Monday, May 2, 2005

The Great Social Security Debate

There has been a lot of debate since President Bush’s Thursday night press conference and his statement on social security. Certainly, if one truth has emerged in the following days it is the truth that only the bravest (or dumbest) of politicians will attempt to touch this issue.

As written here in the past, I believe that the behavior of the Democratic Party with regard to this issue has been particularly shameful, and in the long-run will result in their own self-marginalization before the electorate. Reasonable people can argue about the extent of the Social Security (SS) crisis, and many have. Notably, most of those arguments are exercises in foot stamping and accusations of bad faith. Missing are such mundane details as demographic assumptions, underlying worker productivity, discount rates used to calculate the funding gap, and return on alternative investments.

Without these details it is impossible to asses the extent to which SS is in trouble. I will not enter the debate about whether or not we have a “crisis” other than to say that for reasons that I hope to make clear, I am inclined to side with those who say we do. We know there is a serious funding gap as SS is currently structured, and there seems to be some agreement that the government will need to borrow an additional USD 3.7 trillion over the next 75 years. The larger question for me exists beyond solving the funding gap.

I strongly believe that this question should be addressed on a level much deeper than how our seniors will be spending their golden years. While this is important, the question of what kind retirement plan is necessary for our workforce in this century is more so. It seems obvious that we live in a world that is greatly changed from the one in which SS was initially conceived. The economy of the mid 20th century was much more structured, focused around manufacturing and the labor required to keep the machines of commerce humming. A man graduated from high school (or left the military service) found a job, and generally worked for the same firm until retirement. A defined benefit pension was not unusual and health care benefits were provided because they were viewed as a cheap, non-taxable means of additional compensation.

Today, a college education is considered the ante for entrance into the workforce of skilled jobs. Men and women graduate, join the workforce and most often continue their education with graduate degrees or some other career specific training. Virtually nobody remains at the same employer for their entire career, and many workers not only change employers, but also jump career paths as market economics dictate. Capital markets are sophisticated, resilient and increasingly efficient, the market for skilled labor is dynamic and for many positions, global. Workers are in more control of their destiny, and follow far more interesting career paths than their fathers, but are also expected to be more responsible for their well being and training.

In my view then, our Social Security system must be changed to reflect the dramatically altered landscape in which we lead our modern lives. At the same time, we cannot forget our obligations to those in our world who, for a variety of reasons, are less fortunate in their economic status. The question then is, “what would such a plan look like?”

Before addressing this question directly, certain facts must be made clear which I present without comment on their validity, morality or economic justification:

  1. Social Security is not a pension system: While many people realize this fact, it still cannot be stated often enough. Pension systems are funds structured to be backed by a pool of invested assets, against which all future liabilities are calculated, and solvency is maintained. SS has no such pool, nor are all of it’s future liabilities calculated on some government ledger as liabilities.
  2. Social Security is not insurance: Insurance is a risk sharing mechanism where premiums are paid in, a pool of invested assets is maintained against actuarial calculations of event risk, and payments are made upon the occurrence of a covered event. SS has a “trust fund” but this is only a promise to borrow in the public markets in the future or a promise for future congresses to increase taxes on future generations. SS also doesn’t pay out on event risk so much as it pays to everyone a benefit once they achieve a certain age, regardless of need.
  3. Social Security is a wealth transfer system: Simply put, it is the guarantee of the government to tax future generations to transfer wealth to senior citizens in an effort to ensure that seniors stay out of poverty in their later years.
  4. Social Security faces a long-term demographic challenge: The challenge of the funding gap is not simply a historical anomaly resulting from the wave of retiring baby boomers. It is the result of this wave plus declining birth rates, and maybe most importantly, increased longevity. In short, the problem is not short-term, it is structural, driven mostly by the fact that life expectancy is now 15 years longer than it was when the system was created. The longevity problem will most likely get worse (or better, if you want to live a while!).
  5. Private accounts alone will not solve the funding problem: In fact, private accounts will have the effect only of shifting government borrowing to the present in what is commonly called a debt swap.

This final point 5 is a little tricky, and not well understood in the ongoing SS debate. Typically, opponents of private accounts talk about the onerous “transition costs” of restructuring SS to include private accounts. This is misleading because the government accounting of SS is misleading – in fact it would be criminal for a private fund found to be doing the same thing.

The U.S. government keeps on it’s “balance sheet” all debt that has been issued to support it’s operation. With regard to social security, it lists the debt held by the “trust fund” in the form of treasury’s. However, what is not listed is it’s future obligations to pay retirees their promised SS benefits. Why this is done is unclear to me and ultimately not important. However, as those who look to the trust fund as a source of solid funding point out, these obligations to pay future retirees are viewed by all as real liabilities.

