The Outlook for Social Security

March 2005

Time for Change? The Outlook for Medicare and Social Security

Stephen Goss
Social Security Administration

Social Security’s current outlook is very similar to last year’s: the program’s finances are not sufficient to pay its scheduled benefits. The main pressure on the program is the large demographic shift slated to occur in just a few years. The government’s commitment to retirees has expanded considerably and continues to increase, since benefits are indexed to wages.

Social Security’s greatest problem is caused by the gradual decline in birthrates that began with the baby boom generation. This has resulted in a major imbalance between current retirees and workers. A smaller working generation will support the baby boomers entering the program, and this represents a permanent shift. Social Security has scheduled benefit levels, retirement age, and revenue via the payroll tax rate. With the impending shift in demographics, we cannot sustain all three.

No major demographic or macroeconomic changes were made to this year’s report. The birthrate, wage growth, and Consumer Price Index (CPI) figures remained the same. The program’s projected cost as a percentage of payroll has worsened slightly from 2004 to 2024, in part because the CPI rose faster and wages grew slower than previously projected. Cost of living adjustments resulted in higher benefits without an increase in tax revenue to pay for them. Estimates also reflected methodological improvements, including better estimates of age-specific earnings levels. Consequently, Social Security will have a slightly smaller surplus through 2016 and a slightly larger deficit by 2024.

In this year’s projections, cash flows begin to be negative one year sooner, in 2017, because of the higher benefits. The trust fund is depleted one year earlier--2041--than reported last year.

The actuarial balance is a measure of the program’s shortfall over the next seventy-five years, usually expressed as a percentage of taxable payroll. That figure was raised from 1.89 percent to 1.92 percent, an increase partially offset by the slightly more favorable outlook past 2024. In present-value dollar terms, this balance has risen from $3.7 trillion to $4 trillion because of measurement issues, but this value expressed as a percentage of payrolls did not change from last year. Another important metric is the level of benefits that could be paid solely from taxes collected after the trust fund is exhausted in 2041. In that year, 74 percent of benefits could be paid, but by 2079, only 68 percent of obligations could be met. The report also estimates the program’s shortfall over an infinite horizon. The shortfall increases from $4 trillion to $11.1 trillion in present value when extending from seventy-five years to an infinite horizon.

The Trustees Report is confident in the sustainability of the pay-go system, but only if critical changes to the program are made. Congress must confront difficult reforms and either increase Social Security’s revenue level, decrease benefits, or increase the retirement age.

Kent Smetters
University of Pennsylvania

The trust fund is projected to be exhausted in 2041, and the crossover date when costs will match income is 2017. The program’s seventy-five-year actuarial balance is $4 trillion.

The report briefly discusses the idea of sustainable solvency, or reducing the seventy-five-year shortfall to zero or less, and ensuring an upward trajectory for the trust fund past the seventy-five-year window. However, the trust fund exhaustion date does not indicate the magnitude of the problem after exhaustion of the trust fund. At the same time, some reforms exist that could improve Social Security’s long-term financial outlook while reducing the size of the trust fund. There is also an implicit assumption that past Social Security surpluses have been saved (adding to trust fund balances)--in other words, that Congress has not spent the money.

The income crossover date has received a lot of attention recently, but it only indicates when the Treasury must start coming up with additional money, not the size of the problem. The seventy-five-year actuarial balance, while indicating the size of the problem, underestimates the present value of the shortfall by as much as two-thirds, and is subject to the "moving window" problem--estimates can change from report to report simply because they look at different seventy-five-year periods. In 1983, Congress supposedly financed the system through seventy-five years, but Social Security now faces a $4 trillion shortfall. Over 60 percent of it is a result of the seventy-five-year window shifting over time to include more deficit years. In order to balance Social Security over multiple long-term windows, additional reforms would have to be made periodically into perpetuity.

The criteria for sustainable solvency address Social Security’s shortfall by requiring the trust fund balance to be increasing at the end of the seventy-five-year window. While it is easy to write policy that makes the trust fund look solvent at that time, the trust fund could reverse directions afterwards. It also does not account for the reduction in the present value of shortfalls after year seventy-five, which represents two-thirds of the problem.

The trustees report two more meaningful measures. Open group obligation (OGO) is the present value of future benefit payments minus the present value of future taxes, and minus the value of the trust fund. This measure captures how much money is needed today to place Social Security on a sustainable course indefinitely. It represents Social Security’s true present value shortfall. The closed group obligation (CGO) is the amount of this shortfall (OGO) due to current and past generations, i.e. the Social Security "debt" being passed to future generations. This is the most meaningful measure for determining Social Security’s impact on the economy.

