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October 28, 2004

Social Security Reform: When will it come?

Social Security was the "third rail" of American politics - woe to the politician who proposed reform of the sacred institution. Social security could be modified (i.e., benefits expanded) or saved (a la the 1983 reforms), but the fundamental program could not be altered. To propose restructuring would be political suicide.

Until the 2000 election cycle. Then-candidate Bush proposed a careful examination of the Social Security system to resolve a projected problem with funding adequacy. His approach to "saving" social security included a bold new political stroke[1] - to somehow incorporate the private market returns into the program. Instead of mass outcry, the opinion polls showed political favor for the broad proposal. Vice-President Gore then joined the chorus with his famous "lockbox" appeal, coupled with more modest reforms to the system. Bush was elected. The third rail had lost its voltage.

The rush to reform was itself derailed by the infamous events of 9-11. But the need for reform has not gone away, and the Bush proposal of accessing private market returns is still alive. The fundamental shift that allowed this conversation to occur on a national political level was simple demographics.

Consider that the contribution made to the Old Age and Survivor benefits consists of two parts: the SS tax withheld from the employee, and the matching portion paid by the employer. Consider also that the benefit level is related to the level of contributions and proscribed by law. It is then a simple (albeit tedious) exercise to generate the following table.

The assumptions embedded in the table are approximate: the worker pays (OASI contributions only were used in this analysis) into the social security system from age 22 until the normal retirement age for her generation (65, working its way up to 67); that she lives for 14 years after reaching a normal retirement age (similar results hold for varying life expectancies); and she receives the benefits generated by the SS benefits calculator (available online at www.ssa.gov). You can then easily calculate the internal rate of return earned by the worker on her contributions.

The significant element revealed is that the rate of return went from an outstanding level of 7% for low-income early entrants into the system (outstanding in that the rates are essentially risk-free bonds) and an acceptable rate of 4.5% for high-income workers of that generation to a much lower return of 2% for low-income workers and a negative nominal rate of return for high income workers of later generations.

Workers born in 1965 or later can anticipate a negative IRR for their SS dollars. It is easy to see that this class of workers will favor reforms to the system, especially if there is some hope that the IRR would be at least modestly positive under an alternative system. As this class of workers ages, it will become a majority of the voting-age population. Quick calculations from census data indicate that the group of voting-age Americans who were born after 1960 was about 13% of all voting age Americans in 1990. That percentage had risen to 29% by 2000, and to 39% by 2003 (the latest available numbers). Census projections have that age group at 46% of the voter eligible population by 2010, and a commanding 60% by 2020.

It was the high percentage of elderly voters that acted in concert to deflect even the conversation of social security reform. As the demographics shift toward the high percentage of people whose vested interest is not in the current level of benefits, but in the future level of benefits, reform becomes politically feasible. It is easy to see that reform will happen in the next six years. It is much more difficult to accurately assess the form that reform will take.

Posted by Allen Seward at October 28, 2004 05:09 PM

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