How Can We Save Social Security?
by william g. gale
william g. gale is the Arjay and Frances Miller Chair in Federal Economic Policy at the Brookings Institution and co-director of the Urban-Brookings Tax Policy Center. This article is adapted from his new book Fiscal Therapy: Curing America's Debt Addiction and Investing in the Future. Copyright© 2019 by William Gale and published by Oxford University Press. All rights reserved.
Illustrations by Kathryn Adams
Published January 21, 2019
Social Security is the federal government’s largest (and, arguably, most successful) program, spending close to $1 trillion in 2018 to support the incomes of roughly 50 million retirees, dependents and survivors, along with some 10 million disabled Americans. It covers almost all workers now on the job and is mostly financed with payroll taxes. But Social Security is financially unsustainable as it’s currently constituted: its expected payouts over the next few decades far exceed its expected revenues — making it a big part of our overall budget problem.
In one sense, that’s not surprising: policymakers haven’t attempted to narrow the gap since 1983, when it was facing an imminent financing crisis. But one way or another, the system will need an overhaul to address the coming shortfall — and, hopefully, to modernize its features to reflect changes in demographics.
The financing problem arises because Social Security is largely a pay-as-you-go program — the taxes that today’s workers pay go mainly to cover the benefits of today’s retirees. As a result, the coming rise in the number of beneficiaries relative to workers as the baby boom generation ages will wreak havoc on the system. With reserves that accumulated in previous years to supplement annual payroll taxes, Social Security can cover all of the benefits that workers claim through 2034. After that, the reserves will be used up and projected revenues will only cover about three-quarters of the benefits to which workers are legally entitled. Some combination of higher payroll taxes, lower benefits and new revenue sources will be needed to balance the books.
Many roads lead to Rome. But I favor a 2016 reform package crafted by a commission (of which I was a member) established by the Bipartisan Policy Center. It would raise taxes and reduce benefits in a progressive manner while also protecting the poor, encouraging people to retire later and fixing the way Social Security payments are automatically adjusted for inflation.
Adopting the commission’s package as of 2021 would mitigate a non-trivial part of the federal government’s long-term fiscal problem, reducing the debt-to-GDP ratio by about 22 percentage points in 2050 and by larger amounts thereafter. Fixing Social Security would also strengthen a social compact that links generations, and perhaps inspire other overdue reforms in how we tax and spend. After all, if we can modify a program long known as the “third rail” of Washington politics, surely we can modify others as well.
The Origin Story
Created in 1935 as part of FDR’s New Deal, Social Security originally covered a modest fraction of the workforce and required employers and employees to pay small payroll taxes dedicated to supporting the system. FDR wanted taxes that were explicitly earmarked to finance the program because, in his words, “with those taxes in there, no damn politician can ever scrap my Social Security program.” Benefits were payable at age 65 (at a time when life expectancy was 66 for 20-year-olds) and were first paid in 1940.
FDR was certainly right that his program was bulletproof. Indeed, over the next several decades, successive presidents and Congresses expanded its size and scope. Today, Social Security, which is formally known as Old-Age, Survivors and Disability Insurance, or OASDI, consists of two linked programs. Old-Age and Survivors Insurance (OASI) — which is what most people regard as Social Security — provides benefits for retirees and their survivors and dependents. Disability Insurance (DI) provides income for working-age people who can no longer work, given their skills and physical abilities. The programs cover almost all Americans except for a minority of state and local government employees.
Almost one in five Americans now receives benefits, mostly through the retirement program. Retirement benefits average about $16,000 per year, less for widows and the disabled. Social Security kept as many as 26 million Americans out of poverty in 2016, including 17 million people aged 65 and older. Although its Depression-era designers never meant for it to become a comprehensive public retirement program, it now provides more than 90 percent of income for more than a third of the elderly and more than half of income for about two-thirds of the elderly.
Social Security’s operating rules are straightforward. Workers pay a 6.2 percent tax on their wages (and employers pay the same 6.2 percent tax on each employee) up to an income cap, which was $128,400 in 2018 and rises each year with average wage growth across the economy. Most experts believe (though the public certainly doesn't) that workers bear the economic burden of the entire 12.4 percent tax because employers offset their share by paying commensurately lower wages. About 85 percent of Social Security payroll tax revenues go to OASI, the rest to DI.
