TESTIMONY OF

William G. Shipman
CarriageOaks Partners LLC
and
co-chairman,
Cato Institute Project on Social Security Choice

before the Subcommittee on Social Security

of the Committee on Ways and Means

June 21, 2005

Chairman McCrery, Ranking Member Levin and members of the subcommittee, I thank you for giving me the opportunity to express my views on the reform of our Social Security system. Eleven years ago, on October 4, 1994, I had the opportunity to speak before this same Committee and in my written testimony I offered:

As both a son and a father, I am interested that the elderly are well cared for, and that the young have the opportunity to build sufficient assets so that they, too, can retire in dignity. Social Security, as presently structured, ultimately will achieve neither objective. Although compassionate in its original intent, it is flawed in design.

The system's financial structure is fundamentally unsound. Legislation of 1977 and 1983 attempted to address this by raising taxes and cutting benefits; Social Security was to be on sound financial footing well in to the 21st century. And now, just a few years later, The 1994 Board of Trustees' report suggests that the system will run out of money seven years earlier than it projected just one year ago. Legislative initiatives to reduce benefits further and raise taxes are again on the drawing board. This did not work in 1977 or 1983; it will not work now. Social Security's financial integrity requires an entirely different approach. I offer this testimony in the spirit of the starting point for an alternative: a concept of privatization wherein Americans benefit from the engine of a free economy and free choice. With privatization properly structured, today's elderly will be protected, the young will retire with higher incomes, and our political leaders will have offered, once and for all, a lasting solution for which all voters will be thankful.

Since that testimony our nation has had a vigorous and open discussion. Many new ideas have been offered, ideas not developed prior to 1994. The climate of opinion has changed; more Americans are now aware of the issue, more Americans want the option to save and invest for their own future. We are getting closer to the point where the “rubber meets the road,” when you, as Members of Congress, will have to vote. Your decision is more important than perhaps you know. It has been eleven years since my first testimony on this issue and in many ways, but certainly not all, little has changed politically; we’re still talking about raising taxes and reducing benefits. We have wasted precious time.

A Collision Course

Like other nations we face an unprecedented challenge of how to deal with a reality that mankind has never confronted before and one that most people are unaware of. How we and other governments respond will affect each American citizen, our families, businesses across the land, indeed our very way of life. The reality is not only unprecedented, it is unyielding.

Dr. Karl Otto Pohl, former president of the German central bank, the Bundesbank, stated it this way: “In a relatively short period, we must adapt our domestic institutions, international relationships, and even our individual life plans to a new, and powerful reality.”

What he was speaking of, and what confronts each of us here, is the fact that there are two powerful forces on a collision course. The first is the aging of society, the reality that the elderly population is increasing more rapidly then the population as a whole. In America, but even more so in other countries, the elderly rely on Social Security to survive financially. Should Social Security falter, many elderly will be destitute.

The second force is that most Social Security systems, including ours, are, in fact, failing. They are financially unstable, and not sustainable as they are presently structured.

The challenge is to avoid the collision of these two forces. In my view, the risks are high that we will not. But should we prevail by structuring a lasting solution, the rewards will be as unprecedented as the challenge itself.

The Early Years: Social Security’s Roots

Social Security was enacted in 1935 during the Great Depression. During the first half of the 1930s real GDP fell by about 25 percent, unemployment jumped to 22 percent and the stock market virtually imploded and fell about 70 percent. Our nation was on her economic knees. President Roosevelt had to do something, something big, but large government programs were anathema to the frontier spirit of our young nation. In order to achieve his goals he needed unprecedented authority. To grasp that authority he went before the nation on March 4, 1933 in his first Inaugural Address and asked for authority “… as great as the power that would be given me if we were in fact invaded by a foreign foe.” He achieved his goal and ushered in Social Security, the flagship program of the New Deal.

Much like other Social Security programs that preceded ours, the first being Germany’s in 1889, benefits paid to the elderly were financed by payroll taxes. In our case, during the Great Depression, people who had jobs were considered the wealthy. It wasn’t like today wherein Americans have portfolios of stock and bonds, real estate, defined benefit and contribution plans and the like; you were considered wealthy if you had a job. And needs were so urgent that the “payroll wealth” was taxed. A saving and investment structure would not have worked at that time because it takes time to compound investment returns to accumulate wealth, and time was short.

Today: A Fundamentally Flawed Program

Over the decades, however, this sort of urgent safety net has turned into the rough equivalent of a defined benefit plan. Yet its financial structure has not advanced. The Old-Age and Survivors Insurance part of Social Security, as its finances are presently structured, is inefficient, financially unsound and fundamentally flawed.

Because benefits are paid by taxing payroll, benefits can increase by no more than payroll increases, assuming that the tax rate on payroll is held constant. Over the last four decades or so, payroll has increased by about 1.5 percent per annum in real terms. That is roughly equivalent to saving and investing and receiving a rate of return of 1.5 percent. To put this into perspective, if one were to save $1,000 each year for a 45-year working career and earn 1.5 percent, the saving would accumulate to about $64,000. During the last 79 years a mixed portfolio of 90/10 percent large/small company stocks earned an inflation-adjusted average annual return of 9.7 percent. One thousand dollars invested annually for 45 years earning that return would accumulate to about $650,000. And a conservative portfolio of 60/40 percent stocks and bonds, respectively, would accumulate to about $288,000. These different values give a glimpse of the lost opportunity that our citizens incur by being required to finance their retirement through payroll taxes.

