In January 1998, The Heritage Foundation published
the first paper in a series analyzing Social Security's rate of
return.
We presented our findings from a detailed study of the retirement
income that typical groups of Americans could expect from the
retirement portion of their payroll taxes, and we compared this
income with the likely return that could be generated by investing
those taxes instead in a conservative portfolio of stocks or
bonds.
Experts across a wide spectrum of
political opinion now concede that Social Security's retirement
program provides a poor return for a lifetime of tax payments--the
conclusion of the Heritage study as well. Indeed, President Bill
Clinton has argued that Social Security's rate of return needs to
be higher. Much of the current debate
discussing Social Security reform focuses on ways to improve its
retirement rate of return--an objective rarely heard just a few
years ago.
This
new emphasis on Social Security's rate of return has reshaped the
Social Security reform debate by connecting the interests of
taxpaying workers to such arcane but important concepts as "trust
fund balances," "dependency ratios," and other elements of a
technical analysis of Social Security's long-term problems. But it
also triggered criticisms of Heritage's rate of return analysis. By
the time the second Heritage report appeared, for instance,
the Commissioner of the Social Security Administration, Kenneth
Apfel, had given congressional testimony on its alleged
methodological shortcomings, and left-leaning think tanks had begun
issuing studies criticizing our work.
As
the authors of the Heritage study, we responded promptly to several
of these criticisms. Meanwhile, Heritage's Center for Data Analysis
continued to offer workers in various age, income, and ethnic
groupings information about their publicly funded retirement
program--information that the Social Security Administration (SSA)
often refuses to produce, even when asked by the presidentially
appointed Social Security Advisory Council. Given the current emphasis on
Social Security reform, it is both timely and useful to address
specific criticisms of our study and offer a more detailed
response.
CRITICISMS AND RESPONSES
The
following criticisms either paraphrase or, where appropriate, quote
from specific objections to our published rate of return
studies.
On Transition Costs
| To impose an arbitrary rule on the model
would serve to undermine the vailidity of the analysis as an
examination of the "pure" opportunity costs of the current
system. |
Criticism
The Heritage analysis does not take into account the cost
of the transition to a system of private Social Security accounts.
The rates of return cited fail to acknowledge that workers entering
a private system would have to pay for their own retirement as well
as support the benefits paid to those who are currently retired and
close to retirement.
Response
The purpose of Heritage's rate of return analysis is to
apply a yardstick to measure the performance of the current Social
Security system, not to propose or cost out an alternative plan. To
that end, the comparison of outcomes under Social Security today
with outcomes under a hypothetical private system illustrates the
opportunity costs of the current program instead of setting out a
specific blueprint for reform. In other words, the Heritage
analysis provides a benchmark for comparing alternative
reforms.
Rate
of return outcomes vary enormously, of course, depending on the
transition rules that are adopted. Interim financing could be
raised through tax increases, benefit cuts, and the issuance of
debt--which pose widely different implications for the rates of
return of different groups. To impose an arbitrary transition rule
on the model would serve to undermine the validity of the analysis
as an examination of the "pure" opportunity cost of the current
system.
Moreover, it is far from certain that
including transition costs would significantly alter the
differences in rates of return between the current system and a
private system, since maintaining the current system as a viable
long-term program also involves large costs. Nevertheless, Mark
Weisbrot of the Institute for America's Future has claimed that "as
soon as we take into account the real world costs of moving from
Social Security to a system of private accounts, the superior
return that the [Heritage] authors calculate for private savings
vanishes, and in fact becomes negative." In support of his criticism, he
cites the increased taxes contained in the 1994-1996 Social
Security Advisory Council's Personal Security Account (PSA)
proposal to fund the transition to a partially privatized Social
Security system.
However, Weisbrot fails to note that the
SSA's Office of the Chief Actuary analyzed this PSA proposal and
found that, even when transition costs are included, it
actually offers a higher rate of return to virtually all
participants than the current Social Security system does.
Table 1 shows the returns
calculated by the SSA for a low-income single male worker who made
$11,000 in 1995, under both the current system (fully funded, using
the SSA's own assumptions) and the Personal Security Account
proposal of Carolyn L. Weaver, Sylvester J. Schieber, and several
other members of the Social Security Advisory Council.
On Rate of
Return Methods of Calculation
Criticism: Steve Goss,
Deputy Chief Actuary of the Social Security Administration's Office
of the Chief Actuary, has charged that
[T]he Heritage study erroneously analyzes
a single outcome where an individual is assumed to know how long he
or she will live.... This approach consistently overestimates the
expected number of years of work and consistently underestimates
the expected number of years after reaching retirement age. As a
result, it grossly underestimates the expected rates of return from
Social Security retirement benefits.... Clearly, computed rates of
return for all men will be much higher for all men [sic], and,
moreover the difference between rates of return for black and white
men will be dramatically smaller than if the erroneous Heritage
method is used.
Response
This criticism will be addressed directly later in this
section, but it is worth noting here that rates of return for
20-year-old white and black male workers--based on Goss's own data
and calculating method--are 0.59 percent and -0.15 percent,
respectively. When Goss calculates rates of return for whites and
blacks in this same age group, he will find that the return for
blacks is below that for whites and is negative.
We
chose our method for calculating Social Security's rate of return
after careful consideration of the advantages and disadvantages of
three alternatives:
-
The "expected value"
method involves summing the expected (or "probability
adjusted") value of benefits and taxes on a year-by-year basis.
-
The "median value" return
method calculates the return to the 50th percentile in a
population's mortality distribution, and essentially yields the
return below which half of a population would receive less.
-
The "average life expectancy"
method involves first calculating a group's life
expectancy and then calculating the return from Social Security for
a worker who lives to that life expectancy. This method, which we
selected, usually yields results that lie between the "expected"
return and the "median" return.
Each
of these methods has strengths and weaknesses. Goss favors the
expected value method. In his discussion of the Heritage analysis,
Goss chose to characterize the method we selected as "erroneous"
while failing to note some of the disadvantages of the expected
value method as a measure of the typical return for members of a
demographic group. The expected value method in particular is
susceptible to distortion by skewed data. This can make it an
unsuitable estimator of the likely return from Social Security for
a typical member of a population.
A
simple analysis of an imaginary lottery will illustrate this point.
Consider a lottery with a single prize of $1,000,000. There are
1,000 contestants, each of whom pays a stake of $900. According to
the method suggested by Goss, the expected price for each
individual from this lottery would be $1,000, implying an overall
positive (net) return of $100. Yet 99.9 percent of the entrants
would actually lose $900. It would be misleading to suggest to
potential buyers of these lottery tickets that they will receive
$100--based on the expected return method.
Although this is an extreme example, there
is evidence that the returns from the current Social Security
system, and those for African-Americans in particular, are highly
skewed in a similar fashion. Preliminary calculations made by
Heritage (which will be the subject of a future publication)
suggest that, while the calculated expected return for a group of
recipients may be positive, a large majority of the members of this
group (up to 70 percent in the case of African-Americans) may in
fact receive negative returns from the Social Security program.
Thus, while the expected rate of return
may be useful to the actuary who is responsible for administering
an entire program (such as the administrator of the lottery
mentioned above) and must account for all participants (including
exceptional cases like the single winner above), it often is a less
useful tool for those charged with advising individual participants
on how they likely will fare in the program. This is why many
actuaries, especially in the private sector, have long recognized
the weaknesses associated with the expected value method. In
offering investment advice to their clients, actuaries routinely
use the average life expectancy method that we employed in our
study. Since our objective was to enable ordinary Americans to
compare the likely consequences of remaining within today's Social
Security program with their likely returns realized from a reform
that incorporates some private investments, it was also logical to
adopt the average life expectancy method.