Only some numbers geeks (and, mercifully, some government computers) understand the details of how Social Security pensions are calculated. But the basics are fairly intuitive. A retiree’s monthly benefit depends on their average lifetime wages, adjusted for national wage growth and a handful of other factors. In 2018, the basic monthly benefit (the “primary insurance amount,” or PIA) was 90 percent of the first $895 in career-average monthly earnings, plus 32 percent of average earnings between $895 and $5,397, plus 15 percent of average earnings above $5,397, up to the taxable earnings cap.
Retirement benefits are 100 percent of the PIA for workers who first claim benefits at the “full retirement age,” less if they claim benefits earlier, and more if they claim later. The retirement age was 65 during Social Security’s first several decades. Under the 1983 reforms, it rose gradually to 66 as of 2017 and will continue to rise, reaching 67 by 2027. At that point, someone who claims benefits at age 62 (the youngest eligible age) will receive only 70 percent of their basic benefit. Someone who first claims benefits at age 70 (the latest eligible age) will receive 124 percent. These age adjustments are meant to give people about the same expected value of benefits over their lifetimes, regardless of when they choose to start claiming them.
But Wait, There’s More
Social Security includes insurance features that would be expensive (or simply impossible) to buy in the private market. Start with the facts that benefits rise each year to offset inflation and last for a lifetime, no matter how long the beneficiary is around. Benefits are allocated under the progressive formula outlined above, through which those who earned relatively low wages during their working years receive relatively more in retirement benefits as a share of pre-retirement income compared to high earners.
Now consider that qualifying spouses and former spouses of retirees can choose between their own benefits and 50 percent of the retirees’ payments. A retiree’s children also may be eligible for dependent benefits if they are under age 18 and unmarried. When a beneficiary dies, surviving spouses are eligible for payments that are usually at least 75 percent of the retiree's benefits.
The single most important change would be to ensure that the Social Security Administration has the resources to review the status of existing beneficiaries on a regular basis.
Disability benefits provide further protection against income loss and play an immensely valuable but widely overlooked role in the economy (and society). Disability before retirement age doesn’t just happen to “other people.” Workers face about a one-in-four chance of becoming disabled at some point, and without the safety net provided by Social Security, the consequences would often be catastrophic.
DI’s mandate is to provide benefits to workers who suffer from a medical condition that’s expected to last at least one year (or result in death) and that prevents the individual from working. To be eligible, one must have worked a sufficient number of years and have an impairment that the Social Security Administration determines is severe enough to qualify.
An individual who earns more than $1,180 per month while disabled loses DI eligibility. The program does not cover partial disability. Like OASI, DI plays a critical role for its beneficiaries, providing at least 90 percent of income for almost one-half of recipients and at least half of income for more than two-thirds of recipients.
That said, DI presents some thorny issues for policymakers and administrators that are quite different than those posed by the retirement program. In particular, it aims to protect people against disability risk without materially reducing their willingness to work. And that creates serious tensions. Indeed, private markets for disability insurance do not work very well in providing coverage at affordable rates, in part because disability is hard to define and measure — especially with regard to hard-to-verify conditions like back pain or mental health, each of which has been the source of rapidly rising claims in recent decades.
The problem is that they check in, but, alas, don’t check out: only about one percent of DI beneficiaries return to the workforce each year. Yet research implies that a sizable minority of DI recipients could plausibly return to work. Numerous policy changes could help to focus the program on its mission, including giving employers better incentives to retain or hire disabled workers, giving states less incentive to transfer indigent citizens from state welfare programs to federal disability insurance and allowing for partial or temporary disability payments.
But the single most important change would be to ensure that the Social Security Administration has the resources to review the status of existing beneficiaries on a regular basis. Funds for reviews have been restricted with the discretionary spending cuts and sequestration in recent years, and there is now a significant backlog of cases. The Social Security Administration estimates that each dollar it spends doing reviews saves $10 in future benefits.
Progressive? Yes and No
The ratio of annual retirement benefits to a measure of prior annual earnings is called the replacement rate. For workers who earn average wages and claim benefits at the full retirement age, the replacement rate is about 40 percent in the United States, which is about one-third lower than in other industrialized countries when calculated in a similar manner. But as noted earlier, the formula for Social Security’s benefits is progressive; the replacement rate is higher for lower-income workers compared to higher-income workers.
