...position of the Social Security program. Among other measures, the report draws attention to the program's 'crossover date' (the year the program's benefit outlays will begin exceeding its tax receipts), the date of 'trust fund exhaustion,' and the present value of the program's financial shortfalls over the next seventy-five years. (2)

These measures have two problems. First, they create misleading impression of the program's financial outlook. Second, they are biased against potential reforms that could improve the program's finances.

Fortunately, the trustees have recently adopted new accounting measures that deal with both problems. These measures reveal an $11.1 trillion present-value shortfall, which equals about 3.5 percent of the present value of all future taxable payrolls. Unfortunately, because these new measures are buried in the trustees' report, they have received only scant consideration from policymakers and the media. The newer measures should receive greater attention. Indeed, were these new measures taken more seriously, reforming Social Security and Medicare could reemerge as the top policy priority that it deserves to be.

Social Security covers almost the entire U.S. population, providing participants and their spouses with retirement, disability, and other benefits during different stages of life. Social Security is currently the largest single outlay in the U.S. federal budget; many consider it one of the most successful programs in U.S. history. Although Social Security, on average, replaces only about 40 percent of a worker's annual earnings before retirement, it provides an important 'first pillar' of retirement income. Indeed, for poorer retirees, Social Security replaces 90 percent or more of their previous earnings. Social Security is often credited with reducing poverty among the elderly in the United States. (3)

Participation in Social Security is mandatory for most occupations. (4) Social Security is financed by a 12.4 percent payroll tax on covered earnings up to a limit. This limit is currently $94,200, but it increases each year with the economy-wide average wage. Employer and employee split this tax evenly. Participants become 'fully insured' after they have worked in a covered job for forty calendar quarters and earned more than a predetermined wage. Fully insured participants, however, do not acquire a contractual right to specific amounts of benefits. (5) Instead, they earn a noncontractual right to benefits that are governed by the laws in effect when they become eligible to receive benefits. These laws as well as the benefit formula are subject to change by Congress.

Social Security's benefit formula is similar to a private-sector defined-benefit plan's, where a specific formula applied to a retiree's wage history determines his or her benefits. (6) In contrast, voluntary, tax-favored defined-contribution retirement plans--401(k), 403(b), Keogh, and others--generate retirement income based directly on a person's previous contributions and subsequent market investment returns.

Whereas previous contributions 'fully fund' withdrawals from voluntary tax-favored retirement plans, Social Security operated mostly on a 'pay-as-you-go' basis between the 1940s and the early 1980: payroll tax revenue collected each year was paid out almost immediately as benefits rather than saved, thereby producing rates of return on previous contributions in excess of the risk-adjusted rates of return that those contributions could have earned in financial markets. (7) For those who retired shortly after Social Security began, this financing structure meant that they received more benefits from Social Security in present value than they had paid in payroll taxes. These windfalls occurred each time that Congress expanded Social Security's coverage and benefits, after 1950 until well into the 1970s. (8)

Unfortunately, the windfalls awarded to prior generations of retirees do not come for free: future generations must pay for them by receiving lower rates of return on their payroll taxes compared to the rates they could have earned if they had invested their contributions in government bonds instead. In fact, all future generations are worse off. (9)

During the early 1980s, the independent Office of the Actuary at the Social Security Administration projected that revenues would fall short of benefit outlays during the early part of the twenty-first century, largely because of the baby boom generation's retirement. Although this generation enlarged the labor force considerably (in part through the greater participation of women in the workforce) and made significant contributions over the past several decades, its members will soon retire, substantially reducing the number of workers available to finance their Social Security and Medicare benefits through payroll and other taxes. As Figure 1 shows, today there are almost five people of working age--between ages 20 and 64--for each retiree age 65 and older. By 2030, the number of people of working age per retiree will decline to less than three; by 2080, the ratio will fall to about two.

Recognizing these future demographic changes, Congress amended the Social Security Act in 1983 in an attempt to increase the system's cash flow over the next seventy-five years. Those amendments approved payroll tax hikes, subjected the Social Security benefits of those with other income sources to income taxation, and scheduled a gradual increase in the full retirement age from 65 to 67 beginning in 2003. Since 1983, these changes have generated surpluses in the Social Security trust fund, which currently holds $1.7 trillion in Treasury IOUs.

Despite these reforms, Social Security remains mostly pay-as-you-go in its financing structure. And though $1.7 trillion sounds like a lot, it is insufficient to pay current retirees their scheduled benefits for more than three years. Had the 1983 amendments 'fully funded' the Social Security system instead, the trust fund would hold about $13.7 trillion today. Contributions by past and current generations would have been enough to cover their own benefits, and future generations would not have to shoulder any of the burden.

[FIGURE 1 OMITTED]

At the time, many thought that the 1983 amendments had resolved...

NOTE: All illustrations and photos have been removed from this article.



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