Critics not only characterize the nature
of Heritage's methodology, but in some cases mischaracterize or
misunderstand the data we used. One such critic, former Chief
Actuary of the Social Security Administration Robert Myers,
mistakenly claimed that Heritage used a life expectancy of exactly
69 years for a 21-year-old African-American male. In fact, we used
a life expectancy of 73.81 years, which was based on projections
made by the U.S. Census Bureau and the Social Security
Administration and takes into account future improvements in
longevity.
Perhaps the most flagrant example of
mischaracterization of the Heritage approach was the use by the
Center on Budget and Policy Priorities (CBPP) of a table
created by Steve Goss of life expectancies for 20-year-old white
and black males in 1997. This table featured prominently in a paper
attacking the Heritage rate of return studies. The use of this
table was misleading on a number of levels. Among them:
-
The table referred to examples that
were not even computed in our study. For example, we did not
calculate the rates of return for any white males at all, or for
any African-American males born after 1975.
-
The data presented in the Goss table
were drawn from a different source (the 1992 Life Tables of the
United States ) than the one we used and were
inappropriate for calculating rates of return from Social Security.
In particular, the Life Tables figures are based solely on
demographic conditions prevailing in 1992 and, unlike the data used
by Heritage, do not take into account likely improvements in life
expectancy in the future.
Ironically, despite these shortcomings,
the data presented by Goss in this table and prominently featured
in the CBPP study can be used to illustrate both the shortcomings
of the expected value method favored by Goss and the robustness of
the general results calculated in the Heritage study.
According to the data in the 1992 Life
Tables, half of all 20-year-old black males who enter the
labor force will die before they reach the age of 69.7. Half of all
white 20-year-old males will die by age 77. If the retirement age
is 65, this means that half of all black male workers will die
before receiving Old-Age and Survivors' Insurance (OASI) benefits
for 4.7 years, and half of all white male workers will die before
receiving OASI benefits for 12 years. According to Goss's expected
value method, however, "typical" black and white males would
receive, respectively, 8.1 years and 12.1 years of benefits. In
reality, over 60 percent of black males and 50 percent of white
males will die before
collecting benefits for this length of time.
The
expected value method produces results that do not represent the
experiences of African-American males. As Table 2 shows, the Goss method
suggests that an "average" black male worker fares much better from
Social Security (paying taxes for only 4.8 years for each year of
benefits) than the median black worker (paying taxes for 9.6 years
for each year of benefits). In statistical terms, this difference
is due to the concentration of very high rates of return among a
very few individuals. But, as noted above, far fewer than half of
all black males will receive a rate of return as favorable as the
average rate of return estimated by Goss's method. The racial
disparity between the return received by the 50th white worker and
the return received by the 50th black worker is also much greater
than the disparity revealed in Goss's "expected value" method.
Even
if the expected value methodology and data cited by Goss are used
to evaluate the rate of return from Social Security, the major
conclusions of the Heritage study remain unrefuted. To show this,
we calculated the expected rate of return from Social Security for
the two men described in the Goss memorandum using his "expected
value" method. In line with U.S. Department of Labor data, we
assumed that the white worker would earn 118 percent of the
national average wage and the black earner would earn 89 percent of
the average wage. The results are shown in Chart 1. Chart 1 shows
that a black 20-year-old worker in 1998 can look forward to an
inflation-adjusted rate of return of -0.15 percent. His white
counterpart, however, will "enjoy" a return of 0.59
percent--better, but nothing that should make him too excited.
These calculations show that the real rate of return from Social
Security remains well below the measures of the opportunity rate of
return, even when the expected value method is used (this is the
case whether one uses the 2 percent discount rate used by SSA
analysts, the 2.5 to 3 percent available from long-term government
securities, or the 7 percent real rate of return that the Social
Security Advisory Council estimates to be available from equities).
In short, regardless of the method used to measure its return,
Social Security remains a poor retirement investment for either
minority or non-minority Americans.
Treasury Department Findings
A number of critics have referred to a series of studies
carried out by U.S. Treasury Department researchers James Duggan,
Robert Gillingham, and John Greenlees. For example, Steve Goss claimed
that
[I]n fact more careful research reflecting
actual work histories for workers by race indicates that the
non-white population actually enjoys the same or better expected
rates of return from Social Security than for the white population.
(See Duggan et al., "The Returns Paid to Early Social Security
Cohorts," Contemporary Policy Issues (October, pp. 1-13).
| Rather, the aim of our analysis was to
compare workers of similar age, income level, and family structure.
In this respect, the result of the U.S. Treasury Department studies
is unequivocal: For the African-American worker, Social
Security offers a worse deal than it does for a white worker with
an identical income and family structure. |
The evidence from this valuable study, however, has been
misused and distorted. For one thing, the studies carried out by
Duggan, Gillingham, and Greenlees refer only to workers born in the
period before the one covered in our Heritage study. In
particular, the report cited by Goss is based on workers who were
born between 1895 and 1922 and who retired between the early 1950s
and the mid-1980s. By contrast, the Heritage study calculates
returns for workers born after 1932 and retiring from 1997 until
2042. These two periods have seen extensive changes, both in the
structure of Social Security taxes and benefits and in
socioeconomic differentials in life expectancy. For example, recent
trends and projections suggest that the longevity gap between
African-Americans and whites, and between rich and poor, is
growing.
The
other mistake in the use of the Duggan et al. study is that Goss
implies we calculated a general weighted average rate of return for
all African-Americans and all whites. This is not the case. Such an
average is almost impossible to calculate and in practice is
meaningless, requiring as it does an amalgamation of workers of all
income levels, marital status, ages, etc. Rather, the aim of our
analysis was to compare workers of similar age, income level, and
family structure. In this respect, the result of
the U.S. Treasury Department studies is unequivocal: For the
African-American worker, Social Security offers a worse deal than
it does for a white worker with an identical income and family
structure.
Chart 2, which is based on
data from the most recent study by Duggan, Gillingham, and
Greenlees, shows that black workers born in 1918 can expect a real
rate of return from Social Security that is 0.75 percent below that
which a white worker with an identical income will receive.
On the Exclusion
of Disability Insurance
Criticism
The Heritage study ignores Disability Insurance (DI).
Disability Insurance taxes are included, but not disability
benefits. When this is corrected, many of the findings are
reversed. This is especially true regarding the result that
African-Americans have particularly low rates of return from Social
Security.
Response
This common objection is simply wrong and is based on a
failure to read our study carefully. DI is a separate program
within the Social Security system that has its own tax rate and
trust fund. Heritage's study explicitly examined only the Old-Age
and Survivors' Insurance program within Social Security, ignoring
DI taxes as well as benefits.
It
is possible to reform the OASI program and leave the Disability
Insurance program untouched. With this in mind, both DI taxes and
benefits were excluded from the analysis. We carefully accounted
for pre-retirement Survivors' Insurance by excluding the taxes
necessary to purchase this insurance.
The
Heritage study thus constitutes a complete and consistent analysis
of the retirement portion of Social Security--and only this portion
of Social Security. In effect, it assumes that, in the hypothetical
partly private system, Disability Insurance and pre-retirement
Survivors' Insurance are retained exactly as they exist under
current law.
Moreover, no empirical study exists to
support the claim of Social Security's defenders that including the
DI program in rate of return calculations will offset the racial
differentials embedded within the OASI program. Many advocates
of the current Social Security system cite higher than average DI
payments to black workers as a defense against the criticism that
Social Security yields a lower than average retirement rate of
return for blacks. Besides the fact that DI payments are made to
workers and not retirees, the argument that Disability
Insurance is the principal means by which Social Security makes up
for poor retirement rates of return is a particularly tortured
defense of the current system. It is like telling people whose bank
gives a poor return on their savings accounts that they should not
worry because their homes are insured.
