What We Can Do
Fixing the Social Security Problem
Given the grim outlook for public pension systems, what can be done to ensure that individuals entering the workforce today will have adequate income in retirement? The first step is to ensure that economic conditions ar e optimal for maximizing contributions to the system. This requires that the economy grow fast enough to provide job opportunities for those in the labor force and that productivity grow fast enough to promote growth in real wages.
Governments can help achieve these goals best by enacting policies that promote economic growth. Thus, government polices that provide incentives for working, saving and investing will tend to stimulate growth. Increases in the level of education of the workforce and improvements in the quality of education will also help.
Central banks, like the Federal Reserve, can help promote growth by maintaining price stability. Inflation - even at moderate rates - and inflation uncertainty impose substantial costs that hinder economic activity.
While economic growth and productivity are important, however, they cannot by themselves eliminate the problems caused by an aging population. Given the sweeping demographic trends discussed earlier, it is highly unlikel y that the public pension systems of these seven countries can maintain the current level of benefits without raising taxes or running substantial deficits. Put simply, if the number of workers paying the pension benefits of each retiree declines as expec ted, then real wages would have to rise much faster than they have in the past 25 years in order to compensate. Those who espouse economic scenarios that would allow the systems to function free of problems through the middle of the next century are ignor ing the prevailing trends, both economic and demographic.
Reform Proposals
Proposals to reform public pension systems are abundant. Generally, these proposals fall into two categories: those that maintain the pay-as-you-go structure of the current systems and those that move toward a fully fund ed system.
Maintain the Pay-as-you-go Structure
Proposals that would maintain the pay-as-you-go structure typically look for ways to raise contributions or decrease benefits. Seven proposals are listed below:
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Interestingly, when public pension systems were established, most workers were not expected to reach retirement age. When Germany established its system in 1889, for example, only 20 percent of workers lived until age 70 , the minimum age for receiving benefits. Even after the retirement age was reduced to 65 in 1916, most German workers still did not live to collect a pension. As lifespans have risen (see figure below), a higher percentage of workers is living to collect retirement benefits - and they are collecting for a much longer time. Legislation that made it easier to retire early has only compounded the problem.
Reducing the effect that increases in life expectancy have on the cost of public pension systems is the goal of the first four proposals mentioned earlier. All of these would reduce the total benefits a worker can expect to receive in retirement. The first three would do this by delaying retirement, while the fourth proposal reduces the monthly benefit a retiree would receive.
| Some countries have considered adjusting pension benefits by less than the inflation rate. |
While the first four proposals would affect only future retirees, the fifth and sixth proposals would affect current as well as future retirees. In the United States, some have suggested that we treat Social Security inc ome the same way we treat private pension income for tax purposes; benefits in excess of a worker's previously taxed contributions would be treated as ordinary income and taxed accordingly. Taxes applied to Social Security income would be returned to the coffers of the system, reducing the overall cost of benefits.
Some countries have considered adjusting pension benefits by less than the inflation rate. For example, if the inflation rate were 3 percent, benefits might increase by only 2 percent. This would reduce the real pension income of retirees.
The last proposal attempts to increase revenue rather than cut costs. This can be done by increasing taxes on workers directly or by increasing the taxable wage ceiling, thus increasing the tax rate paid by high wage ear ners.
| LASTING A LOT LONGER: Life Expectancy |
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| Across the globe, people are living to riper old ages, threatening to topple public pension systems already heavy with retirees and light on money to support them. |
SOURCES
Back to the text.
Move to a More Fully Funded System
A more radical set of reforms would require each generation to finance more of its own retirement. Proponents of a more fully funded system base their proposals on the belief that we can no longer sustain a pay-as-you-go system given the demographic changes affecting most countries. While we could devise a theoretical combination of benefit cuts and tax increases to keep a pay-as-you-go system in balance, such changes are probably not politically viable. As contribution rates rise and benefits are cut, the system's value to a young worker lessens. Even in the absence of further legislation, the contributions of young and future U.S. workers (including implied accrued interest) are projected to exceed the benefits they co uld earn in retirement.
Often, reform proposals of this type will maintain a portion of the pay-as-you-go system to guarantee a minimum pension for all retirees. This minimum then would be supplemented by workers' mandated contributions to a pe nsion to fund their own retirement, forming a two-tier system.
The first tier could function like the Canadian, British and Japanese universal flat-rate systems. The second tier would operate like the defined contribution private pension plans that many individuals currently partici pate in, except that workers would be required to invest a fixed percent of their salaries in these plans. At retirement, these benefits could be converted into annuities (investments that provide a stream of income for as long as an individual lives).
Benefits under the first tier would be assured by the government; benefits under the second tier would depend on the return on your investments. Thus, the first tier would provide some insurance in the face of adverse ma rket conditions.
Such a system could even be supplemented with a third tier of incentives for additional voluntary savings. The third tier would provide tax incentives to encourage individuals to increase their savings for retirement bey ond the mandatory contributions of the second tier.
For a multi-tier system to work, the benefits under the first tier must be modest enough to sustain in the face of projected demographic changes, but substantial enough to provide a cushion against the market risk inherent in the second-tier benefits. This is particularly relevant for low-wage workers. In the United States, 42 percent of the elderly would have incomes below the poverty line were it not for public pension benefits. Right now, only 6 percent of the elderly in the United States receive public assistance, less than half the proportion 30 years ago. A reform that reduces public pension benefits but increases the need for public assistance provides no cost saving.
| IN A NUTSHELL: A Generational Profile of Social Security | ||||||||
| . | Several trends are converging in a way that spells trouble for the U.S. Social Security system: People are living longer, and the number of workers per retiree is on the way down. | |||||||
| AGE 70 | AGE 45 | AGE 25 | AGE 5 | |||||
LIFE EXPECTANCY AT BIRTH |  | 58 (M) 61 (F) |  | 66 (M) 72 (F) |  | 67 (M) 75 (F) |  | 72 (M) 79 (F) |
RETIREMENT AGE | 65 | 66 | 67 | 67 | ||||
TAX WHEN ENTERING WORKFORCE | 2% | 9.2% | 12.4% | NA | ||||
WORKERS PER RETIREE WHEN ENTERING WORKFORCE | 7.3 | 5.4 | 4.8 | 4.7 | ||||
WORKERS PER RETIREE WHEN EXITING WORKFORCE | 4.8 | 3.6 | 2.7 | 2.5 | ||||
NOTE: Assumes that worker enters workforce at age 20.
[ How It Works ] [ Keeping It Going ] [ What We Can Do ] [ Conclusion ]
[ The U.S. Advisory Council on Social Security: A Group Divided ] [ More Information ]