Security: The Past, the Present, and Options for Reform
Susan B. Anders and David S. Hulse
MAY 2006 - Social Security is one of the most popular, broadly
subscribed, and positively perceived federal government programs.
The system plays an important role in the American economy,
and it functions as both a retirement savings plan and a redistribution
of wealth to reduce poverty among the elderly. For nearly
three-quarters of a century, it has provided many benefits
to individuals and to society. However, it also suffers from
serious funding problems, is quite complicated, and is not
well understood by the American public. For example, the Employee
Benefit Research Institute’s (EBRI; www.ebri.org) 2005
annual retirement confidence survey indicates that 68% of
current workers are skeptical about receiving benefits at
least equal to that of today’s retirees.
Security currently provides a substantial portion of retirement
security for the majority of elderly persons in the United
States. According to the Congressional Research Service
(CRS; Report 94-27, digital.library.unt.edu/govdocs/crs),
approximately 50% of recipients have household incomes from
all sources, including Social Security, of $25,000 or less.
For more than one-quarter of recipients, Social Security
provides more than 90% of their retirement income.
Private pension coverage has increased since the inception
of Social Security, and Social Security Administration (SSA)
statistics indicate that in 2002, 41% of Americans aged
65 or older received retirement benefits from sources other
than Social Security. According to the EBRI survey, however,
18% of workers whose employers offer a retirement savings
plan don’t participate, and less than 40% of workers
have an individual retirement account (IRA). Only 69% of
current retirees and 62% of current workers report saving
at all for retirement, and fewer than half of those respondents
have saved more than $25,000 on their own.
The original designers of the Social Security system were
focused on ameliorating the desperate economic conditions
faced by older Americans in the early 1930s. When the Social
Security Act of 1935 first became law, the U.S. unemployment
rate had reached 20%. The 1935 Act provided unemployment
insurance and welfare programs, in addition to old-age pensions.
In fact, the pension coverage was a relatively minor aspect
of the original Social Security plan (Henry J. Aaron and
Robert D. Reischauer, Countdown to Reform: The Great
Social Security Debate, the Century Foundation Press,
1998), although it has since become the program’s
major focus. According to the AICPA’s 2005 report
Understanding Social Security: The Issues and Alternatives
(second edition), Social Security was an important
factor in reducing the poverty rate among the elderly from
35% in 1959 to 10% in 2003, the lowest of any adult group.
The median net worth of Americans age 65 or older was twice
that for the entire population, according to the 2000 Census
(Shawna Orzechowski and Peter Sepiella, Net Worth and
Asset Ownership of Households: 1998 and 2000, Current
Population Reports P70-88, 2003, www.census.gov/prod/2003pubs/p70-88.pdf.).
The pension aspect of the Social Security program was originally
designed as a prepayment plan, with benefits tied to contributions.
Soon after inception, however, benefits were increased beyond
originally envisioned levels, and the program became a “pay-as-you-go”
system, with current workers’ taxes supporting current
retirees’ benefits. Given a ratio of current workers
to current retirees that declines over time, such a funding
arrangement creates serious problems. Today, many experts
expect that the Social Security system is going to run out
of money in the future. The estimated deadlines vary depending
on the assumptions made by the analysis, but it is widely
expected that Social Security will not have the funds available
to continue to provide expected benefits within about 25
The poor economic outlook for Social Security is not a
recent development, nor has it only recently been recognized.
A major attempt at improving its fiscal soundness was made
in 1983, when Congress increased the payroll tax rate and
raised the retirement age to 67, creating an expected surplus
through the year 2065. Several factors have affected the
revised deficit projections, including the continuous forward
shifting of the measurement period, the growth in the disability
caseload, and changes in forecasting methodology; these
bring the peak in the surplus forward by about 25 years.
The potential solutions will cause economic hardship to
some important groups, and implementing any will require
substantially more attention from policymakers and more
communication to the public. Research has shown that Americans
tend to favor reform options that affect their own demographic
group the least (Susan B. Anders, “Social Security:
An Opinion Survey of the Issues and Alternatives,”
Journal of Accounting and Finance Research, Fall II,
2001). Any proposal to reform Social Security must consider
the program’s history, address the current funding
problems, and plan for implementation and transition.