Even
if a study of the combined OASDI program as a whole were conducted
and led to a narrowing of racial differentials in rates of return,
such a study would itself be vulnerable to the criticism that it
failed to include the effects of Hospital Insurance (HI)--more
commonly known as the Medicare program. Chart 3 shows that medical
expenditures are highly concentrated among the very old.
The
inclusion of HI is likely to increase racial differentials in
Social Security's rates of return. Compared with the general
population, African-Americans have a much lower probability of
reaching the very old ages at which medical costs tend to escalate.
For example, according to the 1992 Life Tables cited by
Goss, a white male has a 40.1 percent chance of living to the age
of 80, while a black male has only a 24.3 percent chance.
On the Risk of
Private Rates of Return
Criticism
Private investments, unlike Social Security, are highly
risky. Given that most people are risk-averse, if the returns from
a private system are adjusted for uncertainty, they will compare
much less favorably with those from Social Security.
Response
Before addressing the risk associated with private
investments, it is important to recognize that Social Security is
not inherently less risky than private investments. There are at
least two major risks associated with Social Security: a
demographic risk and a political risk.
- Social Security's Demographic
Risk. Every participant in the Social Security retirement
program faces the risk of dying before reaching retirement age. In
the event of death, Social Security pays a monthly benefit to a
worker's children who are under the age of 18 and to the spouse who
cares for these children. However, if a worker is childless or has
adult children, the family receives no such pre-retirement
Survivors' Insurance benefits, other than a one-time-only death
benefit of $255.
Widowed retired spouses sometimes collect
Old-Age benefits based on the taxes paid by their husband or wife.
If they do so, they receive nothing in return for the taxes they
themselves have paid. Thus, when one partner of a married couple
dies without leaving children under the age of 18, at least one
spouse ultimately loses all of the taxes he or she has paid into
the system.
Most workers who die between ages 50 and
70 face a high risk of receiving little or nothing in return for a
lifetime of paying Social Security taxes. In most cases, their
children, if any, are older than age 18 when they die and are
ineligible for pre-retirement Survivors' benefits. Those who die in
a slightly narrower age band (ages 50 to 65) are not eligible to
collect full Social Security retirement benefits. Those dying at
age 70 are eligible to collect less than five years' worth of full
Old-Age benefits.
Chart
4, using the National Center for Health Statistics data cited
by Goss,
shows that 13 percent of white males and 22 percent of
African-American males will die between the ages of 50 and 65.
Another 8 percent of all white males and 11 percent of all
African-American males will die between the ages of 65 and 70.
Thus, one in three African-American males and one in five white
males will die between ages 50 and 70.
Stanford University economist Daniel Garrett drew on such data and
calculated the variation in returns from Social Security for a
single cohort of individuals with the same average life expectancy
and income. These variations are shown in Chart 5. For this set of
workers, the lifetime net present value of participation in Social
Security ranges from -$92,259 for the worst-performing percentile
to $85,993 for the best-performing percentile, in terms of 1988
dollars in 1990 present values.
- Social Security's Political
Risk. The political risk in Social Security arises because
workers and families do not enjoy secure property rights, which are
enforceable in court, over their future Social Security benefits.
The U.S. Supreme Court has ruled in Fleming v. Nestor that
a worker's claim to Social Security benefits is "non-contractual
and cannot be soundly analogized to that of a holder of an annuity,
whose right to benefits are [sic] bottomed [based] on his
contractual premium payments.... To engraft upon the Social
Security system a concept of accrued property rights would deprive
it of the flexibility and boldness in adjustment to ever-changing
conditions which it demands."
In other words, the future benefits of
retirees are completely dependent upon future voters and
politicians. Given the tax burden needed to fund promised benefits
under the current system, it seems appropriate to assign a
considerable degree of political risk to future Social Security
benefits.
On Figuring the
Private Rates of Return
Criticism
The rates of return on private investments assumed in the
Heritage study are too high. This exaggerates the benefits of a
privately held individual account.
Response
We used very cautious assumptions regarding the rates of
return paid on private investments. For the years up to 1997, we
used the actual annual historical rates of return on bonds and
equities. For 1998 and future years, the real rate of return on
equities was assumed to be 5.7 percent, and the real rate of return
on bonds was projected to be 2.8 percent.
The
5.7 percent real rate of return on equities lies well below the
long-term rates found in the professional literature. For example,
the Social Security Administration's own 1994-1996 Advisory Council
used a projected return of 7 percent on equities after considering
a wide range of expert testimony. During the 1926 to 1997 period,
large company stock returns averaged 7.7 percent after inflation,
while small company stocks yielded an average post-inflation return
of 9.3 percent. Heritage reduced even these
returns on equities and used a return of 5.7 percent.
The
2.8 percent return on U.S. government bonds is the same as the
long-term rate used by the Social Security Administration in the
1998 Report of the Trustees of the Federal Old-Age and
Survivors' Insurance and Disability Insurance Trust Funds.
However, even if ultra-pessimistic
predictions regarding the returns on stocks are adopted, the major
conclusions of the Heritage study would be unaffected. One critic
of the study cited a report by Dean Baker of the Economic Policy
Institute in which the claim was made that
economic growth, as projected in the Social Security Trustees'
Report (whose assumptions were used as the basis for the Heritage
study), was consistent with a real rate of return on stocks of only
4.5 percentage points. Citing this rate of return on equities does
not, however, indict the Heritage analysis: Our assumed rate of
return is even lower, at a very cautious 4.25 percent. In the great
majority of cases, returns from a private account exceeded returns
from Social Security, even where taxes were invested wholly in
ultra-low-risk U.S. government bonds.
In
our study, we assumed that individuals were extremely risk-averse
in their investment strategies and would concentrate their
investments among low-yield, ultra-secure investments. The riskiest
portfolio we used was one in which half of all investments were
made in long-term government bonds and the remainder in a broad
market equity index. The projected future rate of return on this
portfolio is 4.25 percent, with the bond component returning only
2.8 percent annually.
On
Administrative Costs and Private Rates of Return
Criticism
Administrative costs would eat up 1.5 percent to 2 percent
of all private funds annually. This would remove much or all of the
gains from privatization for most workers.
Response
Heritage's first rate of return study did not consider
administrative costs explicitly. Instead, these costs were taken
into account implicitly through an assumption of extremely low
rates of return on private assets. However, both a Social Security
Administration study and empirical data show that administrative
fees will be much lower than the critics' 1.5 percent to 2 percent
projection. A study by the Actuary's Office for the 1994-1996
Social Security Advisory Council estimated that administrative
costs for the Personal Security Accounts (PSA) plan, which would
privatize a substantial part of Social Security, would be only 1.0
percent of fund assets.
In
actual practice, costs are even lower. A 1996 U.S. Department of
Labor study showed that the administrative costs for
private-sector, multi-employer defined contribution plans were only
0.82 percent of assets. The mean administrative cost for Standard
& Poor's 500 Index mutual funds was lower still--0.39 percent,
according to Lipper Analytical Services. And the Thrift Savings Plan, a
privatized retirement plan run by the federal government for its
employees, has costs for its three funds that range from 0.08
percent to 0.10 percent.
These lower estimates are supported by
data from Australia's privatized social security system, in which
annual administrative costs average 0.8 percent of fund
assets.
The structure of the plan is also important. Limiting investment
options and creating larger investment pools will hold costs down.
These are features of most privatization plans. Also, costs decline
rapidly after the plan starts. For instance, administrative costs
for the Thrift Savings Plan are 76 percent lower than they were
when the plan began operations in 1988.
