Social Security's Future Needs Investment and Liability Recognition

October 28, 2003

The latest Federal Reserve Bank of Dallas issue of Southwest Economy claims that Social Security has below market returns and a $10 trillion "closed group liability." In their paper "Social Security Restructuring: Tough Decisions Ahead," senior economists Jason L. Saving and Alan D. Viard suggest that private investment must be coupled with recognition of the unfunded liability.

"In recent years, talk of Social Security restructuring has grown because the system offers many current and future workers below-market returns. This means they will retire with less income than they would have had if Social Security had never been established. Some have suggested that workers be allowed to deposit some or all of their Social Security contributions into individual retirement accounts.

"Many people believe Social Security provides below-market returns because it is not just a pension program—it also, for example, redistributes resources from high-wage to low-wage workers. …These monetary transfers from one worker to another do not change the rate of return achieved by the generation as a whole and have nothing to do with Social Security's low returns.

"The below-market returns paid to current and future workers are directly caused by the fact that Social Security is (largely) a pay-as-you-go system. … In other words, each generation's retirement is financed by the contributions of its children rather than its own past saving. Such a system accumulates no assets; it is merely a sequence of transfer payments from young to old.

"In the first period, the generation that is then retired enjoys a financial windfall, or start-up bonus, because it receives benefits without having contributed to the system. Pay-as-you-go Social Security is an exceedingly good deal for this first generation. … For example, the first recipient, Ida May Fuller, paid $25 in taxes but received $22,889 in benefits over her lifetime."

"But later generations do not enjoy this windfall because they must pay for their elders' retirement before receiving benefits. … Having bestowed above-market returns on earlier participants, a pay-as-you-go system lacks the resources to give market returns to later participants. The losses suffered by later generations are the price of the bonuses paid to the earlier generations.

"The rate of return each generation receives from the system can be computed from the generation's payment to its parents and the payment it receives from its children. Whether Social Security is a good deal for each generation depends on how its return from the system compares with the return it could have earned through capital accumulation.

"What has that growth rate been in the United States? From 1929 to 2002, total labor income (adjusted for inflation) grew at an average rate of 3.4 percent per year. A 3.4 percent real return may seem like a good deal, but it's not. If workers weren't paying into Social Security, they could accumulate capital and earn a return that averages around 6 percent per year (adjusted for inflation).

"In any given year, the difference between 3.4 percent and 6 percent is not very large. But it is quite large when compounded over a lifetime. The lower return cuts the retirement benefit roughly in half. So a generation that faces a constant tax rate throughout its lifetime suffers a net loss from the pay-as-you-go system equal to about half its tax payments.

"[A low birthrate] imposes a significant strain on pay-as-you-go Social Security. Slowing the growth of the working population causes U.S. labor income to grow at a slower rate than it otherwise would, further pushing down the system's returns.

"Every pay-as-you-go system has a 'closed-group liability" that is equal to the benefit promises for which no assets have been accumulated. This liability measures the present value of the burden future generations must bear through below-market returns. … The closed-group liability of the U.S. system is enormous—about $10 trillion, or a year and a half of the country's labor income.

"To forestall this grim outcome, many analysts have proposed a system in which each generation finances its own retirement. Such a system would allow workers to earn market returns on their contributions, boosting their retirement income.

"The inescapable reality is that the pay-as-you-go system has promised benefits to current retirees without accumulating any assets to pay them. If the current system is maintained, every future generation must bear below-market returns to service this liability. If the system is shut down, some generations must bear a large transition cost to pay off this liability. Every subsequent generation, freed from the obligation to pay for its predecessor's retirement, could then earn market returns by accumulating capital.

"There may be sound reasons to support [individual accounts] but neither it nor any other reform can eliminate below-market returns unless and until the closed-group liability has been paid off and each generation pays for its own retirement. No plan to eliminate below-market returns can sidestep the need for $10 trillion of tax increases or spending cuts."

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