But it is worse. For any particular age group it matters how many workers pay taxes relative to the number of retirees who receive benefits. The change in this ratio is largely determined by the change in national wealth, or GDP per capita. As national wealth rises, life spans also rise. We observe this not only here but across all parts of the globe. When Social Security was enacted life expectancy at birth was 61 years of age; it is now about 78. In the post-war period global life expectancy has increased from 45 to 65 years of age, a greater increase in the last 50 years or so than in the previous 5,000 years. This is all new. We didn’t expect it. But now we think it will continue.

Also, as nations become more wealthy birth rates fall. In many countries they have fallen below the population replacement rate of 2.1. The combination of rising life expectancy and falling birth rates causes havoc with pay-as-you-go financed Social Security systems. In the United States there were 16 workers per beneficiary in 1950; today there are about 3.3. It is expected that there will be only two in just 35 years. Therein lies an interesting paradox: as countries become more wealthy their Social Security systems become more poor. The oddity is driven by the causal relationship between increasing wealth—and increasing life expectancy as well as decreasing birth rates—all wrapped around pay-asyou- go financing.

Birth rates have fallen to such low levels in Europe—France-1.9, Germany-1.4, Italy-1.3, Spain-1.3—that “there is now no longer a single country in Europe where people are having enough children to replace themselves when they die.”

The Global Political Response: Raise Taxes

The political responses to the changing demographics that squeeze Social Security’s finances are frequently the same across the world. Governments and politicians tend to see the problem in the narrowest of lights: merely a solvency issue—too many benefits paid, too few taxes received. This near-sighted analysis is further compounded by the focus on just today’s solvency and not tomorrow’s.

But from this myopic perspective the options are clear; raise taxes, cut benefits. Of the two, governments tend toward raising taxes first. This makes sense for at least a couple of reasons. There are more workers to tax than there are retirees from whom to cut benefits. Therefore, if the choice were only one or the other, raising taxes inflicts a lesser per capita burden. The second reason is that workers are younger than retirees, therefore, they have more time to adjust to a tax increase than retirees have to adjust to a benefit cut.

The short-sighted strategy of raising taxes has been employed world-wide. In the United States, for example, in 1950 when there were 16 workers per beneficiary, the maximum Social Security tax any American worker paid was $90 a year. At that time the tax rate was 3 percent on only $3,000 of wage income. As the glacial force of demographics slowly and unrelentingly squeezed the system, the $90 tax rose and squeezed the worker. Now, the tax, just for the retirement portion of Social Security, is 10.6 percent of $90,000, or $9,540. After adjusting for inflation over the last 55 years, that tax has increased almost 2,000 percent. In all likelihood, the reason that we stood for this is that the tax rose slowly; the increase was never really noticeable in any one year, but over time it has become more of a burden than the income tax for about three quarters of American workers.

Our friends in Europe, however, would consider us lucky. The payroll tax in France is about 50 percent and in Germany, Italy and Spain it ranges roughly between 38 and 42 percent. It is true that these countries’ systems provide more services than ours, but this is not a plus. Europeans are dependent on more of their needs from government programs that are not sustainable.

As many European nations have raised their payroll taxes to prohibitive levels they have choked individual economic freedom and incentive. Economic growth is stagnant, and unemployment rates hover around 10 percent, even 12 percent in Germany. Civil unrest is now more common in Germany and France as governments tell their people that benefits are no longer affordable and will have to be cut, while at the same time they extol the virtues of the welfare state. We are on the same path, but for the moment we trail far behind.

Then, Cut Benefits

At some point, the strategy of raising taxes approaches a political wall. People sense that maybe, just maybe, they could achieve more with their hard-earned wages than they get from Social Security. Politicians sense this and move to the lesser desirable option of cutting benefits. Such blunt language, however, is not commonly uttered. Code is employed: progressive price indexing, longevity indexing, adding a third bend point, reducing bend point factors, increasing the NRA, decreasing the PIA, and it goes on and on. It’s all code for cutting benefits.

Fundamental Reform: Retarded by the Claim of Insurance

Eventually, after cutting benefits hits its political wall, the thinking shifts to fundamental reform, saving and investing in wealth-producing assets for all workers. This idea of market-based financing for retirement income is not new, in fact it is old and well established in the private sector, but it is viewed with some disdain from advocates of the status quo. They object to the notion that Social Security should be an investment structure and defend their objection by claiming that it is insurance. This claim had some merit decades ago. Not now. In fact, Social Security’s finances are in trouble largely because they are inappropriately based on the insurance model.

Insurance works well when many people are subject to an event that has little chance of happening to any single individual. A good example is homeowners’ fire insurance. Many people buy fire insurance to protect their homes and yet few homes burn. Because the number of homes insured is many times the number of homes that burn, the annual insurance premium is very low relative to the replacement cost of one’s house. Insurance companies are simply the medium through which individual uncertainty of loss is transferred to, and financed by, the group.