One
low-cost option would be to allow individuals to invest their
Social Security taxes in the new 30-year Series I Savings Bonds,
which currently pay a return of 3.3 percent over the inflation
rate. These bonds can be obtained at virtually no cost, and they
pay a substantially higher rate of return than does the current
Social Security system.
On the
Employer's Share of Payroll Taxes
Criticism
The Heritage study included not only the employee's share
of taxes, but also those paid by the employer. This overestimates
the costs of the program to workers.
Response
Glen Lane, district manager of the Social Security Field
Office in Cedar Rapids, Iowa, was among those who criticized our
inclusion of the employer's share of the Social Security tax burden
in our study. However, the "employer's share"
of Social Security taxes is part of the total amount an employer
expends on employee compensation, which includes the worker's wages
and employer-provided benefits. The ascription of the term
"employer's share" is an accounting label, rather than a meaningful
distinction. In the absence of Social Security taxes, this money
from the employee's paycheck would be available for the worker to
invest in a private account or to use as an addition to take-home
pay. As Dean Leimer, chief author of the Social Security
Administration's own calculations of its rate of return, has
noted:
In
any event ignoring the employer share of the tax is clearly
inappropriate, because it results in the comparison of benefits
with taxes that are insufficient to fund those benefits; as a
consequence, Social Security appears to be a much better deal than
it actually is when all taxes required to fund the program are
considered.
On Judging
Social Security's Effectiveness by Its Rate of Return
Criticism
The rate of return is not a proper measure of the
effectiveness of the Social Security program. Rather, the system
should be judged on social criteria, such as its success in
reducing the poverty rate among the elderly.
| When the rate of return from Social
Security for lower-income workers is below the rate available from
alternative investments, the program actually may add to
poverty--or at least slow wealth accumulation--by reducing the
resources available to a family over their lifetime. |
Response
To be judged effective, a retirement social insurance
program not only must protect all workers from the threat of
poverty when they are elderly, but also must provide an efficient
level of retirement income for the taxes paid. The rate of return
measures the difference between the money that Social Security
takes from a family and the money that the family receives from
Social Security. A low or negative rate of return means that
individual families are foregoing higher retirement income because
Social Security is returning less to them than they could have
accumulated had they been able to invest their payroll taxes in
private accounts. When the rate of return from Social Security for
lower-income workers is below the rate available from alternative
investments, the program actually may add to poverty--or at least
slow wealth accumulation--by reducing the resources available to a
family over their lifetime.
The
founders of Social Security recognized the importance of the
program's rate of return. Arthur J. Altameyer, chairman of the
Social Security Board from 1937 to 1946 and the first Commissioner
of the Social Security Administration, argued against policies that
would lead to the evolution of a social security system that robbed
workers of the chance of higher lifetime incomes or a more
elaborate safety net by subjecting them to rates of return below
those available from private markets. As Altameyer stated in
1945,
Therefore, the indefinite continuation of
the current contribution rate will eventually necessitate raising
employees' contributions later to a point where future
beneficiaries will be obliged to pay more for their benefits than
if they had obtained this insurance from a private insurance
company.... I say it is inequitable to compel them to pay more
under this system than they would have to pay to a private
insurance company, and I think that Congress would be confronted
with that embarrassing situation.
On Payroll Tax
Assumptions
Criticism
Heritage inappropriately assumes that if Social Security
is not partially privatized, it will be restored to balance
entirely by raising payroll taxes and that this tax increase will
begin in 2015, a decade earlier than the Social Security actuaries
project would be necessary.
Response
There are several ways to balance the Social Security
system within its current framework. In addition to increases in
payroll taxes, Congress could cut benefits, increase the retirement
age, and require all state and local government workers to
participate. Each of these proposals would have a different impact
on workers of different ages and income levels. For example,
extending Social Security coverage to all state and local
government workers would create a massive unfunded liability among
existing state and local employee retirement funds that would have
to be corrected either by cuts in payments to retired state and
local employees or by increased taxes.
In
their calculations of the rate of return to the current system,
Social Security's own actuaries used two assumptions to reflect the
financial imbalance in the system. The first of these assumes that
the system is balanced through across-the-board cuts in Social
Security benefits. The second assumes that balance is achieved by
increases in payroll tax rates. Dean Leimer, who authored SSA's
rate of return calculations, found that the rate of return from
Social Security for workers born between 1932 and 1975 is higher
under a regime of payroll tax increases than in a scenario where
benefit cuts are used to balance the system. This higher
return occurs because current workers bear the full costs of
benefit cuts while bearing only a partial share of future tax
increases.
We
used one of the two assumptions adopted by Social Security in its
examination of the current system, and the assumption that we
selected for Social Security's rate of return was the one that
yielded the higher rate of return. Had we chosen the assumption of
reduced future benefits, the rate of return would have been even
lower.
The
Social Security trust funds are composed entirely of U.S.
government bonds, which means they are a set of IOUs that one part
of the federal government (the U.S. Treasury Department) has
written to another branch of the federal government (the Social
Security Administration). When the Social Security system starts
taking in less money than it needs to pay its promised benefits (as
it is scheduled to do in 2013), then the federal government as a
whole will have to meet the shortfall. It can do this either by
redeeming the IOUs in the Social Security trust fund (which would
mean raising non-Social Security taxes or cutting non-Social
Security spending) or by cutting promised Social Security benefits
or raising payroll taxes.
In
each case, Social Security participants will have to bear the
burden of this shortfall through increased federal non-Social
Security taxes, reduced federal non-Social Security spending,
Social Security benefit cuts, or Social Security tax hikes. In
making their projections, Social Security's actuaries merely assume
that the IOUs in the trust fund are redeemed, and do not take into
account the non-Social Security tax hikes and spending cuts that
the rest of the federal government will have to implement should it
repay these IOUs. The day of financial reckoning is easily within
the lifetime of the baby boomers and their children. Unless
Congress raises taxes or cuts benefits and other spending, the
Social Security Trustees will begin calling in their loans to the
U.S. Treasury by about 2012. By about 2030, the Trustees will have
been paid back all of their loans and will have to begin making
sharp reductions in Social Security's basic programs.
A LACK OF
COMPETING ANALYSES BY OUR CRITICS
The
criticisms leveled at Heritage's rate of return analysis have not
succeeded in altering our finding: Social Security offers a
very low rate of return for most Americans, including minorities
and low-income families. Not only does a low rate of return
reduce a family's potential retirement income, but it also
diminishes the ability of families to pass wealth on to
children.
That
Heritage's major finding remains unrefuted is perhaps best
underscored by the failure of any of its critics to publish their
own estimates of Social Security's rate of return. In advancing
their criticisms, neither the Center on Budget and Policy
Priorities, nor the American Association of Retired Persons, nor
Robert Myers, nor the Institute for America's Future has produced
their own estimates of the rate of return for Social Security or
the degree to which our estimate is affected by the alleged errors
in its analysis.
However, one major question remains: Why
has the Social Security Administration itself not published
calculations of the impact of the current program (or any of the
major reform alternatives) on minorities, especially in light of
the fact that it readily answers rate of return questions based on
age and income? This stunning silence is puzzling, given that
Social Security constitutes the federal government's largest
domestic program, that the mortality and income data required to
complete such a study are readily available to federal
researchers, and that the impact on
minorities of almost every other federal program has been subjected
to extensive analysis.
William
W. Beach is John M. Olin Senior Fellow in Economics and
Director of The Center for Data Analysis at The Heritage
Foundation. Gareth G. Davis is a former Policy Analyst in The
Center for Data Analysis at The Heritage Foundation.