A Brief History of Social Security
The United States was in the throes of high levels of unemployment
and poverty when Congress passed the Social Security Act
of 1935. The 1935 Act was not the first attempt to provide
a social safety net for workers. Retirement programs for
specific groups of Civil War veterans and state and local
government employees were initiated in the latter half of
the 19th century. According to the SSA, in the early 20th
century federal workers in hazardous occupations were covered
by social insurance, and many states had enacted early workers’
compensation laws. Many other industrialized countries had
already adopted government-sponsored social security systems
by 1930 (C. Eugene Steuerle and Jon M. Bakija, Retooling
Social Security for the 21st Century: Right and Wrong Approaches
to Reform, the Urban Institute Press, 1994).
President Franklin D. Roosevelt initiated the proposals
that led to the Social Security Act of 1935 following the
bank failures and loss of private savings resulting from
the Great Depression (Steuerle and Bakija). The original
social insurance programs incorporated into the 1935 Act
included old-age retirement benefits, welfare programs,
and unemployment insurance. Many modifications and additions
have been made to Social Security since the original law
was passed, including the disability insurance program in
1956 and the Medicare program in 1965.
Social Security payroll tax rates have increased steadily
each decade, from 2% in 1940, to 9.6% in 1970, to 15.3%
in 2000. In 1983, in recognition of the longer life expectancies
of retirees, Congress raised the retirement age from 65
to 67, to be phased in for workers turning age 65 between
2003 and 2025. Additionally, as of 2000, retirees between
age 65 and 69 no longer suffer any reduction in benefits
if they continue to work. Exhibit
1 summarizes some of the quantitative changes to the
system over the past 65 years.
Benefits were increased substantially in 1939 and 1950.
Benefits were originally tied to contributions, but by 1975,
retirees were receiving benefits that far exceeded the payroll
taxes paid by themselves and their employers (Aaron and
Reischauer). In 1972, new revenue forecasting methods led
Congress to increase benefits, but an error in the projections,
as well as a downturn in the economy, led to deficits rather
than surpluses. By 1982, the trust fund was essentially
“bankrupt” (Charles F. O’Donnell and Robert
Strittmatter, “Social Security Trust Funds and the
Federal Budget,” The CPA Journal, April 2000).
Congress addressed the problem by cutting benefits and raising
payroll tax rates in 1983. According to the SSA, the average
annual benefits paid to retirees in 2006 are approximately
$11,870 for single individuals, $19,775 for one-earner couples,
and $23,735 for two-earner couples.
The number of people who participate in the Social Security
system has also increased greatly beyond the original program,
which initially covered about 50% of all workers. Between
1946 and 1983, the categories of covered jobs were gradually
expanded to include agricultural workers, federal and state
government employees, and members of the armed forces, among
many others. Currently, 96% of all civilian workers hold
jobs covered by Social Security (Aaron and Reischauer).
The Current Social Security System
Social Security taxes for employed individuals are usually
7.65% of earnings, payable by both the employee and the
employer for a total of 15.3%; the general consensus among
tax scholars is that the employee bears the economic burden
of the employer’s share of the tax through a reduced
real wage or salary (Daniel Shaviro, Making Sense of
Social Security Reform, the University of Chicago Press,
2000). Of this 7.65%, 5.3% is earmarked for the old age
and survivor’s insurance (OASI) portion of Social
Security, 0.9% is designated for disability insurance (DI),
and the remaining 1.45% is allocated to the Medicare system
(HI). The Medicare portion of the tax is imposed on all
earnings, but the other 6.2% of the tax is not assessed
on earnings in excess of $94,200 (in 2006; adjusted annually
based on growth in average earnings). For self-employed
individuals, the tax rates are doubled (e.g., 10.6% for
OASI, 15.3% in total), reflecting the fact that the individual
is effectively both the employer and the employee.
Because it is affected not only by changing demographics
but also by the rising expenditures and costs of the U.S.
healthcare system, the Medicare portion of the Social Security
system faces funding problems that are likely more severe,
complex, and imminent than those of the OASDI portion. Medicare
will be ignored for the rest of this article, which will
focus on Social Security’s retirement benefits.
Social Security benefits are generally based on an individual’s
primary insurance amount (PIA), which, in turn, is based
on that individual’s average indexed monthly earnings
(AIME). In brief, AIME is computed by adjusting each year’s
covered earnings (i.e., earnings not in excess of the maximum
OASI base) for growth in average earnings between the time
they were earned and age 60. The 35 highest years of adjusted
earnings are averaged, and the result is divided by 12 months
to yield AIME. The PIA based on this AIME increases as AIME
increases, but it does so at a decreasing rate. In 2006,
the PIA is 90% of AIME below $656, plus 32% of AIME between
$656 and $3,955, plus 15% of AIME in excess of $3,955. The
PIA is subsequently adjusted for inflation (rather than
growth in average earnings), and it is adjusted downward
or upward for individuals who begin receiving Social Security
benefits before or after attaining full retirement age,
respectively. Full retirement age had been 65 but will gradually
increase to age 67 by 2022.
