March/April 1997
Social Fund Isn't Really a Ponzi Scheme of IOUs
Social Security: Sorting Fact from Fiction

By David Langer

Enormous potential business income is at stake under the two privatization proposals considered by the Social Security Advisory Council. If Old-Age, Survivors, and Disability Insurance (OASDI) were privatized, annual investment management, brokerage, and administrative expenses for individual investment accounts would rise to $14 billion by 2010, assuming a worker contribution rate of 1.6 percent, and $44 billion if the rate is 5 percent. Ten years later, the numbers would mushroom to $45 billion and $141 billion, respectively. (Annual investment and administrative expenses are assumed to be 1 percent of assets and the inflation rate, 4 percent.)

The public thus needs to prepare itself to be inundated by an intensive media and political campaign waged by the entities with a stake in the potential profits from privatization. The message will be, as it has been for many years now, that OASDI is slipping rapidly into bankruptcy, and there won't be enough money to pay the benefits for today's young people (who don't get their "money's worth" anyway). Remedies offered to date include cutting benefits, raising the retirement age, setting up separate 401(k)-type accounts for all workers, and investing part of the OASDI trust funds in equities.

Well, OASDI isn't your typical employer retirement, life, and disability insurance plan. It covers 141 million workers, plus their dependents, and pays an average monthly benefit of $671 to 43 million retirees and beneficiaries-about $350 billion annually. Congress could be making a serious, if not irretrievable, error if members rush to a hasty solution for OASDI's perceived problems.

In fact, it's expected that OASDI's trust funds will be able to pay full benefits until the year 2030, which suggests that a year or two of study and discussion of the issues and solutions is in order.

The best way to begin a study, of course, is by examining the validity of the criticisms leveled against OASDI.

Table 1
Key Years for OASDI operations (billions)
Year Income Interest Total Income Outgo Surplus Assets 12/31
1996 $392 $41 $433 $358 $75 $577
2011 $873 $147 $1020 $857 $164 $2471
2013 $973 $167 $1139 $986 $154 $2786
2019 $1338 $202 $1540 $1528 $12 $3306
2020 $1409 $202 $1611 $1641 $-30 $3275
2029 $2249 $22 $2271 $2959 $-687 $86

2011 Surplus peak is attained of $164 billion.
2013 Outgo exceeds income for first time, before interest is added.
2019 Assets reach high of $3,306 billion.
2020 Surplus is negative for first time; assets start to fall.
Treasuries need to be sold to meet benefit payments.
2029 Assets are positive for last time.

Surplus reduces unified budget defecit until 2019; Negative surplus increases it thereafter.
Data are based on intermediate assumptions used by Social Security actuaries (1995 report to Trustees).

Young people won't get their benefits
Those who maintain that OASDI is going bankrupt point to the projection of income versus outgo for its trust funds, which indicates a shortfall commencing in the year 2030. This forecast is based on the intermediate or "best estimates" of Social Security actuaries for the trust funds' Board of Trustees (Table 1). As a matter of definition, to call OASDI "bankrupt," its financial condition would have to be so impaired that it could no longer pay its debts (i.e., make benefit and expense payments in full) as they came due. However, OASDI's benefit payments are a statutory obligation of the federal government; the benefits must be paid. So bankruptcy isn't possible.

Furthermore, and more appropriate in this case, the government can take action to correct projected imbalances between contributions and benefits, and there are measures that will accomplish this fairly easily. Robert J. Myers, former chief actuary of Social Security, has suggested to Congress that all that's required to keep the program on sound financial footing are gradual increases in the retirement age to 70 and starting in 2015, in the payroll tax rates to a total increase of 1 percent over a 20-year period.

Incremental change seems like wise policy. It's entirely possible that the economy will improve at some point, thereby creating additional jobs (and more highly paid ones), which will increase the inflow of contributions and mitigate the need for further changes.

OASDI clearly isn't a candidate for bankruptcy, and its estimated future financial ailments do not require strong medicine.

'Young workers don't get their money's worth.'
The "money's worth" or individual-equity argument is based on the savings account concept-getting back all your contributions, plus a reasonable rate of interest. But this comparison overlooks the simple truth that Social Security is a social insurance program and emphasizes benefit adequacy as well as individual equity. To achieve adequacy, benefits are deliberately skewed in favor of lower-paid employees.

In return, paying adequate benefits makes it less likely that means testing will be necessary for sustaining lower-income workers and their families upon retirement, disability, or death. Experience to date indicates that means testing is costly, intrusive, and damaging to self-esteem. Providing income sufficient to maintain at least a minimum lifestyle can also smooth family relations. If older people have enough money to live reasonably well, they're less likely to turn to their children for help-frequently a double whammy: humiliating to the parent and a source of potential resentment for financially strapped children.

The typical money's worth calculations are considerably enhanced by OASDI's policy of paying greater benefits to those who contributed little at the outset of Social Security and upon later benefit liberalizations. The intent is to avoid penalizing those who worked during the years that preceded the enactment of the program or its subsequent amendments.