In January 1998, The Heritage Foundation published
the first paper in a series analyzing Social Security's rate of
return.
We presented our findings from a detailed study of the retirement
income that typical groups of Americans could expect from the
retirement portion of their payroll taxes, and we compared this
income with the likely return that could be generated by investing
those taxes instead in a conservative portfolio of stocks or
bonds.
Experts across a wide spectrum of
political opinion now concede that Social Security's retirement
program provides a poor return for a lifetime of tax payments--the
conclusion of the Heritage study as well. Indeed, President Bill
Clinton has argued that Social Security's rate of return needs to
be higher. Much of the current debate
discussing Social Security reform focuses on ways to improve its
retirement rate of return--an objective rarely heard just a few
years ago.
This
new emphasis on Social Security's rate of return has reshaped the
Social Security reform debate by connecting the interests of
taxpaying workers to such arcane but important concepts as "trust
fund balances," "dependency ratios," and other elements of a
technical analysis of Social Security's long-term problems. But it
also triggered criticisms of Heritage's rate of return analysis. By
the time the second Heritage report appeared, for instance,
the Commissioner of the Social Security Administration, Kenneth
Apfel, had given congressional testimony on its alleged
methodological shortcomings, and left-leaning think tanks had begun
issuing studies criticizing our work.
As
the authors of the Heritage study, we responded promptly to several
of these criticisms. Meanwhile, Heritage's Center for Data Analysis
continued to offer workers in various age, income, and ethnic
groupings information about their publicly funded retirement
program--information that the Social Security Administration (SSA)
often refuses to produce, even when asked by the presidentially
appointed Social Security Advisory Council. Given the current emphasis on
Social Security reform, it is both timely and useful to address
specific criticisms of our study and offer a more detailed
response.
CRITICISMS AND RESPONSES
The
following criticisms either paraphrase or, where appropriate, quote
from specific objections to our published rate of return
studies.
On Transition Costs
| To impose an arbitrary rule on the model
would serve to undermine the vailidity of the analysis as an
examination of the "pure" opportunity costs of the current
system. |
Criticism
The Heritage analysis does not take into account the cost
of the transition to a system of private Social Security accounts.
The rates of return cited fail to acknowledge that workers entering
a private system would have to pay for their own retirement as well
as support the benefits paid to those who are currently retired and
close to retirement.
Response
The purpose of Heritage's rate of return analysis is to
apply a yardstick to measure the performance of the current Social
Security system, not to propose or cost out an alternative plan. To
that end, the comparison of outcomes under Social Security today
with outcomes under a hypothetical private system illustrates the
opportunity costs of the current program instead of setting out a
specific blueprint for reform. In other words, the Heritage
analysis provides a benchmark for comparing alternative
reforms.
Rate
of return outcomes vary enormously, of course, depending on the
transition rules that are adopted. Interim financing could be
raised through tax increases, benefit cuts, and the issuance of
debt--which pose widely different implications for the rates of
return of different groups. To impose an arbitrary transition rule
on the model would serve to undermine the validity of the analysis
as an examination of the "pure" opportunity cost of the current
system.
Moreover, it is far from certain that
including transition costs would significantly alter the
differences in rates of return between the current system and a
private system, since maintaining the current system as a viable
long-term program also involves large costs. Nevertheless, Mark
Weisbrot of the Institute for America's Future has claimed that "as
soon as we take into account the real world costs of moving from
Social Security to a system of private accounts, the superior
return that the [Heritage] authors calculate for private savings
vanishes, and in fact becomes negative." In support of his criticism, he
cites the increased taxes contained in the 1994-1996 Social
Security Advisory Council's Personal Security Account (PSA)
proposal to fund the transition to a partially privatized Social
Security system.
However, Weisbrot fails to note that the
SSA's Office of the Chief Actuary analyzed this PSA proposal and
found that, even when transition costs are included, it
actually offers a higher rate of return to virtually all
participants than the current Social Security system does.
Table 1
shows the returns calculated by the SSA for a low-income single
male worker who made $11,000 in 1995, under both the current system
(fully funded, using the SSA's own assumptions) and the Personal
Security Account proposal of Carolyn L. Weaver, Sylvester J.
Schieber, and several other members of the Social Security Advisory
Council.
On Rate of
Return Methods of Calculation
Criticism: Steve Goss,
Deputy Chief Actuary of the Social Security Administration's Office
of the Chief Actuary, has charged that
[T]he Heritage study erroneously analyzes
a single outcome where an individual is assumed to know how long he
or she will live.... This approach consistently overestimates the
expected number of years of work and consistently underestimates
the expected number of years after reaching retirement age. As a
result, it grossly underestimates the expected rates of return from
Social Security retirement benefits.... Clearly, computed rates of
return for all men will be much higher for all men [sic], and,
moreover the difference between rates of return for black and white
men will be dramatically smaller than if the erroneous Heritage
method is used.
Response
This criticism will be addressed directly later in this
section, but it is worth noting here that rates of return for
20-year-old white and black male workers--based on Goss's own data
and calculating method--are 0.59 percent and -0.15 percent,
respectively. When Goss calculates rates of return for whites and
blacks in this same age group, he will find that the return for
blacks is below that for whites and is negative.
We
chose our method for calculating Social Security's rate of return
after careful consideration of the advantages and disadvantages of
three alternatives:
-
The "expected value"
method involves summing the expected (or "probability
adjusted") value of benefits and taxes on a year-by-year basis.
-
The "median value" return
method calculates the return to the 50th percentile in a
population's mortality distribution, and essentially yields the
return below which half of a population would receive less.
-
The "average life expectancy"
method involves first calculating a group's life
expectancy and then calculating the return from Social Security for
a worker who lives to that life expectancy. This method, which we
selected, usually yields results that lie between the "expected"
return and the "median" return.
Each
of these methods has strengths and weaknesses. Goss favors the
expected value method. In his discussion of the Heritage analysis,
Goss chose to characterize the method we selected as "erroneous"
while failing to note some of the disadvantages of the expected
value method as a measure of the typical return for members of a
demographic group. The expected value method in particular is
susceptible to distortion by skewed data. This can make it an
unsuitable estimator of the likely return from Social Security for
a typical member of a population.
A
simple analysis of an imaginary lottery will illustrate this point.
Consider a lottery with a single prize of $1,000,000. There are
1,000 contestants, each of whom pays a stake of $900. According to
the method suggested by Goss, the expected price for each
individual from this lottery would be $1,000, implying an overall
positive (net) return of $100. Yet 99.9 percent of the entrants
would actually lose $900. It would be misleading to suggest to
potential buyers of these lottery tickets that they will receive
$100--based on the expected return method.
Although this is an extreme example, there
is evidence that the returns from the current Social Security
system, and those for African-Americans in particular, are highly
skewed in a similar fashion. Preliminary calculations made by
Heritage (which will be the subject of a future publication)
suggest that, while the calculated expected return for a group of
recipients may be positive, a large majority of the members of this
group (up to 70 percent in the case of African-Americans) may in
fact receive negative returns from the Social Security program.
Thus, while the expected rate of return
may be useful to the actuary who is responsible for administering
an entire program (such as the administrator of the lottery
mentioned above) and must account for all participants (including
exceptional cases like the single winner above), it often is a less
useful tool for those charged with advising individual participants
on how they likely will fare in the program. This is why many
actuaries, especially in the private sector, have long recognized
the weaknesses associated with the expected value method. In
offering investment advice to their clients, actuaries routinely
use the average life expectancy method that we employed in our
study. Since our objective was to enable ordinary Americans to
compare the likely consequences of remaining within today's Social
Security program with their likely returns realized from a reform
that incorporates some private investments, it was also logical to
adopt the average life expectancy method.