2 depicts the relationship between AIME and the PIA.
Note that higher-AIME individuals receive larger monthly
Social Security benefits than lower-AIME individuals, but
this represents a lower percentage of their AIME. Because
Social Security taxes are levied at a flat rate, this means
that, all else being equal, lower-income AIME individuals
receive a better “return” from the system than
higher-AIME individuals. Note also that there is not a direct
link between payroll taxes paid into the Social Security
system and benefits received from it; the link is indirect
at best. The effect of an additional dollar of Social Security
taxes paid on future Social Security benefits received depends
on many factors.
For married individuals, Social Security benefits are generally
the larger of the benefit based on their own earnings history
or 50% of the individual’s spouse’s benefit.
For two-earner couples, this usually means that the spouses
receive benefits based on their own earnings histories,
while one-earner couples receive aggregate benefits equal
to 150% of the earning spouse’s benefit. Widows’
Social Security benefits are generally the larger of the
Social Security benefit based on their own work history
or 100% of the benefit that the deceased spouse had been
The Social Security Trust Fund
The Social Security trust fund is an account that the federal
government maintains on its books. Its balance is increased
by Social Security taxes collected, and decreased by Social
Security benefits paid. For the past several years, the
trust fund balance has run an increasing surplus, because
payroll taxes have exceeded Social Security benefits, as
illustrated in Exhibit
3. This excess has been invested in a special type of
interest-bearing federal bond that is held only by the trust
In their 2005 annual report, the Social Security trustees
project the trust fund will reach its maximum balance in
2017, and will then decline to zero by 2041. This projected
fund balance has been the impetus behind much of the concern
regarding the long-term solvency of the Social Security
system. The declining Social Security trust fund balance
is only part of the problem; pressures on the rest of the
federal budget will occur long before 2041.
After the trust fund reaches its maximum balance, the bonds
it holds will have to be redeemed, as the trust fund’s
outflows would otherwise exceed its inflows. As a result,
non–Social Security federal tax revenues will be needed
to pay off the bonds. The forecasted maximum trust fund
balance and exhaustion are based on the trustees’
intermediate (i.e., best guess) assumptions regarding mortality,
retirement patterns, and other relevant factors, all of
which are uncertain. The trustees also make predictions
based on high-cost (more pessimistic) and low-cost (more
optimistic) assumptions. The projected years of maximum
and zero balances are 2013 and 2030 based on the high-cost
assumptions, versus 2022 and “never” based on
the low-cost assumptions.
Social Security inflows and outflows are required by law
to be excluded from the general federal budget totals (O’Donnell
and Strittmatter). The federal government first presented
a “unified” budget in 1969, which turned a pre–Social
Security deficit of $1 billion into a surplus of $3 billion.
The Social Security trust fund became “off budget”
again under the Omnibus Budget Reconciliation Act of 1990.
The trust fund has much political significance, but it
has little or no economic significance, because it is merely
an artifact of government bookkeeping (Shaviro). That is,
the federal government has several revenue sources, including
personal and corporate income taxes, Social Security taxes,
and excise taxes, and it makes various expenditures, including
national defense, Social Security benefits, and interest
on the national debt. For political reasons, Social Security
taxes and benefits are linked via the trust fund (perhaps
reflecting a public consensus that the two should be roughly
equal), but very few other revenue items and expenditure
items are linked in such a way. The fact that Social Security
taxes, rather than some other revenues (e.g., income taxes),
are credited to the trust fund ultimately has no real economic
significance, whatever its effect on government policy.
This is a subtle point and can take some time to appreciate,
but many Social Security reform proposals focus heavily
on the trust fund bookkeeping outcome and less heavily on
the government’s real cash inflows and outflows. The
trust fund should not be given too much significance unless
we, as a society, believe that Social Security taxes and
benefits should be roughly equal (which makes it of political
Problems Facing Social Security
The Social Security system is set up as a pay-as-you-go
system, which is markedly different from private retirement
plans (Steuerle and Bakija). Current workers make contributions
into the system, via a payroll tax, that provide for the
support for current retirees. The policy of building large
reserves was abandoned without controversy in 1939, when
the original levels of benefits envisioned in the 1935 Act
were substantially increased by anywhere from 20% to 75%.
