Just the facts: the truth about Social Security.

The first important fact about the Social Security "crisis" is that there is no crisis. The second important fact is that the Bush administration's proposals for fixing the "crisis," especially its "privatization" scheme, are perversely designed to make the system's finances much more precarious than they are now and to impose deep benefit cuts. In fact, it would be hard to conceive of a more destructive set of policy initiatives than those the president is advocating. And it's all completely unnecessary. Here's why.

Social Security benefits are paid from government trust funds. The lion's share of the funds' income comes from payroll taxes. (The funds also collect interest on their investments and get credited with income taxes levied on the taxable portion of Social Security benefits.) The Social Security payroll tax, the cost of which is split evenly between a worker and her employer, is currently 12.4 percent on the first $90,000 (in 2005) of a worker's annual earnings. All economists agree that the "employer share" of payroll taxes really comes out of the worker's pocket, since paychecks are reduced by the employer's contribution amount. For the great majority of American families, the payroll tax, not including their employer's amount, is the largest tax they pay.

The trust funds use their income and accumulated investments to provide for nearly all retired Americans. Benefit levels are modest, just above the poverty level. Social Security, though, is the most efficient of all American antipoverty programs. More than a third of all elderly lived in poverty in 1960; by 1995, only 10 percent did--an improvement that, according to economists Gary Englehardt and Jonathan Gruber, is almost entirely accounted for by Social Security. Moreover, for fully one-fifth of America's elderly, Social Security payments are their only income, and for a third of the elderly, represent at least 90 percent of their income. Benefits are skewed to be gently progressive--that is to say, the retirement benefits received by a low-income worker will almost always total rather more than he "earned" by his payroll tax contributions, while the benefit payment received by a high-income worker will amount to rather less than she "earned" through her payroll tax contributions.

In addition to retirement benefits, Social Security also provides important insurance and disability benefits. It is frequently forgotten that about a third of all Social Security beneficiaries are the children and spouses of dead or disabled workers. When wonks, especially Republican wonks, calculate the "returns" to workers from the Social Security payroll taxes, they usually overlook the value of the insurance and disability benefits. But the outlays are significant and essential. Social Security payments made to the family of a worker who dies at age forty are equivalent to a $400,000 life-insurance policy.

Finally, Social Security was originally designed as a "pay as you go" system. Instead of accumulating assets to pay benefits to future beneficiaries, payroll taxes from current workers were supposed to just cover benefits to retired workers. The deal was that each generation of workers would pay for the benefits of the current generation of retirees, in the expectation that when they retired, a younger generation would pay for them.

About twenty years ago, though, payroll taxes were very sharply increased to create what is called a partially funded system. That is, the taxes from current workers cover not only the payments to current beneficiaries, but also contribute to a surplus that will fund part of their own future benefits. In 2003, for example, payroll and other tax receipts were about 14 percent larger than benefit outlays. That surplus is held by the trust funds in interest-bearing Treasury bonds. The value of the trust funds' bonds is currently about $1.5 trillion, and will rise to about $2.3 trillion (in 2004 dollars) by about 2018.

What Is the Problem?

According to trust fund actuaries, the current level of payroll taxes and accumulated assets will not fully cover the Social Security benefits that have been implicitly promised to the next generation of retirees. The problem arises both because older people now live much longer, and because the very large baby-boomer generation that created the surpluses will soon create a bulge in the retired population.

Payroll taxes will fully cover benefits until about 2018. After that, the trust funds will have to start digging into their accumulated surpluses. Those surpluses are expected to run out about 2042, or thirty-seven years from now. From that point, payroll taxes will cover only about 73 percent of promised benefits; by 2078, payroll tax coverage will have declined to only 68 percent of promised benefits. Those projections are not cast in stone. In 1997, the trust funds' actuaries projected that the insolvency point would be reached in 2029, or thirteen years sooner than their most recent forecast, and there has been considerable variation in the annual estimates, both up and down, since then. The most frequently criticized assumption, perhaps, is the trust funds' actuaries' projection of flat 1.8-percent real growth for all years from 2015 on. A recent forecast by the nonpartisan Congressional Budget Office (CBO), using slightly different economic assumptions than the trust funds do, showed the insolvency crossover point ten years further out, at 2052.