Critics not only characterize the nature
of Heritage's methodology, but in some cases mischaracterize or
misunderstand the data we used. One such critic, former Chief
Actuary of the Social Security Administration Robert Myers,
mistakenly claimed that Heritage used a life expectancy of exactly
69 years for a 21-year-old African-American male. In fact, we used
a life expectancy of 73.81 years, which was based on projections
made by the U.S. Census Bureau and the Social Security
Administration and takes into account future improvements in
longevity.
Perhaps the most flagrant example of
mischaracterization of the Heritage approach was the use by the
Center on Budget and Policy Priorities (CBPP) of a table
created by Steve Goss of life expectancies for 20-year-old white
and black males in 1997. This table featured prominently in a paper
attacking the Heritage rate of return studies. The use of this
table was misleading on a number of levels. Among them:
-
The table referred to examples that
were not even computed in our study. For example, we did not
calculate the rates of return for any white males at all, or for
any African-American males born after 1975.
-
The data presented in the Goss table
were drawn from a different source (the 1992 Life Tables of the
United States ) than the one we used and were
inappropriate for calculating rates of return from Social Security.
In particular, the Life Tables figures are based solely on
demographic conditions prevailing in 1992 and, unlike the data used
by Heritage, do not take into account likely improvements in life
expectancy in the future.
Ironically, despite these shortcomings,
the data presented by Goss in this table and prominently featured
in the CBPP study can be used to illustrate both the shortcomings
of the expected value method favored by Goss and the robustness of
the general results calculated in the Heritage study.
According to the data in the 1992 Life
Tables, half of all 20-year-old black males who enter the
labor force will die before they reach the age of 69.7. Half of all
white 20-year-old males will die by age 77. If the retirement age
is 65, this means that half of all black male workers will die
before receiving Old-Age and Survivors' Insurance (OASI) benefits
for 4.7 years, and half of all white male workers will die before
receiving OASI benefits for 12 years. According to Goss's expected
value method, however, "typical" black and white males would
receive, respectively, 8.1 years and 12.1 years of benefits. In
reality, over 60 percent of black males and 50 percent of white
males will die before
collecting benefits for this length of time.
The
expected value method produces results that do not represent the
experiences of African-American males. As Table 2
shows, the Goss method suggests that an "average" black male worker
fares much better from Social Security (paying taxes for only 4.8
years for each year of benefits) than the median black worker
(paying taxes for 9.6 years for each year of benefits). In
statistical terms, this difference is due to the concentration of
very high rates of return among a very few individuals. But, as
noted above, far fewer than half of all black males will receive a
rate of return as favorable as the average rate of return estimated
by Goss's method. The racial disparity between the return received
by the 50th white worker and the return received by the 50th black
worker is also much greater than the disparity revealed in Goss's
"expected value" method.
Even
if the expected value methodology and data cited by Goss are used
to evaluate the rate of return from Social Security, the major
conclusions of the Heritage study remain unrefuted. To show this,
we calculated the expected rate of return from Social Security for
the two men described in the Goss memorandum using his "expected
value" method. In line with U.S. Department of Labor data, we
assumed that the white worker would earn 118 percent of the
national average wage and the black earner would earn 89 percent of
the average wage. The results are shown in Chart
1.
Chart 1 shows that a black 20-year-old worker in 1998 can look
forward to an inflation-adjusted rate of return of -0.15 percent.
His white counterpart, however, will "enjoy" a return of 0.59
percent--better, but nothing that should make him too excited.
These calculations show that the real rate of return from Social
Security remains well below the measures of the opportunity rate of
return, even when the expected value method is used (this is the
case whether one uses the 2 percent discount rate used by SSA
analysts, the 2.5 to 3 percent available from long-term government
securities, or the 7 percent real rate of return that the Social
Security Advisory Council estimates to be available from equities).
In short, regardless of the method used to measure its return,
Social Security remains a poor retirement investment for either
minority or non-minority Americans.
Treasury Department Findings
A number of critics have referred to a series of studies
carried out by U.S. Treasury Department researchers James Duggan,
Robert Gillingham, and John Greenlees. For example, Steve Goss claimed
that
[I]n fact more careful research reflecting
actual work histories for workers by race indicates that the
non-white population actually enjoys the same or better expected
rates of return from Social Security than for the white population.
(See Duggan et al., "The Returns Paid to Early Social Security
Cohorts," Contemporary Policy Issues (October, pp. 1-13).
| Rather, the aim of our analysis was to
compare workers of similar age, income level, and family structure.
In this respect, the result of the U.S. Treasury Department studies
is unequivocal: For the African-American worker, Social
Security offers a worse deal than it does for a white worker with
an identical income and family structure. |
The evidence from this valuable study, however, has been
misused and distorted. For one thing, the studies carried out by
Duggan, Gillingham, and Greenlees refer only to workers born in the
period before the one covered in our Heritage study. In
particular, the report cited by Goss is based on workers who were
born between 1895 and 1922 and who retired between the early 1950s
and the mid-1980s. By contrast, the Heritage study calculates
returns for workers born after 1932 and retiring from 1997 until
2042. These two periods have seen extensive changes, both in the
structure of Social Security taxes and benefits and in
socioeconomic differentials in life expectancy. For example, recent
trends and projections suggest that the longevity gap between
African-Americans and whites, and between rich and poor, is
growing.
The
other mistake in the use of the Duggan et al. study is that Goss
implies we calculated a general weighted average rate of return for
all African-Americans and all whites. This is not the case. Such an
average is almost impossible to calculate and in practice is
meaningless, requiring as it does an amalgamation of workers of all
income levels, marital status, ages, etc. Rather, the aim of our
analysis was to compare workers of similar age, income level, and
family structure. In this respect, the result of
the U.S. Treasury Department studies is unequivocal: For the
African-American worker, Social Security offers a worse deal than
it does for a white worker with an identical income and family
structure.
Chart
2, which is based on data from the most recent study by Duggan,
Gillingham, and Greenlees, shows that black workers born in 1918
can expect a real rate of return from Social Security that is 0.75
percent below that which a white worker with an identical income
will receive.
On the Exclusion
of Disability Insurance
Criticism
The Heritage study ignores Disability Insurance (DI).
Disability Insurance taxes are included, but not disability
benefits. When this is corrected, many of the findings are
reversed. This is especially true regarding the result that
African-Americans have particularly low rates of return from Social
Security.
Response
This common objection is simply wrong and is based on a
failure to read our study carefully. DI is a separate program
within the Social Security system that has its own tax rate and
trust fund. Heritage's study explicitly examined only the Old-Age
and Survivors' Insurance program within Social Security, ignoring
DI taxes as well as benefits.
It
is possible to reform the OASI program and leave the Disability
Insurance program untouched. With this in mind, both DI taxes and
benefits were excluded from the analysis. We carefully accounted
for pre-retirement Survivors' Insurance by excluding the taxes
necessary to purchase this insurance.
The
Heritage study thus constitutes a complete and consistent analysis
of the retirement portion of Social Security--and only this portion
of Social Security. In effect, it assumes that, in the hypothetical
partly private system, Disability Insurance and pre-retirement
Survivors' Insurance are retained exactly as they exist under
current law.
Moreover, no empirical study exists to
support the claim of Social Security's defenders that including the
DI program in rate of return calculations will offset the racial
differentials embedded within the OASI program. Many advocates
of the current Social Security system cite higher than average DI
payments to black workers as a defense against the criticism that
Social Security yields a lower than average retirement rate of
return for blacks. Besides the fact that DI payments are made to
workers and not retirees, the argument that Disability
Insurance is the principal means by which Social Security makes up
for poor retirement rates of return is a particularly tortured
defense of the current system. It is like telling people whose bank
gives a poor return on their savings accounts that they should not
worry because their homes are insured.
