Diminishing Returns to Social Security by Robert G. Murphy* November 1996 Department of Economics Boston College Chestnut Hill, MA 02167 In the next few weeks, the Quadrennial Advisory Council on Social Security will issue its long-awaited recommendations for eliminating Social Security's financial imbalance. Social Security is projected to run short of money early in the next century when payments to a rapidly rising number of retiring babyboomers outstrip revenues from a slowly growing workforce. The Council's report comes at a time when many Americans face the prospect of low and in some cases negative returns on their Social Security contributions. This combination of a looming financial crisis and lagging returns has spawned a growing public skepticism, particularly among young workers, about the viability of Social Security, and has led to calls in some quarters for a drastic overhaul. The Advisory Council has been unable to agree on a single recommendation and will outline three options for restructuring Social Security, reflecting the wide range of views among its members. All three options encompass an array of adjustments to taxes, retirement age, and benefits, along with some degree of investing Social Security contributions in the stock market. One option will call for a significant privatization of the system, effectively replacing Social Security with a universal 401k-type investment plan. The two less-radical options also will propose partial investment of contributions in the stock market, albeit while preserving much of the current system. Investment in the stock market is a way to generate more resources out of current contributions, making it easier to close the long-run financing gap and possibly to raise future returns. Modest changes can eliminate the deficit. Many observers argue, however, that the changes required to restore Social Security to financial balance are modest and need not entail even limited investment of contributions in the stock market, let alone wholesale privatization of the system. Indeed, according to actuarial calculations by the Social Security Administration, the current combined (employer-employee) tax rate of 12.4 percent on taxable earnings (presently up to a ceiling of $62,700) need be raised only a little over 2 percentage points to ensure long-term solvency for the system. If changes in the earnings ceiling, benefit rates, retirement age, cost of living adjustment, and other parameters also were made, then tax rates would not need to be increased as much. Such tinkering around the edges can stabilize Social Security far into the next century without the added risk of stock-market fluctuations. The argument that Social Security can be fixed through relatively modest changes, however, misses a key point. Social Security has enjoyed broad public support in the past because most people believed they would receive benefits representing a fair return on their contributions. Even though the progressive nature of benefit rates meant some individuals would reap a higher return than others, the system provided a reasonable return for all. Returns have fallen sharply. Over time, though, Social Security has become less of a good deal. The return to Social Security naturally declined as the system matured, since participants retiring during the early years of the program had contributed relatively little but still got full benefits, while participants retiring in later years contributed relatively more. In addition, increases in payroll taxes during the 1980s, which were necessary to pay for the significant boosts in benefit levels made during the 1960s and early 1970s, caused the return expected for future retirees to decline further. For many Americans, the return they will receive on their Social Security contributions is abysmally low (see chart below). According to calculations reported in a 1994 study by the Urban Institute, an average-income dual-earner married couple retiring in 2020 can expect a real (after inflation) return of around 2.5 percent per year. A dual-earner couple with one spouse whose income exceeds the contribution ceiling each year of their working lives can expect a real return of about 1.3 percent. An average-income single male can expect a real return of roughly 1.2 percent, while a high-income single male can expect to earn a negative real return! By way of comparison, people who retired in 1980 are reaping a real return of 6.2 percent for average-income dual earners, 5 percent for high-income dual earners, 4.2 percent for an average-income single male, and 4 percent for a high-income single male. Low real returns, however, are not necessarily a bad deal, provided they are earned on a relatively safe investment. Social Security is an extremely safe asset: its benefits are fully indexed for inflation and represent a social contract which the Federal government is obliged to uphold. But Treasury bonds are also relatively risk free. Over the past 40 years, the average annual real return on ten-year Treasury bonds has been slightly more than 2.5 percent. And, in exchange for bearing some risk, an investment in the S&P 500 over the past 40 years would have earned an average annual real return of nearly 6 percent. Prospective retirees who are anticipating low or negative returns on their Social Security contributions are increasingly likely to conclude that Social Security is a poor investment. Reform should include stock market investment. Social Security has been an overwhelming success in dramatically reducing poverty among the elderly and in guaranteeing a retirement with dignity for all Americans. It has enjoyed broad public support precisely because its role in redistributing income has been complemented by its role in providing reasonable (and often overly generous) returns to participants. With returns now projected to fall sharply over the next two decades, however, the broad consensus favoring Social Security is weakening. Only by simultaneously addressing the problem of declining returns while bringing the system into financial balance can reform of Social Security ultimately succeed. The Advisory Council is right to consider reforms involving some measure of investment in stock markets. Such investments could help limit the projected decline in returns and thus bolster public support for Social Security, particularly among young workers. As the debate unfolds, discussion should center not on whether to invest in stocks, but on how far to go. A version of this article appeared in the Journal of Commerce, November 20, 1996. Projected Average Annual Real Rates of Return on Social Security Contributions for Selected Demographic Groups Source: Steuerle, C. E. and J.M. Bakija, Retooling Social Security for the 21st Century: Right and Wrong Approaches to Reform, Urban Institute Press, 1994. Data Used in Article and Chart Year Turning age 65 Avg.-Income Single Male High-Income Single Male Avg.-Income One-Earner Couple High-Income One-Earner Couple Avg.-Income Dual-Earner Couple High-Income Dual-Earner Couple 1965 8.13 6.38 12.05 9.98 10.16 8.13 1970 6.37 5.19 10.29 8.83 8.55 6.84 1975 5.00 4.30 8.85 7.81 7.16 5.76 1980 4.24 3.78 7.66 6.94 6.16 5.05 1985 2.73 2.30 6.20 5.76 4.76 3.69 1990 2.39 1.82 5.66 5.24 4.30 3.26 1995 1.82 1.05 4.79 4.26 3.54 2.48 2000 1.59 0.72 4.31 3.65 3.11 2.07 2005 1.32 0.35 3.91 3.11 2.74 1.68 2010 1.16 0.11 3.64 2.72 2.52 1.45 2015 1.16 0.03 3.56 2.55 2.46 1.37 2020 1.15 -0.07 3.54 2.39 2.45 1.29 2025 0.97 -0.30 3.38 2.15 2.29 1.10 2030 1.00 -0.25 3.37 2.15 2.29 1.11 Source: Steuerle, C. E. and J.M. Bakija, Retooling Social Security for the 21st Century: Right and Wrong Approaches to Reform, Urban Institute Press, 1994.