is always the problem raised in regard to SS, in the long run I don't believe solvency is the real political problem of SS any more than it is of the Defense Department or Department of Agriculture.

The real issue that in all likelihood will drive the politics of changing SS is the fact that in the future masses of people are going to be getting back from it much less than they put in.

A fundamental principle of SS from FDR's day on was that SS would give a fair positive return on contributions to participants.

Of course, its great political popularity resulted from it giving *much more* than a fair return, due to the changes in it that moved it from being funded to unfunded starting with the legislation of 1939.

But in the future it is going to provide *much less* than a fair return -- with negative returns to many, including the poor, as shown by SSA actuarial figures at http://www.ssa.gov/OACT/ASKACT/part2.html

Examples of the value of benefits to be received from SS relative to the amount of payroll taxes paid in, discounted to current value for persons entering the work force in 1994:

Single males:
low income - 2.6% (Ouch, the poor poor)
medium income - 27.5%
earnings limit income - 52.1%

Single women:
low income +12.9%
medium income -16.0%
earnings limit income -44.0%

Married couples with kids, SS's big winners.
low income +99.8% (Jackpot! That's over 2.5% a year!)
medium income +49.7% (2nd place, 1% a year)
earnings limit income -1.1%

And note that these are the legislated benefit levels -- not the funded level of benefits which is maybe 25% less, making the true returns that will arrive even more negative, since either tax increases or benefit cuts used to close the funding gap reduce returns on contributions still lower.

And that's the problems with increasing the retirement age -- it's a benefit cutback that reduces returns on contributions to even lower than the above.

Really, closing the "funding gap" of Social Security is easy. Doing so in a way that maintains SS's popularity in the face of it's providing increasingly negative returns, reducing the wealth of so many, when so many *much* better investment options today are available for that 12.4% payroll tax, will be the challenge.

Private accounts of at least 2 points of contributions placed in real investments could restore SS to providing positive returns to almost all. That's the only solution to this problem I see.

Private accounts coupled with benefit cutbacks -- such as a later retirement age, and means-testing benefits away from the growing numbers of retired 401(k), IRA, tax-free homes millionaires -- could readily restore the whole program to fiscal and poltical viability, and that's what I'd think politics will drive things to maybe a decade from now when SS goes cash-flow negative.

Jake said...

Generally people are so healthy today at age 65, it does not make sense to turn them out of the workforce. If people reach 65 their life expectancy is close to 90 years old.

It will be difficult for people to have 25 years of retirement both financially and psychologically. The retirement age should be raised to age 70.

Anonymous said...

But what about the larger problem, Medicare? The current administration has made this worse with last year's Big Pharma subsidy act. Extending retirement in theory helps this problem as well. However, you are exposing the majority of our older work force to being dumped from the work force without either retirement or health care. I suspect employers will not want to shoulder the cost of the health care issues of a very large number of 65-69 year old employees.

It would seem to me that your suggestion does not work without a simultaneous health care remedy, e.g. some sort of single payer system.

David Connor said...

While the need to increase retirement age as life expectancy increases is indisputable, a few comments are in order.
First, in the 1930's the age of entry into the work force was much lower. High School graduates were a minority, and most workers were working and contributing to SS before they were twenty, not 22 to 25 as is the case today.
More significantly for planning purposes is the number of workers in the public sector who are not contributing to the system. Folding civil service employees into the system in some form will help tremendously with the funding problem. Federal, state and local workers should contribute to social security as a base, with their pensions funded as a supplement.
Double dipping should be stopped. The current practice whereby a federal civil servant can retire after thirty years at 80% of salary, and then take a job in the private economy, qualifying for social security on top a civil service pension cannot be sustained.