There is one catch here: thanks to the cap on wages used to calculate Social Security payroll taxes, the tax side of the system is regressive. The average payroll tax rate that a worker pays falls as their wages rise above the cap.
For most low-and middle-class households, payroll tax burdens (including Medicare payroll taxes and the employers’ share of them) exceed income tax payments.
Combining the progressive benefits and the regressive taxes, Social Security as a whole is still progressive on first calculation. As discussed below, however, retirees (and the permanently disabled) from higher-income households tend to live longer and thus receive benefits for longer periods, making the program less progressive.
From a contributor’s perspective, Social Security may look like an IRA or a 401(k) plan — you put in money while you’re working and get the money back in retirement. As noted earlier, however, Social Security is a pay-as-you-go system. If payroll taxes collected exceed the benefits paid in a given year, the excess revenues help to “build up the trust fund” — that is, to buy special U.S. Treasury bonds, which pay interest that’s credited to the system. When benefits exceed taxes, balances in the trust fund help pay current benefits.
The 1983 reforms raised payroll taxes and cut benefits. As a result, in every subsequent year until 2009, revenues exceeded benefits, and the excess went into the trust fund, making Social Security a partially prefunded system rather than pure pay-as-you-go. At the end of 2018, the trust fund held almost $2.9 trillion in Treasury bonds. Benefits now exceed revenues, however, and the gap is growing rapidly.
The headline-grabbing fact is that the proverbial cupboard will be bare by 2034. But even if nothing were done before then, Social Security would not disappear. Workers will still be paying sufficient payroll taxes to cover about 79 percent of benefits in 2034 and about 74 percent down the road.
The Really Long Run
While the trust fund’s depletion naturally gets the public’s attention, Social Security experts generally focus on Social Security’s financial outlook over a 75-year period. Social Security’s projected shortfall over the next three-quarters of a century averages roughly 1 percent of GDP. The shortfall does grow with time, though, with the figure reaching 1.5 percent of GDP by the 75th year.
Why is there a long-term shortfall? Because in a pay-as-you-go system, demography is destiny. The number of retirees will rise rapidly as life spans increase and as the huge “baby boom” cohort of Americans born between 1946 and 1964 all retire (the youngest boomers turn 65 in 2029). At the same time, the number of workers will grow more slowly than in the past because fertility rates have fallen.
It follows that fewer workers will need to support more beneficiaries. With roughly five beneficiaries for every 10 workers (as projected for 2070), payroll taxes would have to be two-thirds higher, or benefits 40 percent lower, than with three beneficiaries for every 10 workers (as in 2010).
The Seven Principles of Highly Effective Reform
Any successful reform needs to advance some basic objectives.
• First and foremost, reforms should eliminate Social Security’s 75-year shortfall and put it on a sustainable path thereafter. The 1983 reforms addressed the former, but not the latter.
• The financing should come from dedicated sources. Although revenue diverted from the income tax would keep the system progressive, it would not reduce the size of the government’s overall budget shortfall. And it would muddy the political waters, as Social Security has basically stood on its own over time.
• Cost-cutting should protect vulnerable Americans and enhance the social insurance and anti-poverty features that make Social Security so successful. It should not pare benefits significantly for low-and middle-income retirees, who depend on Social Security for critical needs. Cutting their benefits might not save much anyway, because this could push many more seniors into means-tested federal programs such as Supplemental Security Income.
• It should reflect changes in the economy since the 1983 reforms. For one thing, widening income inequality, coupled with the way Social Security calculates increases in the payroll tax cap, means that a smaller share of total wages is now subject to the Social Security payroll tax. For another, the widening gap in life expectancy between high- and low-income households means that high-income retirees will benefit disproportionately from the program. Before raising Social Security’s retirement age any further, policymakers should account for this demographic trend. Also, women’s entry to the labor force en masse suggests a need to reexamine how Social Security calculates spousal benefits.