Currently, approximately 80% of Social Security receipts
are transferred to current beneficiaries (Aaron and Reischauer).
The remaining 20% is “invested” in government
securities. Questioning the soundness of a pay-as-you-go
system is beyond the scope of this article; however, that
design is in a large part responsible for the economic problems
facing Social Security.
It is apparent from Exhibit 1 that fewer and fewer workers
are providing the support for more and more retirees. In
1945, there were 50 workers for every retiree; in 1950,
there were 17 workers for every retiree. By 1960, this ratio
had declined to 8.6 workers for every retiree. Currently,
there are 3.3 workers for every retiree, and this ratio
is expected to decline to only 2.2 by 2025, at which time
22% of the population will be eligible for Social Security
retirement benefits (Aaron and Reischauer).
Americans are living longer after retirement, which is
a positive development, but one which requires more years
of benefits than were expected when the system was designed.
The life expectancy in 1990 for males who reach age 65 is
15 years longer than it was in 1940, when benefits were
first paid; for females, it is almost 20 years longer. The
Social Security system also encourages early retirement,
which results in an early termination of contributions,
an early payout of benefits, and a longer payout of benefits
(although the amount of each monthly payment is reduced).
Approximately 25% of men retire at age 62 (Aaron and Reischauer).
According to the EBRI survey, about 34% of current workers
plan to retire before age 65, while 66% of current retirees
actually retired before age 65.
Another problem attributed to the Social Security system
is that the promise of its benefits may discourage personal
retirement savings. The Social Security funds have also
been invested in low-yield treasury bonds, which may exacerbate
the pay-as-you-go nature of the program by preventing potential
reserve accumulation. Additionally, the Social Security
trust fund has been used for government purposes other than
retirement distributions, which means that the funds were
not really “invested.”
It is often believed that the financing problems facing
Social Security are due to the approaching retirement of
the baby boom generation. However, the longer-term problems
should not be overlooked. According to the 2005 trustees’
report, the unfunded obligation in the Social Security trust
fund is expected to become increasingly negative over the
next 75 years, long after the baby boom generation is deceased.
As the Social Security funds available for distribution
decrease, personal savings and private pension plans will
have to provide a greater percentage of retirement income.
Unfortunately, the personal saving rate in the U.S. has
declined from 10.4% in 1984 to 1.4% in 2003 (Marshall B.
Reinsdorf, “Alternative Measures of Personal Saving,”
Survey of Current Business, Bureau of Economic
Affairs, November 2004). The percentage of workers covered
by more-costly defined benefit plans has also dropped, while
defined contribution plans, which shift the investment risk
to the employee, have grown in popularity (Annamarie Lusardi,
Jonathan Skinner, and Steven Venti, “Pension Accounting
and Personal Saving,” The CPA Journal, September
2003). Many traditional defined benefit plans have converted
their benefit formulas to become “cash balance”
plans, which define benefits in terms of a stated account
balance, rather than in terms of average or final pay (Reinsdorf).
Private pensions also face funding problems, as employers
have relied on rising investment values, rather than contributions,
to cover retirement liabilities. The Government Accountability
Office (GAO) reported that pension plan underfunding grew
from $39 billion in 2000 to more than $450 billion in 2004,
according to AccountingWeb reports. A study by Watson Wyatt
Worldwide indicated that 11% of large companies have either
terminated or frozen their traditional pension plans. Some
employees have watched their pension plans shrink or even
evaporate as companies like Enron have become entangled
in business and accounting scandals, and companies like
United Airlines have entered bankruptcy.
Income Redistribution Within Social Security
One aspect of the current Social Security system that is
frequently overlooked is the various ways in which it redistributes
income. One may agree or disagree with this income redistribution,
but it is important to appreciate its presence when evaluating
reform proposals. For example, the “return”
that one obtains from the Social Security system (i.e.,
taxes paid in versus benefits received) reflects any net
income redistribution to or from that person. Many commentators
lament the low return that some individuals receive from
Social Security and argue that a particular reform proposal
would provide a better return, without acknowledging that
much of this increased “return” would derive
from eliminating some of the income redistribution.
One direction in which income redistribution occurs is
from higher-income to lower-income workers, as noted above
and illustrated in Exhibit
4. Lower-income workers therefore tend to receive a
better “return” from Social Security than higher-income
workers. This redistribution is partially offset by a second
type of redistribution, from those with shorter life-spans
to those with longer life-spans. Demographic groups that
tend to have shorter life-spans include lower-income individuals,
males, and some racial minorities.