Even
if a study of the combined OASDI program as a whole were conducted
and led to a narrowing of racial differentials in rates of return,
such a study would itself be vulnerable to the criticism that it
failed to include the effects of Hospital Insurance (HI)--more
commonly known as the Medicare program. Chart 3
shows that medical expenditures are highly concentrated among the
very old.
The
inclusion of HI is likely to increase racial differentials in
Social Security's rates of return. Compared with the general
population, African-Americans have a much lower probability of
reaching the very old ages at which medical costs tend to escalate.
For example, according to the 1992 Life Tables cited by
Goss, a white male has a 40.1 percent chance of living to the age
of 80, while a black male has only a 24.3 percent chance.
On the Risk of
Private Rates of Return
Criticism
Private investments, unlike Social Security, are highly
risky. Given that most people are risk-averse, if the returns from
a private system are adjusted for uncertainty, they will compare
much less favorably with those from Social Security.
Response
Before addressing the risk associated with private
investments, it is important to recognize that Social Security is
not inherently less risky than private investments. There are at
least two major risks associated with Social Security: a
demographic risk and a political risk.
- Social Security's Demographic
Risk. Every participant in the Social Security retirement
program faces the risk of dying before reaching retirement age. In
the event of death, Social Security pays a monthly benefit to a
worker's children who are under the age of 18 and to the spouse who
cares for these children. However, if a worker is childless or has
adult children, the family receives no such pre-retirement
Survivors' Insurance benefits, other than a one-time-only death
benefit of $255.
Widowed retired spouses sometimes collect
Old-Age benefits based on the taxes paid by their husband or wife.
If they do so, they receive nothing in return for the taxes they
themselves have paid. Thus, when one partner of a married couple
dies without leaving children under the age of 18, at least one
spouse ultimately loses all of the taxes he or she has paid into
the system.
Most workers who die between ages 50 and
70 face a high risk of receiving little or nothing in return for a
lifetime of paying Social Security taxes. In most cases, their
children, if any, are older than age 18 when they die and are
ineligible for pre-retirement Survivors' benefits. Those who die in
a slightly narrower age band (ages 50 to 65) are not eligible to
collect full Social Security retirement benefits. Those dying at
age 70 are eligible to collect less than five years' worth of full
Old-Age benefits.
Chart
4, using the National Center for Health Statistics data cited
by Goss,
shows that 13 percent of white males and 22 percent of
African-American males will die between the ages of 50 and 65.
Another 8 percent of all white males and 11 percent of all
African-American males will die between the ages of 65 and 70.
Thus, one in three African-American males and one in five white
males will die between ages 50 and 70.
Stanford University economist Daniel Garrett drew on such data and
calculated the variation in returns from Social Security for a
single cohort of individuals with the same average life expectancy
and income. These variations are shown in Chart
5. For this set of workers, the lifetime net present value of
participation in Social Security ranges from -$92,259 for the
worst-performing percentile to $85,993 for the best-performing
percentile, in terms of 1988 dollars in 1990 present values.
- Social Security's Political
Risk. The political risk in Social Security arises because
workers and families do not enjoy secure property rights, which are
enforceable in court, over their future Social Security benefits.
The U.S. Supreme Court has ruled in Fleming v. Nestor that
a worker's claim to Social Security benefits is "non-contractual
and cannot be soundly analogized to that of a holder of an annuity,
whose right to benefits are [sic] bottomed [based] on his
contractual premium payments.... To engraft upon the Social
Security system a concept of accrued property rights would deprive
it of the flexibility and boldness in adjustment to ever-changing
conditions which it demands."
In other words, the future benefits of
retirees are completely dependent upon future voters and
politicians. Given the tax burden needed to fund promised benefits
under the current system, it seems appropriate to assign a
considerable degree of political risk to future Social Security
benefits.
On Figuring the
Private Rates of Return
Criticism
The rates of return on private investments assumed in the
Heritage study are too high. This exaggerates the benefits of a
privately held individual account.
Response
We used very cautious assumptions regarding the rates of
return paid on private investments. For the years up to 1997, we
used the actual annual historical rates of return on bonds and
equities. For 1998 and future years, the real rate of return on
equities was assumed to be 5.7 percent, and the real rate of return
on bonds was projected to be 2.8 percent.
The
5.7 percent real rate of return on equities lies well below the
long-term rates found in the professional literature. For example,
the Social Security Administration's own 1994-1996 Advisory Council
used a projected return of 7 percent on equities after considering
a wide range of expert testimony. During the 1926 to 1997 period,
large company stock returns averaged 7.7 percent after inflation,
while small company stocks yielded an average post-inflation return
of 9.3 percent. Heritage reduced even these
returns on equities and used a return of 5.7 percent.
The
2.8 percent return on U.S. government bonds is the same as the
long-term rate used by the Social Security Administration in the
1998 Report of the Trustees of the Federal Old-Age and
Survivors' Insurance and Disability Insurance Trust Funds.
However, even if ultra-pessimistic
predictions regarding the returns on stocks are adopted, the major
conclusions of the Heritage study would be unaffected. One critic
of the study cited a report by Dean Baker of the Economic Policy
Institute in which the claim was made that
economic growth, as projected in the Social Security Trustees'
Report (whose assumptions were used as the basis for the Heritage
study), was consistent with a real rate of return on stocks of only
4.5 percentage points. Citing this rate of return on equities does
not, however, indict the Heritage analysis: Our assumed rate of
return is even lower, at a very cautious 4.25 percent. In the great
majority of cases, returns from a private account exceeded returns
from Social Security, even where taxes were invested wholly in
ultra-low-risk U.S. government bonds.
In
our study, we assumed that individuals were extremely risk-averse
in their investment strategies and would concentrate their
investments among low-yield, ultra-secure investments. The riskiest
portfolio we used was one in which half of all investments were
made in long-term government bonds and the remainder in a broad
market equity index. The projected future rate of return on this
portfolio is 4.25 percent, with the bond component returning only
2.8 percent annually.
On
Administrative Costs and Private Rates of Return
Criticism
Administrative costs would eat up 1.5 percent to 2
percent of all private funds annually. This would remove much or
all of the gains from privatization for most workers.
Response
Heritage's first rate of return study did not consider
administrative costs explicitly. Instead, these costs were taken
into account implicitly through an assumption of extremely low
rates of return on private assets. However, both a Social Security
Administration study and empirical data show that administrative
fees will be much lower than the critics' 1.5 percent to 2 percent
projection. A study by the Actuary's Office for the 1994-1996
Social Security Advisory Council estimated that administrative
costs for the Personal Security Accounts (PSA) plan, which would
privatize a substantial part of Social Security, would be only 1.0
percent of fund assets.
In
actual practice, costs are even lower. A 1996 U.S. Department of
Labor study showed that the administrative costs for
private-sector, multi-employer defined contribution plans were only
0.82 percent of assets. The mean administrative cost for Standard
& Poor's 500 Index mutual funds was lower still--0.39 percent,
according to Lipper Analytical Services. And the Thrift Savings Plan, a
privatized retirement plan run by the federal government for its
employees, has costs for its three funds that range from 0.08
percent to 0.10 percent.
These lower estimates are supported by
data from Australia's privatized social security system, in which
annual administrative costs average 0.8 percent of fund
assets.
The structure of the plan is also important. Limiting investment
options and creating larger investment pools will hold costs down.
These are features of most privatization plans. Also, costs decline
rapidly after the plan starts. For instance, administrative costs
for the Thrift Savings Plan are 76 percent lower than they were
when the plan began operations in 1988.