How big a problem is the funding shortfall? There are two standard ways to answer that question. The first is: How much cash would you have to deposit into the trust funds today to ensure that combined payroll taxes and interest earnings would cover promised benefits over the entire seventy-five-year forecast period? The answer is about $3.7 trillion. The second way to answer the question is to ask by what amount the payroll tax would have to be raised now to accomplish the same result. The answer is 1.89 percent. That is, instead of today's 12.4-percent payroll tax, a 14.29-percent payroll tax would put the current system into balance over the entire forecast period. (The somewhat more optimistic scenario of the CBO, indeed, projects the payroll tax gap at only 1 percent.) In short, while the Social Security funding gap is clearly a problem, it doesn't quite sound like a crisis.

Solutions

The 1.89 percent payroll tax gap, in fact, would be fairly easy to bridge with some good-faith horse-trading across the political spectrum. Suggestions from centrist policy organizations include a smorgasbord like the following, which is drawn from a recent analysis by economists at the Brookings Institution:

* Continued modest increases in the age for full retirement. People, after all, are much healthier into their sixties and seventies than they used to be, and the country could face labor shortages in the 2010s and beyond anyway.

* A tax of, say, 3 percent, split between employer and employee, on earnings above the $90,000 payroll tax cutoff level. Upper-income households have disproportionately benefited from the Bush tax cuts, so clawing back a share of the consequent deficits seems reasonable.

* Requiring all state and local government employees to participate in the system.

* Some tinkering with the formulas for cost-of-living increases for current retirees, along with benefit adjustments for higher-income people.

Many other schemes rejiggering taxes and benefits could be constructed with comparable results. While the net effect of the changes would be barely noticeable by workers and beneficiaries, the trust funds would be restored to balance without any radical changes in the system's functioning or increases in the basic payroll tax.

So much for the "crisis."

The Bush Administration's Plan

At this writing, the administration has not yet announced an official plan, but insiders have left little doubt that it intends a two-pronged approach, combining deep benefit cuts with a shift toward private accounts, as recommended by a 2001 presidential commission. The favored model would make very deep cuts in the basic benefit by changing the method for calculating benefit increases after 2009, and would permit 4 percent of payroll taxes to be diverted to private investment accounts.

Compared with private accounts, the benefit cuts have received relatively little attention. The current system groups workers' wages into three bands--low, middle, and high. The retirement wage is based on replacing 90 percent of the low-band wage, 32 percent of the mid-band wage, and 15 percent of the high-band wage, up to a ceiling. All the bands are adjusted each year to track actual changes in wages. The practical effect is that a median-wage worker retiring in 2005 would receive a retirement benefit equal to about 40 percent of his previous wage. As the full-benefit retirement age is increased to sixty-seven under current law, the replacement rate for the sixty-five-year-old median-wage worker will drop to about 36 percent.

The presidential commission recommended keeping this system with one major change. Instead of adjusting the bands based on average increase in wages, they would be adjusted based on average increase in prices. Historically, wages grow faster than prices--if they didn't, our standard of living would never change. The consequences of this change would be almost unnoticed at first, but over time would become quite large. By using the same actuarial assumptions as the trust funds do, a median-wage worker retiring in 2042 would receive a benefit that was only 27 percent of his previous wage, and one retiring at the end of the forecast period would receive only 20 percent of his previous wage, or 44 percent less than under the current system. The same reduction factors would apply to workers who become disabled or, should they die early, to their dependents. In the commission's proposals, though, the loss of basic coverage is concealed by the higher returns (about 2.6 percent a year higher after inflation) assumed for worker's new private accounts. While technically, the private accounts make no contribution to reducing the forecast system deficits--that is accomplished through benefit reductions--they are used to mask the reductions by assuming that higher returns from the private accounts will make up much of the difference.

The Trouble with Private Accounts

The second prong of Bush's proposal is to introduce private accounts. What is so wrong with that? Let us count the ways.

