Wednesday, October 06, 2004

How to Save Social Security: Part I

REVISED AT 4:58 PM (CT) - 10/06/04

The day of reckoning for Social Security -- as we know it -- can be postponed by converting the trust fund to real assets that generate real income. The question then becomes whether to keep it as we know it, to privatize it, or to do some of both. This post shows how the day of reckoning can be postponed. Future posts will examine the future shape of the program.

In an earlier post I pointed out (1) that the Social Security trust fund is mythical, not real, and (2) that the trust fund could be converted from myth to reality by gradually selling the Treasury securities now held in the fund and replacing them with high-grade corporate bonds and conventional mortgages.

The trust fund would then hold real assets, and those assets would yield a higher rate of return than the putative rate of return on the "special obligation bonds" now held by the trust fund. How much higher? The following graphic compares the interest rates credited on new special obligation bonds issued from 1990 to 2003 with the yield to maturity for AAA corporate bonds, conventional mortgages, and BAA corporate bonds:

(Sources: Average annual interest rates on new trust fund bonds from Nominal Interest Rates on Special Issues at Social Security Online, Actuarial Resources; average annual rates on AAA corporate bonds, conventional mortgages, and BAA corporate bonds from Federal Reserve Statistical Release.)

For the period 1990-2003, the average yield on AAA bonds was 7.43 percent, as opposed to 6.34 percent for trust fund bonds. That's 17 percent more interest income, on average, for each dollar invested in a AAA bond rather than a trust fund bond. Conventional mortgages and BAA bonds are even better: Conventional mortgages yielded 7.76 percent on average, 22 percent more than trust fund bonds; BAA bonds yielded an average of 8.27 percent, or 30 percent more than trust fund bonds. Somewhere in that mix lies a partial solution to Social Security's underlying problem.

What is that problem? According to the 2004 report of Social Security's trustees, it's this:
[P]program cost will exceed tax revenues starting in 2018....Social Security's combined trust funds are projected to allow full payment of benefits until they become exhausted in 2042.
What's the solution? Again, according to the trustees, it's this:
Over the full 75-year projection period the actuarial deficit estimated for the combined trust funds is 1.89 percent of taxable payroll--slightly lower than the 1.92 percent deficit projected in last year's report. This deficit indicates that financial adequacy of the program for the next 75 years could be restored if the Social Security payroll tax were immediately and permanently increased from its current level of 12.4 percent (for employees and employers combined) to 14.29 percent. Alternatively, all current and future benefits could be immediately reduced by about 13 percent. Other ways of reducing the deficit include making transfers from general revenues or adopting some combination of approaches.
* If no action were taken until the combined trust funds become exhausted in 2042, much larger changes would be required. For example, payroll taxes could be raised to finance scheduled benefits fully in every year starting in 2042. In this case, the payroll tax would be increased to 16.91 percent at the point of trust fund exhaustion in 2042 and continue rising to 18.31 percent in 2078.

* Similarly, benefits could be reduced to the level that is payable with scheduled tax rates in every year beginning in 2042. Under this scenario, benefits would be reduced 27 percent at the point of trust fund exhaustion in 2042, with reductions reaching 32 percent in 2078.
Changes of this magnitude would eliminate the actuarial deficit over the 75-year period through 2078. However, because of the increasing average age of the population, Social Security's annual cost will very likely continue to exceed tax revenues after 2078. As a result, ensuring the sustainability of the system beyond 2078 would require even larger changes than those needed to restore actuarial balance for the 75-year period.
The nugget in all of that is this: An immediate tax increase from 12.4 percent to 14.29 percent would eliminate the problem for 75 years. A tax increase of that size -- about 15 percent -- is equivalent to about $81 billion. (According to this table, Social Security "contributions" for 2003 were $533.5 billion; 15 percent of that is $81 billion.)

Interest on trust fund bonds generated $84.9 billion in 2003. That's a fictional return of about 5.8 percent on the trust fund's average assets of $1,454 billion for the year (from end-of-year data for 2002 and 2003 given here). That's more than the return on new bonds, because the trust fund's portfolio consists of a mix of bonds issued in various years at various rates. In any event, if the trust fund's portfolio had been invested equally in AAA bonds, conventional mortgages, and BAA bonds, it would have yielded around 7.1 percent -- about 23 percent more.

Let's say the trust fund were completely converted to real assets by 2015, at which time it would have a current-dollar value of $4.4 trillion and earn about 5.6 percent interest (estimates derived from this table). The accumulation of additional interest earnings in the years after 2015 would prolong the life of the fund by about five years, that is, from 2042 into the late 2040s. Almost everyone who is now collecting Social Security benefits and who will begin collecting benefits in this decade would be assured of complete lifetime coverage. There would be no need to raise tax rates, cut benefits, or raise the retirement age beyond the current maximum of 67 years (for persons born in 1960 or later).

A slight upward adjustment in the retirement age would buy even more time in which to save Social Security without unduly burdening the coming generation of workers and retirees. And time is what it will take.