February 14, 2005

What the Kids Think About Social Security

By: Brooke Oberwetter

Not many twenty-somethings spend time thinking about the year 2042. I confirmed as much recently with a casual survey of the clientele at the Starbucks in Union Station. I figure if the young politicos in a Capitol Hill Starbucks don’t know that 2042 is the year Social Security is projected to exhaust its “trust fund,” it’s a fair bet that not many young people elsewhere know it either. Maybe they’ll know about 2018, the year Social Security will start paying out more in benefits than it takes in from taxes? No. I didn’t even bother to ask.

In 1999, the Wall Street Journal surveyed attitudes on Social Security and discovered that only 11 percent of non-retired Americans said they were very confident that Social Security would be around when they retired. For something designed to provide retirement security, that’s astonishingly low confidence. Since then, the system’s finances have grown worse. Not many people–young folks in particular–seem to comprehend the obvious reason and the likely solution. Meanwhile, the people who are aware of the problem don’t seem particularly interested in doing anything about it.

Robin Landauer, a 26 year-old hill staffer and graduate student, agrees that among her peer group, Social Security is not at the forefront of important issues. “But perhaps it should be,” she says. “So many of us are trying so hard to pay off our undergraduate and graduate school loans and earn a decent living, that we don’t often focus on what our financial predicament will look like in ten to fifteen years.” Robin is right: Social Security should be on young people’s minds. The way Social Security is reformed–or not reformed–will affect the rest of Robin’s life. The lives of all American workers, especially the younger ones, will be affected. Social Security has the potential to increase growth, prosperity, saving, and financial security. Or it could be a disaster.

Drawing the Battle Lines

Social Security is effectively a Ponzi scheme: You pay in, and your payments provide benefits for the people who paid earlier. Our payroll taxes are paying for our grandparents and parents. Anyone who tells you that your money is safely guarded in a trust fund doesn’t know much about government spending. In government, money doesn’t just lie around in bank accounts. Congress spends money from the “trust fund” on everything from a half-million dollar statue of Dr. Seuss in Massachusetts to a $750,000 grant for grasshopper research in Alaska. It replaces the money with accounting entries, IOUs that represent penciled-in promises, not actual cash.

This might have kept working had the baby boomers not bungled the scheme’s delicate balance. The boomers simply didn’t have enough kids to keep the system solvent. Advances in medicine and healthier lifestyles, too, have led to longer lives and longer retirements. In 2018, the government will have to start cashing in those IOUs from general revenues to pay for benefits, putting an enormous strain on the budget.

The baby boomers’ modest fertility is in some senses the opening volley in a generational war, one where we–the young people–will have no choice but to revolt against the host of entitlements that the boomers promised themselves.

Both sides in the coming generational war are assessing troop strength, but the young people aren’t winning when it comes to size. In 1950, there were sixteen workers paying Social Security taxes for every one retiree; now there are 3.3. By 2030, every dual income couple will be carrying one retiree on their backs. One out of every six dollars they earn will go to fund the retirement of a total stranger. So much for Social Security building a glorious bridge between the generations. It won’t be long until workers realize that retirees voted themselves a substantial portion of their children’s income. $26 trillion of it, to be exact, according to the 2003 Social Security Trustees Report.

But apart from the $27 trillion in unfunded liabilities, there are other problems too. It isn’t just going to be a bad deal in the future. It’s a bad deal now.

Broken Promises

Politicians say that every dollar “contributed” through FICA taxes is a promise made. What most people don’t know is that federal government has absolutely no obligation to fulfill those promises. As the Supreme Court decided in Flemming v. Nestor, Americans are not entitled to Social Security benefits when they retire. Flemming v. Nestor “established the principle that entitlement to Social Security benefits is not a contractual right.” In other words, Congress can change the rules whenever it wants, making people who have paid into the system their whole lives suddenly ineligible for benefits at the drop of a hat.

Better to think of these so-called “contributions” as taxes, just like any other, that Congress can spend on whatever it likes. You don’t own your Social Security benefits, so there’s nothing you can do about it. All you can do is hope that Congress will give you your money back, or even a part of it, when you need it. It’s a little like throwing 12.4 percent of your income–half from you and half from your employer–into a wishing well.

“Young people won’t want to plan around Social Security,” says New Haven-based financial consultant Michael Lynch. Many of his younger clients already know not to expect much from Social Security, but he estimates that about half of them still want to factor it in when designing their retirement plans. Lynch, who doesn’t include projected Social Security benefits in his own retirement plan, says that apart from the fact that Social Security can’t afford to pay promised benefits, the rate of return from Social Security makes it a bad investment. In developing plans for his clients’ retirements, Lynch shoots for a conservative five percent return after inflation. By contrast, Social Security’s return averages less than two percent.