The 2005 Trustees Report indicates that the present value shortfall is about $11.1 trillion. Past and current generations have overspent more than $12 trillion, but future generations are projected to pay about $0.9 trillion more in taxes then they receive in benefits.

Medicare’s problem is about seven times that of Social Security. Part A’s shortfall is $24.1 trillion; Part B’s is $25.8 trillion; and Part D’s is double Social Security’s. And these figures already make optimistic assumptions about the growth of medical spending.

If employees are allowed to divert a portion of their payroll taxes into a personal account, scheduled benefits would be reduced dollar-for-dollar for every dollar put into the account. In the context of the report, this plan looks bad because the trust fund gets smaller, the crossover date is sooner, and the seventy-five-year solvency measure also worsens. The unfunded obligations, however, decrease equally, and there is no impact on the $11.1 trillion shortfall. Traditional metrics appear to reveal transition costs associated with this plan, since those measures do not track long-run obligations. In fact, the president’s plan is completely neutral.

Another plan, a "carve out with a hair cut," would allow a portion of payroll taxes to be invested into personal accounts but would reduce future Social Security benefits by slightly more than the present value of diverted payroll taxes. From a traditional accounting standpoint, this plan appears unfavorable, but unfunded obligations would be reduced.

The new measures should receive greater attention in the Trustees Report’s executive summary. Social Security’s actuaries should also report measures for various reform plans, particularly on their potential to bring sustainable solvency to the program.

Eugene Steuerle
Urban Institute

Social Security’s seventy-five-year actuarial balance is largely unchanged, but some changes deserve particular attention. The trustees estimate more single and divorced households, more single heads of households, and more households with two earners whose incomes are evenly split. These trends suggest fewer benefits and an improvement in the trust fund, but this is a strange way to reduce benefits—to configure them based on family structure instead of need.

In the debate over Social Security and Medicare reform we are all at risk of a great deal of hubris. We run the danger of making too many promises too far in the future. As Social Security and Medicare consume greater shares of the federal budget, other domestic spending becomes crowded out.

Despite the debates over individual accounts, the main problem is labor. The retirement age has not changed with the aging of the system, and fewer benefits are going to those truly in need. However, in the future, people will likely want to work longer. The designation of sixty-two as "old age" is a problem, if nothing else, symbolically. If there is a demand for older workers, the current labor force projections may be wrong. When they retire, the baby boomers could become one of the most underutilized labor force pools, and there will likely be a large demand for them at that time.

If Social Security continues to make promises for the future, it must accept accounts, albeit uncertain ones, of funding shortfalls in its future commitments. In its current design, Social Security’s excessive promises underestimate future voters. They deny future generations the authority to determine when benefits must be scaled up or when taxes must be raised. This disengages current voters and is likely a key source of dissatisfaction with government. Ideally, reform will ensure continued program sustainability, preserve the government’s commitment to other programs, and maintain Social Security’s stability in the face of external pressures, like changing family dynamics.

Christian E. Weller
Center for American Progress

The outlook for Social Security depends on labor market performance, which was worse than expected last year. In 2004, the trustees projected real wage growth for 2004 to be 2.4 percent, but it was only 1.2 percent. The trustees also projected employment growth to be 1.7 percent in 2004 when it was only 1.1 percent. Earnings as part of compensation were expected to decline by 0.3 percent but instead fell by 0.5 percent. All of these contribute to the weakened outlook.

Inequality plays a role when talking about Social Security and where those funds come from. The decline in the share of earnings subject to the Social Security payroll tax is partially attributed to faster wage growth for high-income earners in the late 1990s. While the trustees do not assume that this trend will continue, they also do not assume that earnings inequality will diminish. Since inequality is comparatively high, future declines in the share of earnings that are taxable for Social Security, should they occur, could slow the erosion of the program’s revenues.

There is no crisis in Social Security. The system can fund benefits for decades to come, but its long-term solvency should still be considered. Even after the trust funds are exhausted, Social Security can still pay more then 70 percent of promised benefits. And even with no changes, funded benefits will still be higher than current benefits and higher than benefits under a privatized system. Plus, there are different estimates of when the trust fund will be exhausted: the Congressional Budget Office, for instance, puts the date at 2052.

It is okay to have this debate within a seventy-five-year horizon, but basing policy on infinite horizon estimates is unsound.

The current reform debate focuses on two issues: solvency and wealth creation. Wealth creation and private accounts are not the best way to reform Social Security. Privatization is often couched in terms of improving solvency and increasing wealth for the least advantaged. In fact, it does neither of these. Carving private accounts out of Social Security will worsen solvency in the short term, and the government will have to incur massive amounts of debt that future generations will have to pay back.