The reason then that the talk of transition costs is misleading is because while the creation of private accounts would remove some current worker funding that goes towards paying current retiree benefits, an equal amount of future benefit liabilities to these workers would be deducted from the balance sheet in a one for one trade. The net effect is that while borrowing must necessarily increase in the short-term, it will be less by an equal amount in the long-term. This is a common mechanism used in our capital markets all the time, and is called a debt swap.

So with these facts out of the way, and hopefully agreed upon, perhaps we can address what must be done with regards to making SS solvent, and creating a retirement program for our new, educated, mobile and highly skilled 21st century workforce, while maintaining a safety net for those less fortunate. As I see it, and I’m open to other ideas, we are constrained to only a few options:

  1. Do Nothing: Always an option, the Do Nothing approach, while often attractive in a passive aggressive sense, will only serve to push the problem to future generations.
  2. Raise Taxes: Raising taxes would solve the funding problem, but are not politically popular, are not progressive, and would be a drag on economic growth. Further, raising SS taxes, increases the marginal cost of workers to their employer which would decrease the velocity with which our system allocates workers.
  3. Cut Benefits: This is difficult to do fairly, and would most likely require cuts through most economic classes to achieve the necessary affect.
  4. Raise Retirement Age: This would get after the source of our real underlying problem, and would remove the concern that SS in many cases is funding a leisure class and not simply providing economic security, but in unpopular.
  5. Cut Other Government Spending: Good luck.

I’ve presented the options above complete with each reason on why we shouldn’t follow them because I believe this is how each will be met in the marketplace of ideas. None-the-less, we need to do one, or some combination, of all of the above. For what it is worth, I think 1 and 2 are not rational solutions to our funding problem. As stated before, doing nothing really doesn’t seem to be an option. Raising taxes is, in my view, a fool’s game disconnected from reality. We’ve tried this solution in the past when the trust fund was created, and regardless of how real you believe the trust fund is, there can be no argument that the additional revenue was used, by both parties, to fund current spending on non-SS programs. Fool me once, you’re an ass, fool me twice, I’m a ass.

So realistically I think we’re looking at some combination of reducing benefits and raising the retirement age. The retirement age increase is particularly attractive since this is the one variable that has most adversely effected the solvency of the system since it’s establishment. Cutting benefits is attractive since we can achieve the needed benefit by cutting the growth of benefits, not the level of benefits.

Cutting the growth of benefits, while a reduction of overall benefits from the current system, can only be called a “cut” in terms of Washington speak. As most proponents of this approach have suggested, the growth rate of benefits should be tied to the rate of inflation, instead of the growth rate of wages as they currently are set. This change alone, while small in the short-run, is significant in the long-run and can have a large impact on reducing the funding gap. Further, by de-linking benefits growth from wage growth we can achieve another benefit that has not been widely discussed – the benefit of productivity growth. Wages typically grow faster than inflation because of productivity growth in the application of labor. One of the great stories of the last few decades has been the rate at which the productivity of the American workforce has grown. If this trend is to continue, then once we re-set benefit growth to the inflation rate, we will provide our younger workers with the chance to work out of the funding gap problem in part by advances in their productivity.

As we’ve seen from the response to President Bush’s Thursday evening comments, there will be objections to the cutting of the rate of growth of benefits for retirees. This is a real issue, and should be thoughtfully addressed, which is where personal accounts enter the picture.

As I’ve demonstrated above, personal accounts have no transition cost associated with them; instead they move borrowing to the present, while reducing future SS liabilities. With this in mind then, we can consider how personal accounts can comprise a powerful component of SS reform.

As traditionally proposed, personal accounts would be established by allocating some portion of a worker’s current SS contributions into the PA. The accounts would be invested in a conservative mix of high quality debt and equity vehicles and rebalanced annually to maintain appropriate asset allocation.

Under this structure, it is virtually certain that personal accounts would provide a better return to the retiree, than if the same amount of money had gone into the SS system. In a world with reduced benefit growth, there is a good chance that personal accounts would fill in this gap and possibly exceed it providing a more lucrative benefit than even under the current system assuming it was solvent. President Bush talks about the benefits of ownership and the ability to pass accounts between generations which only add to the appeal of these accounts.

While I’m sure we haven’t achieved a perfect formulation yet, I am convinced that something akin to what I’ve described here is inevitable. Politically, I think the president captured some of the Democrat’s ground on Thursday, with his proposal for indexing and it will be interesting to see how long it takes Poor Dim Harry and Nancy P to realize this fact. It is quite interesting that he has followed the advice of a prominent Democrat to make his most recent recommendations.

Hopefully this begins to shed a little light on why I’m more inclined to support the president’s proposal for benefit cuts and PA’s than not. I would go a step further and include an increase in the retirement age beyond those already scheduled. This addition would address the root of our problem and also allow us to be more generous in benefit growth for the middle class.

Any thoughts folks?

No comments:

Post a Comment