Part of the reason for the low rate of return is that the system’s architects didn’t envision it as a retirement system. The Social Security Act passed in 1935 as an insurance program: old-age insurance, it was called. As Franklin D. Roosevelt said at the time, “We have tried to frame a law which will give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age.” Certainly it was necessary to help those whose retirement savings had been ravaged by the Great Depression. The Depression-era mindset wasn’t about getting a good return on your Social Security investment. It was about getting anything back at all.

Finding Solutions

That mindset has changed. Millions of Americans now rely on Social Security to fund their retirements, not to supplement savings. According to AARP research, nearly 90 percent of older Americans receive Social Security benefits, and a quarter of those beneficiaries get 90 percent or more of their retirement income from them. As a whole, retirees get 40 percent of their retirement income from Social Security. Lynch says that while most of his younger clients seem to be putting enough away for retirement, many of his older clients haven’t. “They are in real trouble,” he adds.

There’s a way to head off the looming generation war, thankfully. Private retirement accounts. These can satisfy both those who rely on the insurance component of the system and those who are increasingly unhappy forking over large chunks of their income for paltry returns. The idea is to set up the system such that payroll taxes, instead of being frittered away by Congress, go into individually-owned accounts that are invested in capital assets, such as stocks and bonds. This solves the two most glaring problems with the current system: when your payroll tax money is in an account that you own, the government can’t use it for its ground-breaking grasshopper research; and when you invest in capital assets, you get a much better rate of return on your money.

Using the default values on the Heritage Foundation’s Social Security calculator, a 27 year-old male will actually see a negative rate of return from his investment in the Social Security system. Under a private retirement account (PRA) plan, he could have a 4.87 percent rate of return. Since he would own the money he accumulates, he could pass on whatever he doesn’t use in his retirement to his heirs. That isn’t an option under Social Security right now, but it’s an aspect of PRAs that makes them particularly attractive to minorities and lower-income workers, two groups that tend to have lower life expectancies: they get the lowest return on their investment, and they’re the groups that could benefit most from being allowed to create inheritable wealth.

There is overwhelming support for private accounts, particularly among young people. According to a 2003 Gallup poll, 83 percent of those aged 18-29 supported a private account option, compared to 62 percent support across the board. Support for PRAs is consistent across race, economic, and regional lines. But not all young people are convinced.

That “Can’t-Do” Spirit

“Social Security has weathered many storms: a World War, a Cold War, Vietnam, several recessions. I don’t think it’ll be catastrophic,” Kip Malinosky tells me. A teacher in his mid-twenties, Kip is sure that Social Security will be around in its current form or something like it when he retires, but he doesn’t plan to rely on it. That is a luxury he can afford. “There will probably be some combination of benefit cuts and raising taxes. And maybe raising the retirement age.” Kip’s other suggestion, one shared by various groups that oppose privatization, is eliminating the payroll tax cap, currently set at $87,900. Though doing so would appease proponents of progressive taxation, the revenue generated would be only a drop in the bucket of what’s needed. A Social Security Administration report concludes that removing the tax cap might slow the march towards insolvency, but it won’t eliminate it. And doing away with the tax cap would create the largest tax hike in American history.

Others worry that the volatility of the market could wipe out retirement savings. But they might be surprised to learn–as Kip was–that the market’s worst twenty-year period of the twentieth century, 1929-1948, still produced a 3.36 percent return, higher than the average return from Social Security.

One heavy-hitting opponent of PRAs is AARP. They remind their members that Social Security is just one part of a “three legged stool,” which also includes employer-funded pensions and personal savings. (AARP recently added adequate health care to the three-legged stool, making it, apparently, a chair.) Given that corporate pensions have been in steady decline since the federal government got involved in the retirement business, it isn’t surprising that their own research indicates that many people, especially lower income workers, have no choice but to rely heavily on Social Security as their primary source of retirement income. Nevertheless, they rail against “privatizing” Social Security, claiming that the costs would be prohibitive and that investing in the market is too risky.

Two trillion dollars is the number AARP and the media have latched onto: private accounts would cost that much over the next ten years. The actual cost for the complete transition is somewhere between $5 and 7 trillion, which will be spread out over several decades. But what they don’t tell you is that it’s $7 trillion now instead of spending $27 trillion in the future. Supporters liken the transition to refinancing a mortgage: we’ll pay the points up front to save money down the road.