The Funding Gap About 86 percent of current payroll taxes are used to fund benefits to current retirees and other beneficiaries. If 4 percent of payroll taxes were diverted to private accounts, therefore, the trust funds would fall into deficit much sooner than currently projected. The cost of making up the difference would be in the range of $2 trillion. The administration is planning to make up that shortfall by borrowing. With the alarming jump in government deficits in the wake of the Bush tax cuts and the Iraq war, such enormous additional borrowing might well have serious effects on interest rates and the economy. It appears that the administration will attempt to finesse this problem by the blatant expedient of pretending the borrowing never happened. (Their logic is that since the government will owe the money anyway at some point, nothing will have changed.)

Increased Risk The drumbeat for privatization first moved up-tempo during the late-1990s stock-market boom. With stocks producing such spectacular returns, it seemed foolish to leave such large sums moldering in stodgy risk-free bonds. Amazingly, the market crash since then has had no apparent effect on the fervor of supporters of privatization. Suffice it to say that the hypothetical "privatized" pensioner who retired in 2002 would have had much lower benefits than one who retired in 1999. The recent market crash, moreover, is not nearly as unusual as stock market enthusiasts let on. The Dow Jones Industrial Average (DJIA), for instance, stood at 905 at the end of 1967; by the end of 1982, it had reached 1,046, which was the highest annual close during that entire fifteen-year period. Inflation averaged about 6.5 percent over that time. In real purchasing power, a portfolio of stocks indexed to the DJIA would have been worth just a bit over a third as much as they were worth in 1967.

Many studies, moreover, have shown that individuals usually do rather worse than the market. Consider the case of Martha Stewart. From an investment perspective, the true scandal was the terrible portfolio of stock she owned, much of it tied up in companies like Lucent, which had been getting murdered for years. Ironically, the sale that caused her legal troubles was of a stock that rose after she sold it. And this was a brilliant businesswoman paying top dollar for advice.

No one has ever claimed that Social Security should be the only, or even the primary, retirement savings program. Its purpose is to set a floor for everybody. Thirty-six percent of the median wage is a modest floor, but high enough to have substantial antipoverty impact. To make deep cuts in that floor on the assumption that people will make it up with stock-market returns is dangerous and offensive.

Costs Those advocating privatization almost never deduct the fees paid to those managing the funds from the assumed returns for privatized accounts. How much would the fund managers charge? In other words, what is the cash value today of the fees that will be paid to Wall Street for managing the private accounts over the seventy-five-year forecast period? An economist at the University of Chicago's Graduate School of Business, Austan Goolsbee, has recently estimated the costs for the plan reportedly favored by the president, using a lowest likely fee system (one considerably lower than the current market average). The answer is $940 billion, an amount equal to 25 percent of the entire Social Security deficit. In short, the administration's path to fixing a $3.7-trillion funding gap starts by awarding the financial services industry almost another $1 trillion. Wall Street portfolio managers, at least, will never have to worry about financing their own retirements.

Other Nasties People are poor actuaries. All the evidence is that they are apt to spend retirement windfalls quickly. Social Security benefits come in the form of a lifetime annuity. Since the "private account" is being diverted from money dedicated to long-term annuity payments, will the administration therefore require that all private accounts be converted into annuities upon retirement? The pressure not to make such a rule will be overwhelming. Over the years, there has been a steady loosening of the rules governing tax-deferred savings, like IRAs--making exceptions for house down payments, tuition payments, and the like. The more Social Security private accounts are like 401(k)s, given the proposed cuts in the basic benefits, and the normal skews in private-market returns, the more people will find themselves in serious trouble, and will clamor to make up the shortfalls from public resources. But that will be some other administration's problem.

... And Now for the Scary Part

Finally, there is one truly scary undertone in the administration's "privatization" campaign. Advocates frequently suggest that the bonds held by the trust funds may not be solid investments. Washington's Heritage Foundation, one of the strongest voices for the president's plan, says that the surpluses are just "accounting entries," and that it is "[m]isleading the public" to claim that "Social Security is secure until 2042 or beyond." It is true that the trust funds do not have a safe filled with hundred-dollar bills or gold bars. When they need to cash in their bonds, they will show up at the Treasury's window and ask for their money. And the Treasury will have to find that money either from tax receipts or from borrowing. Suggestions, therefore, that the bonds may not be paid imply that the Treasury may not honor its debts.

