Now that the President's Commission to Strengthen Social Security has issued its interim report exposing a financial crisis in Social Security's future, its time to begin the discussion of how we should solve it.
The commission's report explains that Social Security is facing a crisis because its pay-as-you-go structure is not capable of dealing with our nation's demographic realities. With fewer and fewer workers paying to support an ever-growing elderly population, the financial burden on each worker – meaning the rate at which we tax workers through payroll to pay for benefits – will increase to levels that will have sever economic consequences, both individually and nationally.
By the time today's college-age workers begin to retire, the payroll tax rate will have to steadily rise to about one-third (30.82%) of a workers earnings, just to pay for all elderly benefits promised under current law. And that's just the intermediate assumption. The worst-case scenario points to a total payroll tax rate of nearly one-half (49.15%). If you believe that it would be difficult for Uncle Sam to collect that without crushing economic growth or without effectively tossing many Americans into poverty, then you understand the need for reform.
That's why the commission is likely to recommend that we allow younger workers to invest a portion of their payroll tax funds in the private capital market. This would mean transforming Social Security from a money transfer program into a real retirement investment system.
In the coming months we are likely to hear from many critics of reforming Social Security with personal retirement accounts. They'll say that investing payroll taxes in the stock market is too risky. They'll say it will lead to huge benefit cuts, and they'll say that many retirees will lose everything if the market slumps.
Hogwash! Investing in stocks or bonds is not very risky at all – especially compared to the financial consequences of maintaining the status quo.
Although market returns can fluctuate widely from day-to-day or even year-to-year, the volatility of the market is reduced to a few percentage points over long holding periods. For example, over the past 128 years the annual return on stocks ranged from a worst-year drop of 35 percent to a best-year increase of 47 percent. But over investment periods of 35 years (the period Social Security uses to gauge benefits), the return ranged between 2.7 and 9.5 percent.
By contrast, the return on bonds was much more consistent, with the return ranging from a one-year low of 10.8 percent to a one-year high of 18.4 percent. But over investment periods of 35 years, the return ranged between 0.6 and 5.1 percent.
Over long periods, investing in the stock market is much better than investing in bonds or in mixed portfolios of stocks and bonds. In any 35-year period over the past 128 years the average annual real rate of return for an all-stock portfolio was 6.4 percent, with the lowest being 2.7 percent. By contrast, most young people entering the labor market can expect a return on Social Security taxes they pay of less than 2 percent.
How will these higher returns affect a retiree's benefit, or the government's ability to pay for it? In short, it will increase the level of security while reducing the burden on government.
To provide insurance against outliving one's savings, a retirement system based on individual retirement accounts must convert the funds into annuities upon retirement. If a typical worker contributes 2 percent of earnings to an all-stock portfolio over a 35-year working life, during retirement, the average expected return from a private annuity would equal 43 percent of currently promised Social Security benefits. However, the actual annuity could range from 85 percent to 17 percent of the currently promised Social Security benefit.
How these potential variations affect the retiree's actual pension benefit depends on the specific Social Security reform adopted. Every serious reform proposal limits the downside risk to the retiree. Under most proposals, retirees would be guaranteed a benefit of at least as much as under the current system.
The transition to a privately funded system would be gradual, taking many years. But moving now to personal investment accounts would enable us to make the transition and save Social Security without escalating taxes or escalating debt.