At a recent briefing on Capitol Hill, Brookings senior fellow Peter Orszag suggested that the disincentives to private saving through employer sponsored pension plans need to be removed: workers should be encouraged to save, and government should make it easier for them to do so. The briefing, hosted by unlikely allies–the right-leaning National Center for Policy Analysis (NCPA) and the center-left Brookings Institution–was called “Strengthening Retirement Saving: A Bipartisan Proposal.”

In the spirit of bi-partisan agreement, Social Security was barely mentioned. But it was the big elephant sitting behind Orszag: one of the policy world’s most vocal opponents of private retirement accounts told a room full of people that Americans should be putting more money into their. . .well, private retirement accounts.

Rep. Ben Cardin (D-MD), who opposes private retirement accounts, mentioned twice that private saving through 401(k) or 403(b)-style plans is necessary to “take the pressure off Social Security.” But neither Cardin nor Orszag takes what seems like the logical jump: turning Social Security into a 401(k) style plan.

NCPA’s Social Security analyst Matt Moore agrees that support for private saving should logically translate into support for PRAs. “It seems odd,” he says, “that a Member who encourages private saving would be against personal retirement accounts funded out of current payroll taxes. After all, there is no better way to aid lower-income workers than to allow them to set some retirement money aside out of taxes they already pay.”

When it comes to reforming Social Security, Moore sees two options. We could do nothing and try to recapture the mindset that Social Security is an insurance program, not a stand-alone retirement system, or we could “accept the premise that we are going to fix Social Security and allow younger workers and future generations to enjoy a secure retirement benefit like today’s retirees receive” by adopting private accounts that are structured to protect workers from market fluctuations.

Looking Ahead

Let’s go back to the people at Starbucks. In 2042, most of them will either be in the middle of their retirement or just getting ready to retire. Without reform, what will happen in 2042 when the last IOU in the trust fund has been cashed in? By law, Social Security benefits will have to be slashed by more than a quarter, or payroll taxes will have to increase by 50 percent in order to pay the same paltry benefits Social Security gives now. Given that the system is a bad investment to start with, the case in 2042 could best be described as a lose-lose-lose situation.

Kyle Sturgeon, a twenty-three year old consultant, says he has no particular knowledge of Social Security, except that it’s shaping up to be a pretty bad deal for people his age. He reads the papers and CNN online at work, but he’s not particularly familiar with any of the proposals for Social Security reform currently on the table. “Social Security isn’t really at the top of my list for picking candidates,” Kyle tells me. Like a number of young people, he knows better than to factor Social Security into his retirement plans, which at twenty-three consist solely of participation in his company’s 401(k) plan–though when I ask him if he contributes either as much as he could or as much as he thinks he should to the account, his answer is a swift “No.”

Kyle is dealing with the reality that he might not get his money back from Social Security (a fact that “sucks,” he adds). “I don’t see my [payroll] taxes as being saved for me,” he says. “I just think of them as going away.” But he isn’t ready to scrap the system. Though private accounts sound vaguely intriguing, his interest in them is tempered by his conscience: “There needs to be some kind of safety net,” he says, for the unemployed and low-income workers who might not end up with enough in their accounts for retirement.

This seems to be the consensus among supporters of private retirement accounts. Even the most jaded libertarians aren’t ready to tell seniors that if they don’t have enough to retire on they’re plumb out of luck. Two leading reform bills currently pending, for example–one, sponsored by Rep. Sam Johnson (R-Tex.) and another by Rep. Paul Ryan (R-Wis.)–feature mechanisms that guarantee income levels for all retirees in the system. Kyle says this is the best option he’s heard, and he hopes that such legislation can be sold to a wary public.

But Moore adds a note of caution about any reform proposal: there’s no free lunch. Whether Social Security is reformed through private accounts, higher taxes, or some other measure, “the burden for closing the system’s debt will fall primarily on younger workers,” he says. “We’ll need time to change our consumption habits and our spending habits to prepare for the new Social Security system.”

That means that the reform implemented to bail out Social Security–not to mention the colossal task of overhauling Medicare, which we can expect down the road–will define how Americans spend, plan, and save over this century. It will shape all of the important financial decisions we make, from planning for our children’s educations to putting money down on a first home. It’s a hard issue for people in their twenties and thirties to wrap their heads around, especially when so many other issues seem to loom larger, at least in immediate terms. Some distant day fourteen years from now hardly seems real. But it is. In 2018, when the tax man comes to your door and demands every sixth dollar you earn as you’re trying to figure out how to pay college tuition for two kids, things might–and most likely will–get ugly.

Brooke Oberwetter is a writer in Washington, D.C.