There are two ways to address future solvency. The first is to strengthen the labor market, which would induce faster employment growth, higher wage growth, and less inequality. Much work needs to be done on all three issues. A second way would create additional revenue. Over the past few years, the tax code has shifted toward capital and away from labor, which has reduced progressivity. One Center for American Progress proposal would reverse these trends and make the tax code fairer for middle-class families, while also raising additional revenue.

Privatization would not create new wealth. Private account balances are offset by clawbacks, benefit cuts, and government borrowing. While progressives are not against pension systems in general, carving them out of Social Security would be unsound policy. Some methods to create pension security outside of Social Security would be to simplify savings vehicles, fund progressive initiatives, and provide low-cost, low-risk investment options.

The Trustees Report reveals two important lessons: the labor market matters, and Social Security is fine for decades to come. For the future, solvency and wealth creation should be addressed, but privatization can do neither.

AEI intern Michael Wilson prepared this summary.

Keynote Address

Mark W. Warshawsky
Treasury Department

As evidenced by this conference, the Trustees Reports receive a great deal of attention and are very influential. Several factors contribute to their credibility and impartiality, including the oversight of two public trustees (two members from the private sector), periodic external review of the methods and assumptions underlying the projections, the actuaries’ opinions at the end of the reports, and the annual evaluation of the reports’ presentation and substance.

Social Security’s current funding gap is often measured by the seventy-five-year shortfall, which is estimated at $4.3 trillion or 1.92 percent of taxable payroll. This estimate does not fully capture the financial status of the Social Security program because people pay taxes in advance of receiving benefits. No finite forecast period, then, can completely represent the financial outlook of the program. For example, the current seventy-five-year projections include almost all of the 2010 birth cohort’s taxes, but little of their benefits.

To understand Social Security’s permanent financial problem, income and costs must be calculated for the indefinite future, not just the next seventy-five years. In the 2005 Trustees Report, it is estimated that for the entire past and future of the program, the present value of scheduled benefits exceeds the present value of scheduled tax income by $11.1 trillion. This is the gap that reform must close. The Bush administration is committed to reform that makes Social Security permanently solvent.

Delaying reform only reduces the options for fairly distributing the benefits of Social Security across generations. If reform is deferred, fewer generations will be left to participate in the reformed system, and the changes will have to be more severe. Purely pay-as-you-go financing of Social Security would also unfairly burden future generations. For example, one option for achieving solvency would be to leave benefits unchanged and to raise payroll taxes each year starting when the trust fund is depleted in 2041. The payroll tax rate would reach 19 percent by the end of the seventy-five-year projection period, which most would agree is unfair. Any equitable reform would at least partially pre-fund Social Security benefits.

Fortunately, the current situation of Social Security is fixable. President Bush supports reform that increases the power of the individual, does not increase the tax burden, and provides economic opportunity for more Americans. The president’s guiding principles for reform include protecting the benefits of seniors at or near retirement, not increasing the payroll tax, offering personal retirement accounts (PRAs) to younger workers, and pursuing the goal of a permanently sustainable system.

PRAs provide individual control and ownership and allow individuals to invest in private-sector markets. The accounts will be voluntary; a worker can "opt-in" by choosing to put a portion of his or her payroll taxes into a PRA. Those who do not opt in will receive traditional Social Security benefits, with the system reformed so as to make it permanently solvent. An important benefit of PRAs is that they serve as private and effective "lock boxes." Because the savings are in personal accounts, they do not appear on the government balance sheet as budget surpluses and therefore do not lead to increased government spending.

Some have questioned the policy focus on Social Security when Medicare is facing larger financial shortfalls. One reason is that much more analytical groundwork needs to be done before the options to reform Medicare are clear and well understood. Options for effective Social Security reform, on the other hand, have been thoroughly analyzed by the research and policy communities.

Still, the administration has already begun to lay the necessary policy groundwork to reform Medicare. Medicare finances are projected to rise substantially, primarily due to rapidly increasing health care costs. Because health care cost growth is an economy-wide problem, efforts to contain Medicare expenditures must be done in the context of greater health care system reform.

The administration has promoted policies to make health care choices better informed and more responsive to costs and benefits. The Medicare Modernization Act introduced health savings accounts to the commercial health insurance market, increased the role of private plans in Medicare, and increased price competition between those plans. The administration is also considering how to encourage the utilization of health care information technology, which is believed to reduce errors and waste.

AEI intern Meaghan Ryan prepared this summary.