• It should take intergenerational equity into account. The first generation of Social Security recipients received benefits but paid little in taxes because the program started late in their working years. Similarly, each time Congress expanded the program to cover new groups, it created a new “first generation” — that is, people for whom the value of their benefits exceeded their payroll taxes. There may be good reasons to treat first-generation recipients this way — for example, many initial beneficiaries of Social Security were veterans of World War I and/or elderly victims of the Great Depression. But going forward, workers should pay enough to cover the benefits of their own generation plus some of the legacy burden.
• It should respect public opinion. While any comprehensive reform is bound to include both tax increases and spending cuts, the public seems to favor maintaining benefits over keeping payroll taxes low, so the package should tilt toward higher taxes.
• It should address Social Security’s problems sooner rather than later. For the program to remain the cornerstone of retirement security, Americans should know what benefits they will receive and what taxes they will pay so they can plan ahead. While 2034 — the date of trust fund exhaustion — may seem far away, it would be prudent to change Social Security gradually so no cohort falls off the proverbial cliff. Because no one wants to cut current benefits and because many reform proposals exempt people who are 55 and older from benefit cuts, the effective window for reform is short.
A Durable Fix
Here’s how the reform package crafted by the Bipartisan Policy Center’s special commission would get us from here to there. The commission’s proposals were originally slated to begin in 2016. All dates have been moved back commensurately so that the changes would begin in 2021.
Raise the Payroll Tax Cap
In 1977, the payroll tax cap was set at 90 percent of wages in the economy and was indexed to grow in tandem with average wages. Since then, however, average wages have grown only modestly while the wages of high-earners have charged ahead. Consequently, by 2016, Social Security taxes covered only 83 percent of total wages.
Under the commission’s proposal, the taxable earnings cap would be raised to cover 86 percent of wages by the end of 2024. Thereafter, the cap would be indexed to the growth in average wages, plus half a percentage point annually. This would both buttress the program’s finances and offset decades of stronger income growth among higher-income households.
Tax More of the Benefits of High-Income Households
Currently, people with incomes above $25,000 if single ($32,000 if married) owe income taxes on a portion of their Social Security benefits, with the taxable share peaking at 85 percent. The commission proposes to tax high-income households (singles with income above $250,000 and married couples with income above $500,000) on 100 percent of their benefits. That would constitute a relatively modest tax increase for the affluent, but it would both raise some revenue and make the program more progressive.
Raise the Payroll Tax Rate
The commission would lift the payroll tax rate by 0.1 percentage points each year for the next decade, peaking at 13.4 percent. That is, employees and employers would each eventually pay 6.7 percent of wages below the taxable cap, up from 6.2 percent today. Raising payroll taxes would generate needed revenue, but at the price of increasing the tax burdens of low-and middle-income earners.
Raise the Full Retirement Age
The package would increase the full retirement age by one month every two years starting in 2027, until it reaches 69. The rationale is simple: people are living longer. For example, 20-year-olds in 2014 were expected to live to age 80, while 20-year-olds in 1950 were expected to live to just age 71.
There’s solid evidence that raising the full retirement age prompts people to delay retiring and claiming benefits, perhaps because it sends a signal that the cultural norm for retirement is changing. But make no mistake: each one-year increase in the full retirement age represents about a 5 percent cut in annual benefits. And the cut would be felt more by the poor than the rich because the poor rely more heavily on Social Security during retirement. Consider, too (as noted earlier), that the divergence in life expectancy is making Social Security less progressive, because it raises the average lifetime benefits that the rich receive relative to the benefits received by the poor.
Consequently, as we raise the full retirement age, we should not raise the age (now 62) at which retirees can begin receiving early benefits. Increasing the early retirement age would disproportionally hurt those who find it especially hard to work past age 62 — notably, manual laborers with minor age-related disabilities.
Protect Low-Income Beneficiaries and Make Benefits More Progressive
Because low-income workers would experience benefit cuts resulting from a higher retirement age, the commission’s reforms include several provisions to offset the impact. First, it would make the annual benefit formula more progressive by raising the PIA factor for low-income earners and reducing the PIA factor for high-income earners. Second, it would raise minimum benefits. A single person with a monthly benefit of $500 today would get an increase to $784. The boost would decline as benefits rise, and it would disappear once benefits for a single retiree reached about $900 per month ($1,360 for couples).