One
low-cost option would be to allow individuals to invest their
Social Security taxes in the new 30-year Series I Savings Bonds,
which currently pay a return of 3.3 percent over the inflation
rate. These bonds can be obtained at virtually no cost, and they
pay a substantially higher rate of return than does the current
Social Security system.
On the
Employer's Share of Payroll Taxes
Criticism
The Heritage study included not only the employee's share
of taxes, but also those paid by the employer. This overestimates
the costs of the program to workers.
Response
Glen Lane, district manager of the Social Security Field
Office in Cedar Rapids, Iowa, was among those who criticized our
inclusion of the employer's share of the Social Security tax burden
in our study. However, the "employer's share"
of Social Security taxes is part of the total amount an employer
expends on employee compensation, which includes the worker's wages
and employer-provided benefits. The ascription of the term
"employer's share" is an accounting label, rather than a meaningful
distinction. In the absence of Social Security taxes, this money
from the employee's paycheck would be available for the worker to
invest in a private account or to use as an addition to take-home
pay. As Dean Leimer, chief author of the Social Security
Administration's own calculations of its rate of return, has
noted:
In
any event ignoring the employer share of the tax is clearly
inappropriate, because it results in the comparison of benefits
with taxes that are insufficient to fund those benefits; as a
consequence, Social Security appears to be a much better deal than
it actually is when all taxes required to fund the program are
considered.
On Judging
Social Security's Effectiveness by Its Rate of Return
Criticism
The rate of return is not a proper measure of the
effectiveness of the Social Security program. Rather, the system
should be judged on social criteria, such as its success in
reducing the poverty rate among the elderly.
| When the rate of return from Social
Security for lower-income workers is below the rate available from
alternative investments, the program actually may add to
poverty--or at least slow wealth accumulation--by reducing the
resources available to a family over their lifetime. |
Response
To be judged effective, a retirement social insurance
program not only must protect all workers from the threat of
poverty when they are elderly, but also must provide an efficient
level of retirement income for the taxes paid. The rate of return
measures the difference between the money that Social Security
takes from a family and the money that the family receives from
Social Security. A low or negative rate of return means that
individual families are foregoing higher retirement income because
Social Security is returning less to them than they could have
accumulated had they been able to invest their payroll taxes in
private accounts. When the rate of return from Social Security for
lower-income workers is below the rate available from alternative
investments, the program actually may add to poverty--or at least
slow wealth accumulation--by reducing the resources available to a
family over their lifetime.
The
founders of Social Security recognized the importance of the
program's rate of return. Arthur J. Altameyer, chairman of the
Social Security Board from 1937 to 1946 and the first Commissioner
of the Social Security Administration, argued against policies that
would lead to the evolution of a social security system that robbed
workers of the chance of higher lifetime incomes or a more
elaborate safety net by subjecting them to rates of return below
those available from private markets. As Altameyer stated in
1945,
Therefore, the indefinite continuation of
the current contribution rate will eventually necessitate raising
employees' contributions later to a point where future
beneficiaries will be obliged to pay more for their benefits than
if they had obtained this insurance from a private insurance
company.... I say it is inequitable to compel them to pay more
under this system than they would have to pay to a private
insurance company, and I think that Congress would be confronted
with that embarrassing situation.
On Payroll Tax
Assumptions
Criticism
Heritage inappropriately assumes that if Social Security
is not partially privatized, it will be restored to balance
entirely by raising payroll taxes and that this tax increase will
begin in 2015, a decade earlier than the Social Security actuaries
project would be necessary.
Response
There are several ways to balance the Social Security
system within its current framework. In addition to increases in
payroll taxes, Congress could cut benefits, increase the retirement
age, and require all state and local government workers to
participate. Each of these proposals would have a different impact
on workers of different ages and income levels. For example,
extending Social Security coverage to all state and local
government workers would create a massive unfunded liability among
existing state and local employee retirement funds that would have
to be corrected either by cuts in payments to retired state and
local employees or by increased taxes.
In
their calculations of the rate of return to the current system,
Social Security's own actuaries used two assumptions to reflect the
financial imbalance in the system. The first of these assumes that
the system is balanced through across-the-board cuts in Social
Security benefits. The second assumes that balance is achieved by
increases in payroll tax rates. Dean Leimer, who authored SSA's
rate of return calculations, found that the rate of return from
Social Security for workers born between 1932 and 1975 is higher
under a regime of payroll tax increases than in a scenario where
benefit cuts are used to balance the system. This higher
return occurs because current workers bear the full costs of
benefit cuts while bearing only a partial share of future tax
increases.
We
used one of the two assumptions adopted by Social Security in its
examination of the current system, and the assumption that we
selected for Social Security's rate of return was the one that
yielded the higher rate of return. Had we chosen the assumption of
reduced future benefits, the rate of return would have been even
lower.
The
Social Security trust funds are composed entirely of U.S.
government bonds, which means they are a set of IOUs that one part
of the federal government (the U.S. Treasury Department) has
written to another branch of the federal government (the Social
Security Administration). When the Social Security system starts
taking in less money than it needs to pay its promised benefits (as
it is scheduled to do in 2013), then the federal government as a
whole will have to meet the shortfall. It can do this either by
redeeming the IOUs in the Social Security trust fund (which would
mean raising non-Social Security taxes or cutting non-Social
Security spending) or by cutting promised Social Security benefits
or raising payroll taxes.
In
each case, Social Security participants will have to bear the
burden of this shortfall through increased federal non-Social
Security taxes, reduced federal non-Social Security spending,
Social Security benefit cuts, or Social Security tax hikes. In
making their projections, Social Security's actuaries merely assume
that the IOUs in the trust fund are redeemed, and do not take into
account the non-Social Security tax hikes and spending cuts that
the rest of the federal government will have to implement should it
repay these IOUs. The day of financial reckoning is easily within
the lifetime of the baby boomers and their children. Unless
Congress raises taxes or cuts benefits and other spending, the
Social Security Trustees will begin calling in their loans to the
U.S. Treasury by about 2012. By about 2030, the Trustees will have
been paid back all of their loans and will have to begin making
sharp reductions in Social Security's basic programs.
A LACK OF
COMPETING ANALYSES BY OUR CRITICS
The
criticisms leveled at Heritage's rate of return analysis have not
succeeded in altering our finding: Social Security offers a
very low rate of return for most Americans, including minorities
and low-income families. Not only does a low rate of return
reduce a family's potential retirement income, but it also
diminishes the ability of families to pass wealth on to
children.
That
Heritage's major finding remains unrefuted is perhaps best
underscored by the failure of any of its critics to publish their
own estimates of Social Security's rate of return. In advancing
their criticisms, neither the Center on Budget and Policy
Priorities, nor the American Association of Retired Persons, nor
Robert Myers, nor the Institute for America's Future has produced
their own estimates of the rate of return for Social Security or
the degree to which our estimate is affected by the alleged errors
in its analysis.
However, one major question remains: Why
has the Social Security Administration itself not published
calculations of the impact of the current program (or any of the
major reform alternatives) on minorities, especially in light of
the fact that it readily answers rate of return questions based on
age and income? This stunning silence is puzzling, given that
Social Security constitutes the federal government's largest
domestic program, that the mortality and income data required to
complete such a study are readily available to federal
researchers, and that the impact on
minorities of almost every other federal program has been subjected
to extensive analysis.
William
W. Beach is John M. Olin Senior Fellow in Economics and
Director of The Center for Data Analysis at The Heritage
Foundation. Gareth G. Davis is a former Policy Analyst in The
Center for Data Analysis at The Heritage Foundation.
Endnotes