Repudiating American government bonds would be such a catastrophic financial event, for both the country and the world, that it is usually regarded as unthinkable. But it takes only mild paranoia to imagine that some "conservatives" may speculate that repudiating obligations just to the trust funds may not have such dire consequences--that external investors may somehow consider them a different order of promise; indeed, that Wall Street and other big-asset holders might be relieved to see them dispensed with. And to the mildly paranoid, the administration's drive to make its tax cuts permanent, even as it raises the alarm over Social Security, seems almost designed to force such an outcome.

The administration's assault on Social Security seems motivated by a visceral distaste for government solutions of any kind. But Social Security is one of the best functioning of all government programs. To be sure, it needs some financial fixes, but they could be readily accomplished with a modest degree of good-faith bipartisan effort. The deficits in Social Security, moreover, are dwarfed by the enormous deficits that will result from the president's insistence on making his tax cuts permanent, primarily to the benefit of wealthier Americans. The administration's rhetoric aside, its tax-cutting program--except as a temporary economic boost after 9/11--is almost devoid of economic justification. There is no "tax problem" in America today. Federal taxes are now lower than at any time since the Eisenhower era. All taxes together--federal, state, local--are as low a percentage of national income as in any other country in the world.

But for reasons of his own, the president has chosen to insist that Social Security is in "crisis." The "solution" he is seeking will increase the volatility of retirement outcomes, sharply reduce the guaranteed portion of the Social Security benefit, accelerate the exhaustion of the system's trust funds, raise questions about the government's commitment to its obligations, and increase government borrowing all at the same time. It is a scandal and a shame.

In the meantime, the retirement-related program that really is in trouble--Medicare--is getting very little attention. That will be the subject of a future article.

Further Reading

The Century Foundation's Web site, www.tcf.org, offers a rich source of Social Security-related materials, most of them are available free. It also lists links to other resources.

The Brookings study referred to in the article is by Peter A. Diamond and Peter R. Orszag, Saving Social Security (Brookings, 2004). Their proposed solution was certified as sound by the Social Security trust fund actuaries.

Data on the trust funds in the article follow the OASDI Trustees' 2004 Annual Report.

RELATED ARTICLE: Mr. Bush's--Far Bigger--Crises

It is illuminating to compare the $3.7-trillion cash value of the Social Security shortfalls with two of the administration's other policy choices that will cause much bigger deficits. Virtually all the tax cuts passed in President Bush's first term are scheduled to terminate on specific dates clustered around 2010. The president has stated that he will ask the new Congress to make all those tax cuts permanent. What is today's cash value of the associated revenue losses over the next seventy-five years? About $11.6 trillion. The president is also proud of the new Medicare prescription-drug program. What is today's cash value of that program over the same forecasting period? The Medicare trustees estimate it to be $8.1 trillion. Taken together, they add up to almost $20 trillion, or five times the Social Security deficit. In other words, if Social Security financing is a "crisis," it is only because the administration has chosen to label it so.

RELATED ARTICLE: The British Experiment

Under the Thatcher government, Great Britain introduced a private-account option as part of the national retirement system in the 1980s. Its success has been mixed at best. A noisy scandal over excessive fees and inappropriate investments was finally settled in 2002 with a $21 billion assessment against investment managers, to be returned to a million misadvised savers. The scandal also induced the government to introduce a "stakeholder" class of investments for the mandatory tier of private accounts with fees no greater than 1 percent of total assets. (The University of Chicago's Austan Goolsbee's projection of "privatization's" trillion-dollar windfall to Wall Street assumes even lower fees than that.) A recent UK commission, moreover, concluded that most consumers, along with the vast majority of lower-income consumers, do not understand their investment alternatives. Consumers typically overpay for active management (the average actively managed fund usually underperforms the market, in part because of greater expenses), and overpay for past track records, which are poor guides to future performance. In addition, there was some evidence that the availability of the private accounts caused consumers to reduce other savings.

Charles R. Morris is the author of American Catholic (1997) and Money, Greed, and Risk (1999). His new book, Tycoons, will be published in the fall.