Currently, each member of a married couple is entitled to his or her own benefit or a benefit equal to half their spouse’s. In an era of one-earner families, this spousal benefit provided insurance to families across the income spectrum. Over the past half-century, though, women have entered the workforce in growing numbers, and one-worker families are now increasingly concentrated among high-income families. The proposal would scale back and cap benefits for nonworking spouses in high-income households.
The Big Picture
The package would restore 75-year solvency to Social Security as a whole and to each of its separate programs (OASI and DI), and sustain it for decades beyond. It would also reduce the overall federal debt-to-GDP ratio by 22 percentage points by 2050, and by even more in subsequent years.
In describing the package’s impact, we should distinguish scheduled benefits — the benefits that workers will earn under the current system — from payable benefits — the benefits that Social Security can legally pay if the trust fund runs out of money in 2034. As noted earlier, payable benefits are about 26 percent lower than scheduled benefits over the long run. Relative to payable benefits, the reform package would increase benefits for low-income and middle-income recipients by 53 percent and 31 percent, respectively, and cut benefits for high-income households by 2 percent. Relative to scheduled benefits — which are unsustainable under current law – low-income households would see a 17 percent increase, middle-income households would see a 2 percent cut, and higher-income households would see a 26 percent cut. The package would raise benefits for the most vulnerable retirees and reduce poverty rates among the elderly by 49 percent compared to currently payable benefits, and by 25 percent compared to scheduled benefits.
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This plan isn’t the only way to strengthen Social Security. But whatever lawmakers choose to do, they should avoid two faddish ideas.
The first involves investing Social Security’s surpluses in the stock market. Proponents say it would strengthen the program’s finances because stocks yield higher average returns than the Treasury securities that Social Security invests in today. Higher returns could, in fact, reduce the need for the painful benefit cuts or tax increases contemplated here. But stock market investing isn't the free lunch that its proponents sometimes suggest. Stocks are a riskier investment for Social Security’s surpluses than Treasury bonds for an obvious reason: stocks go up, but they also go down. If the market falls at a time when Social Security needs its surpluses to pay benefits, the program could find itself without adequate resources, leaving policymakers with the choice of cutting benefits, raising taxes or borrowing more money.
If Social Security were converted to private accounts, the program would still need to pay currently promised benefits. Proponents often ignore this burden when they tout the virtues of a private system.
The second (and bigger) mistake would be to privatize part or all of Social Security — that is, to divert some of workers’ payroll taxes into individual accounts that work like IRAs or 401(k) plans. Social Security benefits are adjusted for inflation, last for a retiree’s lifetime and are immune to stock market fluctuations, while individual accounts have none of those features. Private accounts would probably reduce the program's progressivity as well.
Proponents claim that people could do better financially with their own investments than they do when you consider the Social Security payroll taxes they pay and the benefits they will receive. That’s a classic apples-to-oranges comparison, though.
As noted, stocks go up and stocks go down, making private accounts riskier than today’s guaranteed benefits. Under Social Security, people get the money when they need it most — in survivorship, dependency, or disability situations. That wouldn’t be true with private accounts if workers needed income early in their careers (before assets were built up) or at just the time the market tanked.
Moreover, if Social Security were converted — all or in part — to private accounts, the program would still need to pay currently promised benefits. Proponents often ignore this burden when they tout the virtues of a private system. Finally, Social Security operates with extremely low overhead. Privatization would generate administrative costs from managing tens of millions of private accounts.
To be clear, encouraging people to save more in private accounts outside of Social Security — so-called “add-on” accounts — could help people better prepare for retirement. Policymakers could establish automatic enrollment in IRAs and go further to encourage employees to invest more in 401(k) plans. Or they could establish mandatory add-on accounts to which workers and employers would contribute, say, 1 percent of pay, while the government also contributed, with the amount progressively linked to income. Workers could withdraw funds from these accounts beginning at age 62 to match what their Social Security benefits would be. They would have to exhaust funds from these accounts before claiming Social Security benefits. This would allow people to claim Social Security at later ages, raising their annual benefit payments and reducing poverty rates among the elderly.
In any event, we don’t need to destroy Social Security in order to save it. The reforms outlined here would restore sustainability, maintain the program’s role in providing retirement income and social insurance, and increase incentives to retire later.