The insurance model does not work well when the group is subject to an event that the entire group experiences. For example, if it were certain that everybody’s house would burn down, say, when the owner reached age 65, then insurance companies would have to charge annual premiums the future value of which would be the cost of rebuilding all the houses. This premium would be a large multiple of the premium charged for the uncertain case. Central to the insurance model is that the ratio of the annual premium to the dollar value of what it protects is negatively correlated to the uncertainty of individual loss.

Social Security is frequently heralded as insurance, more precisely social insurance. The ‘social’ part of the term merely means that the government plays the role of the insurance company. Other than that, it remains the insurance model. When Social Security was enacted in 1935, life expectancy was 61 but benefits weren’t payable until age 65. Now benefits are payable at age 62 and life expectancy is 78. The element of uncertainty has kind of flipped upside down. Because of this, the retirement component of Social Security isn’t insurance; once born, reaching age 62 and needing retirement income is almost certain. As a result, there is very little risk, or uncertainty, to transfer to the group,resulting in the fact that annual premiums must be enough to accumulate to a sum, including interest, that will finance retirement income.

Under these conditions, social insurance cannot provide such income at a lower cost than saving and investing for retirement. Unfortunately, however, it can and does provide it at a higher cost because it is financed through the payroll tax and is subject to unyielding demographic forces. In a perverse way Social Security’s finances and its adherence to the insurance model are caught in a kind of time warp; in the age of the iPod Social Security is a 78 RPM, wind-up phonograph. Unless protected by the power of the state, it can neither compete nor survive.

The State Monopoly Faces Competition

Being protected by the power of the state really means that for 10.6 percent of their wage income American workers are not free to choose among alternatives for their retirement. Bad as that is, the 10.6 percent doesn’t buy much relative to reasonable and available alternatives. This is why Social Security is mandatory; few would participate if they had the freedom not to. Competition, as always, is a threat to the status quo. For workers, however, competition is their hope.

Competition would allow all workers to invest part of their payroll tax in capital markets around the world, in professionally managed portfolios that are highly diversified across asset classes, national borders and time. Such an opportunity would allow one to accumulate enough wealth to replace the pay-as-you-go benefit entirely.

For an average wage worker retiring this year at age 65, Social Security’s scheduled benefits are projected to replace about 42 percent of his last year’s wage. But for workers retiring in the future full benefits won’t be paid until age 67. For those future retirees, should they choose to retire at age 65, benefits will replace only 36 percent of their last wage. The worker’s cost for these scheduled benefits, which are in excess of what is affordable based on present law, is the 10.6 percent payroll tax.

The Market-Based Alternative

The market-based alternative is significantly more attractive. Over the last 79 years a conservative portfolio of 60/40 percent stocks and bonds, respectively, earned a real return of just a little over 7 percent. Investing just half of the retirement payroll tax, 5.3 percent, each year for 45 years would provide a retirement benefit equal to 97 percent of one’s last year’s wage. This assumes that there is no interruption in saving each year, that the market return is as stated and falls by 2 percent during the distribution phase, and that life expectancy upon retirement is 20 years. Each of these assumptions can be changed. Work may be interrupted. Markets may do worse or better. Life expectancy may be more or less than 20 years once retired.

To take a conservative path, if the market return were only 5.5 percent and if life expectancy were 30 years at the onset of retirement—about 10 years more than assumed by Social Security—then under these conditions the replacement rate would 39 percent, higher than Social Security’s scheduled benefits at age 65 and significantly higher than payable benefits.

Americans Understand the Tradeoffs

Our citizens sense these tradeoffs, risks, uncertainties, and the fundamental differences in providing retirement income from a tax system versus a saving and investment system. This is why, but only part of why, they want the option, the freedom to choose.

If they could acquire this freedom they also would have personal property rights over their accumulated wealth. They have no such rights to Social Security benefits. They also could bequeath some or all of their retirement assets. They cannot under Social Security. They would benefit from the direct relationship between effort, their saving, and reward, their accumulating wealth. They would have the dignity that comes with being personally responsible for their future. They would no longer be tethered to the government. They would no longer be subject to politicians’ preferences over when they can retire, how much they can get, how their spouses are treated, how much they’re going to pay, and all of the rules and regulations that have evolved to the point of being incomprehensible. They would be free.

It’s been eleven years since I had the opportunity to speak before this Committee. Although much of what I am saying today is what I said then, I hope that we are closer to fundamental reform. If we are not, and the two powerful forces that I mentioned above in fact collide, we will edge closer to the wrenching difficulties that Europe is now facing.

You, Congress, are the Hope

But should we grasp the extraordinary opportunity that this challenge offers, we will forever strengthen our nation, our economy, our freedoms, and our ability to finance the many needs that the future will undoubtedly require. It is a matter of will and political leadership in seeing the benefits of greater personal freedom and acting to ensure them. You, as Members of Congress, have the unique opportunity to offer, once and for all, a lasting solution for which all Americans will be forever thankful.

Thank you,

William G. Shipman

June 21, 2005