A third form of income redistribution is from younger generations
to older generations, as shown in Exhibit
5. Older generations tend to receive a better return
because, during the recent decades that represent their
working years, Congress increased their future benefits
more quickly than the taxes they paid.
Finally, income is redistributed from unmarried individuals
and two-earner couples to one-earner couples. Recall that
the nonearning spouse in a one-earner couple receives a
Social Security benefit equal to 50% of the earning spouse’s
benefit; that is, 50% more than a similar unmarried worker
or worker in a two-earner couple. In addition, benefits
will tend to be received for a longer time for a one-earner
couple because there is a chance that the nonearning spouse
will outlive the earning spouse and collect survivor’s
benefits. There is no survivor to collect such benefits
with an unmarried worker, and survivor’s benefits
tend to be greater for surviving spouses who did not work
than for those who did work. Exhibit 5 also provides evidence
of this type of income redistribution.
The current Social Security system and proposals to reform
it embody several, often competing, policy considerations.
Perhaps the foremost of these is ensuring a minimum level
of retirement income so as to mitigate poverty among the
elderly, who are among the most vulnerable members of society.
Social Security benefits alleviate the burden on other social
assistance programs that lower-income elderly might otherwise
avail themselves of. Other social policy considerations
include the various ways that Social Security redistributes
income, such as from higher-income to lower-income workers.
Recall also that the current Social Security system is designed
to redistribute income from unmarried individuals and two-earner
couples to one-earner couples.
The issue of nonworking spouses is ignored in most discussions
of Social Security reform, and it involves difficult choices
(Karen Damato, “Spousal Benefit Is Social Security
Wild Card,” The Wall Street Journal, March
3, 2005). For example, should spouses who did not work during
most or all of their potential working years in order to
raise children be entitled to a Social Security benefit?
If so, who should pay for it? These social policy and distributional
questions are especially important when considering proposals
that would more directly link benefits to contributions,
for example, through private individual accounts.
Several other important policy considerations relate to
the economic effects of Social Security:
- Evidence suggests that wage-related taxes, such as
Social Security, reduce labor supply for some workers,
such as a married couple’s secondary earner, which
has a negative effect on the broader economy.
- There is evidence that the availability of Social Security
benefits induces some workers to retire earlier than they
otherwise would, further reducing the labor supply.
- There is widespread concern about the low U.S. savings
rate in recent years. Social Security taxes collected
are mostly used to pay for current benefits and are not
saved, because they are “lent” to the U.S.
Treasury to help finance the federal budget deficit. Some
believe that the Social Security system should be reformed
so as to increase national savings (e.g., proposals for
- The administrative costs and burdens are important
to consider. Depending on the particular reform option
and its details, the administrative costs could be as
low as 0.1% to more than 1% of the system’s assets.
Over a working career and a retirement period of several
decades, this difference could result in substantially
different retirement benefits.
Like the income tax system, where trade-offs among fairness,
economic effects, and administrative considerations are
often necessary, the policy considerations for the Social
Security system frequently compete. For example, a reformed
system that more strongly emphasizes individual accounts
may have desirable economic effects, but it may also have
higher administrative costs and increase the risk of poverty
in old age.
Finally, one should keep in mind that the Social Security
system cannot be thought of in isolation from the remainder
of the government’s activities. It may be that some
policy objectives are desirable but are more effectively
addressed outside the Social Security system. For example,
poverty among the elderly might be better addressed by programs
similar to those targeted at the non-elderly poor, focusing
Social Security on a narrower set of policy objectives.
The Government Accountability Office has suggested that
reforms to Social Security should be instituted as soon
as possible to avoid serious problems in the overall economy,
not just the retirement system (Social Security Reform:
Early Action Would Be Prudent, Report to House of Representatives
Committee on Ways and Means, March 9, 2005, No. GAO-05-397T).
Comptroller General David M. Walker made five major points:
- Addressing Social Security’s long-term financing
problem is critical to the financial well-being of millions
- Focusing on trust fund solvency leads to a false sense
of security, because trust fund assets are neither marketable
nor readily convertible into cash.
- Social Security is only one of several programs creating
a burden on future generations. The decline in private
pensions further exacerbates the social welfare funding
- The sooner reforms are instituted, the less drastic
they will need to be.
- No one reform proposal can satisfy all parties. Each
proposal has positive and negative aspects, and the various
proposals should be evaluated as packages.
The GAO has suggested that reform proposals be analyzed
using three basic criteria: the extent to which a proposal
achieves sustainable solvency; the relative balance between
individual equity and income adequacy; and how easily a
proposal could be implemented, administered, and explained
to the public.