This approach isn't a government innovation; it's common practice in corporate, public, and collectively bargained multi-employer defined benefit plans. Employers and unions routinely take care of older long-service employees by allocating contributions, in large part, to pay the cost of past service and current service, to enable those employees to retire with benefits that equitably reflect the value of their earlier years of service. As compared with younger employees, the contributions made on behalf of older workers typically represent a much larger percentage of pay.

In short, the concept of Money's worth, with its emphasis on individual equity, needs to be expanded to recognize the important ancillary benefits that accrue from the social-adequacy principle.

The trust fund holds worthless IOU's.
Some charge that the OASDI trust funds are severely flawed in both concept and mechanics. The trust funds, they claim, are made up of worthless IOU's; they're not inviolable; they serve as a pot that can be dipped into for ordinary government expenses; they're even vulnerable to embezzlement. But what do the facts say?

The trusts were set up to receive, disburse, and account for all OASDI monies and are combined for actuarial and financial purposes. For many years, surpluses have been generated. The estimated surplus for 1996 is $75 billion, made up of the #34 billion excess of income over outgo and $41 billion in interest from investments in U.S. Treasuries. OASDI's assets consist of those investments, for a total of roughly $577 billion by the end of 1996.

Federal law requires that investments be made principally in special Treasury issues. Interest is set at the average market yield of all long-term federal obligations not due or callable for at least 4 years. The Treasuries are roughly the same as those offered to the public, and they are also backed by the government's full faith and credit. Interest is paid (8.3% in 1993 and 8% in 1994) with official Treasury checks (in accordance with a 1994 law meant to dispel allegations that OASDI's finances are a sham). The Treasury cashes the checks and credits the amounts to the trust funds.

If the Treasuries are nothing more than empty IOU's and subject to embezzlement, then the mutual funds that carry Treasury securities should, of course, label them as risky, and demand higher interest rates from the Treasury, instead of promoting them as the safest of investments.

Social Security is a Ponzi scheme
It's not unusual to come across an item like this: "Social Security is a giant Ponzi scheme that relies on new contributions to make payments on current retirees."

But there's a world of difference. The infamous Ponzi fraudulently promised initial investors high profits from fictitious sources, which he then paid with funds obtained from later investors to encourage victims to take bigger risks. Social Security, on the other hand, isn't the result of some swindler's scheme to enrich only himself. It's the end product of openly and fully debated public policy, whose purpose was to create a national program as a critical resource for millions of people to cope with the problem created by nonexistent or inadequate retirement plans.

Does the Consumer Price Index overstate the increases in the cost of living? It would be political manna from heaven if that were true. What easier path for policy makers than a quick technical fix to the projected OASDI imbalances! The political repercussions would not be as intense. So, given the temptation involved here, it's crucial that the appropriate CPI level be determined by a thoroughly nonpartisan group of technical experts. At the same time, an objective review would shed important light on recent counterclaims that the CPI is understated.

The political stakes rise sharply if you recall that the federal unified budget incorporated the annual surpluses arising from the OASDI and certain other trust funds. This amounted to about $100 billion in 1995 ($65 billion of it from Social Security), and the regular deficit was cut by this amount. Therefore, lowering the CPI would, by cutting Social Security benefits, correspondingly increase the trust fund's surplus, which in turn would further cut the federal unified budget deficit.

But this would be a politically motivated-and highly questionable-use of trust fund surpluses. Since the fund's income can't be used for other than their stated purpose, and the outgo from them does not derive from general tax revenues, neither income nor outgo is properly includable in the general budget. To include them is to manipulate the budget deficit in a way that paints a rosier picture of it than is justified.

OASDI payments are entitlements
The OASDI payments to retirees and other beneficiaries are commonly depicted as part of an entitlement program and, as such, a financial burden on the public. But this point of view overlooks how OASDI in fact operates--as a self-contained program providing benefits paid for solely by employer and worker contributions. The program was designed this way so that workers could rightfully feel that the program wasn't a government handout, which is what the words "entitlement program" have come to mean to many people. Therefore, OASDI benefits are no more a "public burden" than the benefits of any other plan that's financed by employers and their employees.

Expect More of the Same
The above criticisms have appeared, with notable frequency, in books, news media, and television for perhaps 20 years, and such criticisms, together with the related push to privatize OASDI, will undoubtedly intensify in the next year or two.

To date, the criticisms have persuaded many, especially those with some years to go before retirement, that Social Security benefits will simply not be there when it's their time to retire. This belief has made them anxious about their own futures and thus more receptive to proposals for change.

Adding impetus to the push for privatization is the long lived bull market for stocks. Conversely, a prolonged downturn will dampen enthusiasm considerably. So the advocates of privatization may feel some need to push for legislation as quickly as possible.

But much more needs to be understood about privatization, and precipitous action would be a mistake.

Reprinted, courtesy of Contingencies, the magazine of the American Academy of Actuaries.
March/April 1997