Living Economics

Private pension plans are usually based on defined contributions or defined benefits. A defined-benefit plan specifies retirement benefits rather than contributions into the plan. Thus, a retired employee who has reached a certain age with a given number of years of service and who has earned certain income is entitled to a specific monthly pension payment. A defined-contribution plan specifies an employer's periodic payments into the plan rather than eventual retirement benefits to employees. To reduce the risk of unexpected changes in pension asset yields and life expectancy of retirees, private companies have increasingly converted their pension plans from defined benefits to defined contributions.

Pay-as-you-go

The U.S. federally run Social Security retirement plan, on the other hand, is a so-called pay-as-you-go plan. A pay-as-you-go plan does not collect enough contributions¹ from current contributors to fully fund their promised future retirement benefits. Instead, it pays its benefits to retirees out of contributions from current workers. Whatever surplus there is from current contributions is deposited into the Social Security trust fund. So, in effect the social security is a grossly underfunded defined-benefit plan.

A pay-as-you-go retirement plan like Social Security is financially solvent as long as current contributions exceed current retirement benefits. When the number of workers supporting each retiree is large, this condition is easily satisfied. But as the U.S. population ages, there will be fewer workers supporting each retiree. The accumulated underfunding² will necessitate additional tax revenues on future workers, which should have been paid by future retirees while they were working.

There are some hotly debated Presidential and Congressional proposals to "save" Social Security. They boil down to whether (a) the trust fund should be increased to postpone the date when the fund must be drawn down as projected benefits exceed payroll tax revenues in the year 2013; or (b) some part of the current payroll tax should be set aside for investment in stock equities for higher expected returns.

No matter which side of the debate wins out, there is some immutable facts that cannot be ignored. These facts tell us that there is no way to save Social Security, at least not in the way that the debaters think possible.

Demographic trap

The most important fact is that there will be fewer workers supporting each retiree, no matter how Social Security benefits are funded. Specifically, the number of workers supporting each retiree will decline from the current three to two (see note 3³). There is nothing we can do to change that since all the Baby Boom retirees and the Baby Bust workers beyond 2013 have already been born.

The second fact is that the goods and services that Social Security beneficiaries consume beyond 2013 cannot be stockpiled from the current surplus in the trust fund but must instead be produced when they are needed in the future. If Social Security had been fully funded, the claims of future retirees on future goods and services would require no additional payroll tax on future workers. But, future workers would still have a smaller share of future output when the trust fund is drawn down because the real burden is determined by the smaller number of workers vs retirees. Since Social Security has been grossly underfunded, honoring the defined benefits of Baby Boomer retirees will also require back-breaking additional payroll tax⁴ on future workers.

The real burden of fewer workers per retiree will of course be somewhat offset by the lower costs of supporting fewer children as the number of children is projected to fall as a share of the population. But, the cost of public spending per capita on the elderly is three times as much as per capita spending on children (Concord Coalition).

Privatizing Social Security?

It might be too late to make up for the accumulated underfunding of Social Security. Both the payroll tax rate and the payroll cap on which the tax is based have been raised several times (see note5)5 to postpone the date when Social Security benefits exceed contributions. Currently, many low income wage earners are already paying higher payroll tax than income tax. But, the amount of underfunding depends on the yields of the accumulated assets in the Social Security trust funds. By current law, the trust funds can be used to buy only U.S. treasury bonds, which are projected to yield less than 3% a year after inflation. By comparison, stock equities have been yielding an annual average of more than 7% after inflation (Feldstein). If some or all of the trust funds are invested in stock equities, the amount of underfunding would be considerably reduced. This reasoning lies behind the various proposals to invest Social Security surplus funds in stock equities. But, this seemingly sensible solution may not escape the demographic trap either. The expected higher yield of stock equities may not be realized when the only buyers of the stock equities unloaded by the Baby Boomer future retirees are none other than the Baby Buster future workers. Just as the Baby Boomers currently help drive up stock prices by salting money into their retirement equity funds, they will help drive down stock prices when they cash in their equity funds upon retirement. No relief can be expected from foreign buyers in the developed countries either as they are in a similar demographic trap.

Any way out?

So, demography dictates that not only Social Security, but all private pension schemes, cannot be saved without more radical solutions.