Proposals to Reform Social Security
Many serious proposals to reform the Social Security system
have been offered by economic experts and scholars. The
most recent legislative proposals have been summarized in
the AICPA’s Understanding Social Security: The
Issues and Alternatives (2005), and that discussion
will not be replicated here. Instead, this discussion will
focus on broad types of proposals.
Historically, the options for reform have generally fallen
into three categories—reducing benefits, increasing
revenues, and increasing the return on Social Security trust
fund assets—or some combination thereof. The recommendations
for reducing benefits and increasing revenues could be implemented
without changing the character of a hugely popular and successful
program. On the other hand, the U.S. economy and society
have changed significantly since 1935, and it may be appropriate
to make some major, fundamental changes in the system and
move toward advance funding of retirement obligations (Gary
Burtless, “Social Security’s Long-Term Budget
Outlook,” National Tax Journal, September
None of these proposals is without administrative and political
difficulties, and hardships borne by some particular group.
Reducing benefits places the burden of reform on current
(and future) beneficiaries. Increasing revenues shifts the
burden to current workers and taxpayers. Increasing the
return on assets creates increased economic risk, as well
as administrative complexity, but could improve retirees’
future benefits. Evaluating these proposals is complicated
by the fact that most of today’s workers will also
be tomorrow’s beneficiaries, so the distinctions among
various proposals’ effects are more subtle than they
Although many proposals focus on only two or three specific
actions, the most viable approach may be a combination of
changes, as recommended by the GAO. The specific provisions
of each of these broad ideas vary depending on the policy
objectives of its proponent; however, a general synopsis
can be made.
Benefits could be reduced in a number of ways. Monthly
benefits could be reduced by decreasing the primary insurance
amount (PIA) for a given average indexed monthly earnings
(AIME) or by reducing cost-of-living adjustments. Some suggest
targeting reductions toward higher-income retirees, or other
means-testing of benefits. Benefits could also be reduced
by raising the retirement age or taxing Social Security
benefits in full. Many of the benefit-reduction options
are among the simplest and least costly to implement. If
future beneficiaries expect lower benefits, they may decide
to work longer or save more, both of which would have positive
effects on the economy. An obvious criticism of broad-based
benefit reductions is that they would violate one of the
original goals of the Social Security program, namely, reducing
poverty among the elderly. Additionally, if one believes
that Social Security should provide workers with a reasonable
“return” on their payroll taxes, benefit reductions
would exacerbate the already low returns to single and high-income
retirees illustrated in Exhibit 4 and Exhibit 5.
For overall benefit reductions to fully alleviate future
funding problems, they would have to be enacted as quickly
as possible. An immediate 12.6% reduction in benefits would
eliminate the predicted shortfall. Without reforms, assuming
that the current level of benefits continues to be paid
through 2041, benefits would first have to be reduced by
27% in 2042, and again by 32% in 2078.
Raising the normal retirement age, or an early retirement
age, or both, would have effects similar to across-the-board
benefit cuts. Social Security currently provides a substantial
incentive for early retirement, even though life expectancies
have greatly increased and the physical demands of work
have decreased since 1935. Under current law, the normal
retirement age will gradually increase from 65 to 67, but
it could be amended to increase even further, although none
of the current major proposals include this option. The
early retirement age of 62 has never been changed. Unlike
straight benefit cuts, an increase in the retirement age
would disproportionately affect beneficiaries with shorter
life expectancies and those who already suffer from serious
use of the Consumer Price Index (CPI) to compute cost-of-living
adjustments (COLA) has long been controversial, and some
research indicates that the CPI overstates the real inflation
rate (Richard W. Johnson, “Distributional Implications
of Social Security Reform for the Elderly: The Impact of
Revising COLAs, the Normal Retirement Age, and Taxation
of Benefits,” National Tax Journal, September
the CPI, and therefore the COLA, could have the same effect
as reducing benefits or increasing the retirement age. The
burden for this reform would fall on future beneficiaries.
However, reducing the COLAs would not affect the calculation
of a worker’s initial benefit, which is based on historical
wage growth (Burtless). Reducing COLAs would mean that the
reduction in benefits would be increasingly larger as one
benefits for high-income recipients, or other forms of means-testing,
would preserve benefits for those most in need. However,
reducing benefits for those receiving the highest level
of benefits would not be as effective as it sounds, because
high-income individuals could already be receiving a low
level of Social Security benefits, and would continue to
receive the same low level under this reform. Similarly,
requiring means-testing creates the problem of defining
“means”—for example, income or wealth—and
then further specifying how to measure it. It would also
effectively be a hidden tax on such individuals, which raises
issues of fairness.
Social Security benefits is similar in effect to means-testing
based on income. Social Security benefits have been partially
taxable for higher-income taxpayers since 1983. One approach
to fully taxing Social Security benefits would be to follow
the annuity model and tax recipients on benefits received
in excess of their payroll contributions, which would avoid
double taxation, on the original earnings and again on the
to increasing revenues generally involve one of the following:
increasing the Social Security tax rate, increasing the
upper limit on taxable earnings, using general tax revenues,
or bringing state and local government workers into the
system. Such revenue-increasing reforms could be implemented
within the current pay-as-you-go system, could begin in
the near future, and would not require any major transitions.
Some of the options, however, would place the reform burden
on current workers by increasing their tax liabilities and
lowering their future returns, or would recharacterize Social
Security as a welfare program.
payroll tax rate has historically been increased when the
Social Security system faced increasing benefit outflows,
as illustrated in Exhibit 1. An immediate increase in the
12.4% payroll tax to 14.3% would eliminate the currently
predicted deficit. Raising the payroll tax rate, however,
places more of the burden on current workers and employers,
as well as low- to moderate-income workers.
option is to raise or eliminate the ceiling on wages subject
to the Social Security tax, which was previously done for
Medicare. According to Social Security’s own predictions,
immediately eliminating the taxable-earnings ceiling would
eliminate the anticipated deficit. Increasing the ceiling,
however, would shift the burden to high-income workers.
discussed above, the Social Security trust fund is really
just a bookkeeping description, and exists separately from
the rest of the federal budget only on paper. Because the
trust fund has been used in the past to cover outflows for
expenditures unrelated to Social Security, some reformers
have suggested that it now makes sense to use other revenues
to cover the Social Security shortfall. Opponents of this
option are concerned that using general revenues would reduce
public support for Social Security as a retirement plan,
and would recharacterize it as a welfare program.
other proposal for increasing revenue is to bring the remaining
state and local government employees, who are not currently
covered by Social Security, into the system. If these employees
have spouses who are covered by Social Security, or if they
have part-time jobs that are covered, then they are already
eligible to receive benefits. Unfortunately, this option
is not estimated to raise much additional revenue.
the Return on Assets
final approach focuses on increasing the return on Social
Security assets, which would entail much larger, systemic
changes to the program than do the benefit-reduction and
revenue-increase options. In one proposal, an independent
commission would be charged with investing a portion of
the public trust funds in index or mutual funds. In another
option, separate individual accounts would be maintained
by the Social Security Administration, and workers would
have the opportunity to direct a portion of their own investments.
One of the most controversial alternatives would entail
the complete privatization of the retirement system, with
individually owned and controlled private accounts.
workers would realize greater retirement income under any
of the “privatization” options. To the extent
that benefits result from private investment earnings, they
would not be dependent on real wage increases or labor force
growth (Burtless). Proponents also argue that privatization
of the retirement system would increase national saving.
of the private investment options are concerned about the
ability of government officials to properly manage a large
retirement fund, as well as about the effect of such an
enormous infusion into the private capital markets, although
it may instead be an enormous reshuffling if the government
were to borrow additional monies to continue paying benefits
to current retirees. Under any of the proposals to increase
the return on retirement assets, the administrative and
transition costs would likely be much higher than they would
be for reducing benefits or raising revenues. Transitioning
is also a major concern, and most supporters envision providing
these options for younger workers only.
a portion of Social Security funds in private capital markets.
The simplest approach to increasing the return
on Social Security assets would be for a portion of the
trust fund assets to be invested in private capital markets,
rather than in government bonds, without abandoning the
pay-as-you-go system. Even after adjusting for risk, the
equity market has historically outperformed the bond market
and would provide a higher return for beneficiaries (Edward
M. Gramlich, “Different Approaches for Dealing with
Social Security,” American Economic Review,
Vol. 86, No. 2, May 1996). The investments would be directed
by professional managers for the fund as a whole, which
would keep administrative costs to a minimum and spread
the economic risks across several generations. Because individual
accounts would not be created, transitioning between generations
would not be a major concern.
are several arguments against this option. First is the
concern over added risk to the Social Security system and
further diminution of the trust funds to pay administrative
costs. Second is the difficulty of separating politics from
the investment choices and the management of the fund. Third
is the effect on the equity markets and the economy from
an investment of this magnitude. The federal government
would likely be the largest shareholder in many companies,
and future politicians may find it irresistible to avail
themselves of this means of influence.
held individual accounts. In this approach,
individual accounts within the Social Security system would
be established for workers. Individuals would be able to
direct a portion of their contributions to be invested in
a restricted selection of investment options. The accounts
would continue to be held by the Social Security system,
and earnings would be added to an individual’s regular
Social Security benefits (Gramlich). Proposals for publicly
held individual accounts generally call for mandatory supplemental
employee contributions to create the private investment
of individual accounts include the decentralization of investment
decisions, thus mitigating the political problems caused
by such an inflow of funds into private capital markets.
Individuals may also feel an ownership in the Social Security
system and take a greater interest in providing for their
own retirement. Requiring contributions to personal accounts
that are held in trust for a specific individual may be
more politically acceptable than raising taxes to finance
someone else’s retirement.
individuals to direct their own investments would, of course,
expose their personal accounts to economic risk. Payroll
taxes would have to be increased to establish the individual
accounts. There would probably be pressure on Social Security
to provide a minimum guaranteed benefit to offset poor individual
investment decisions or economy-wide downturns. Additionally,
the political influence on the markets would not be completely
eliminated, as some oversight or approval of investment
choices would have to be made to reduce risk for the individual
privatization. The most radical reform option
is to completely do away with the Social Security system
and require individuals to contribute to personal accounts
held by private investment companies (Gramlich). Account
owners would have greater discretion over their choice of
investments, and any balances remaining in at death could
be passed on to heirs. This approach would increase workers’
connection to their retirement benefits, thereby encouraging
individual responsibility and saving. Complete privatization
would also eliminate the subsidization of one-earner couples
(Laurence J. Kotlikoff, “Privatizing Social Security
at Home and Abroad,” American Economic Review,
Vol. 86, No. 2, May 1996).
privatization presents the most serious transition problems.
The current generation of workers is currently paying for
its parents’ retirement, and would have to pay for
its own retirement if its children would not be contributing
to a pay-as-you-go system. Completely private accounts would
increase the risk to the individual, and remove the safety
net that was the original purpose of the Social Security
system. Retirement incomes for low-earners would no longer
be enhanced by Social Security’s progressive benefit
the other hand, the U.S. economy is quite different from
what it was when Social Security was enacted into law. Similarly,
individuals may be much more knowledgeable about investing
and retirement options today. The relevant political question
is whether Americans would support the eventual termination
of such a popular social program in favor of more individual
control over their retirement funding.
Future of Social Security
Security is facing serious funding problems, due to its
pay-as-you-go design, the declining ratio of workers to
retirees, and the increasing length of retirement. It is
widely expected that within about 25 years Social Security
will no longer have the funds available to continue to provide
the current level of benefits. The much-publicized Social
Security “trust fund” is merely a bookkeeping
account that has little or no economic significance. While
many proposals to reform Social Security exist, the authors
do not seek to promote any particular agenda, but rather
to better inform readers of the major issues surrounding
the Social Security debate.
original social insurance programs incorporated into the
Social Security Act of 1935 included old-age retirement
benefits, welfare programs, and unemployment insurance,
and were later expanded to include the disability insurance
program and the Medicare program. Currently, the Social
Security taxes that one pays and the benefits that one receives
are linked only indirectly, which is quite different from
private retirement plans. Due to the benefit calculation
methodology, the system redistributes income in many ways.
As a result, the “return” obtained from Social
Security varies among beneficiaries.
current Social Security system and proposals to reform it
embody several policy considerations, such as ensuring a
minimum level of retirement income so as to mitigate poverty
among the elderly. These social policy and distributional
concerns are especially important when considering reform
proposals, which generally embody conflicting goals.
the options for reform have generally fallen into three
categories: reducing benefits, increasing revenues, and
increasing the return on Social Security trust fund assets.
Benefits could be reduced and revenues could be increased
without changing the character of the program. It may, however,
be time to make fundamental changes in the system. Although
many proposals focus on only two or three specific actions,
the most viable approach may be from a combination of different
reforms, as recommended by the Government Accountability
B. Anders, PhD, CPA, is an associate professor of
accounting at St. Bonaventure University, St. Bonaventure,
N.Y., and a member of the CPA Journal Editorial Board.
David S. Hulse, PhD, is the Deloitte &
Touche Professor of Accountancy at the Von Allmen School of
Accountancy at the University of Kentucky, Lexington, Ky.