ST. LOUIS — With most indicators pointing to the Social Security system becoming insolvent in the next several decades, an analysis by the Federal Reserve Bank of St. Louis suggests that a great majority of current retirees would have higher retirement income with private accounts than the present system.
The analysis was undertaken by Thomas A. Garrett, a senior economist at the St. Louis Fed, and Russell M. Rhine, an assistant professor of economics at St. Mary's College of Maryland. Their research appears in the March/April issue of the Review, the Reserve Bank's bimonthly journal of economic and business topics. The publication is also available on the Reserve Bank's web site.
Introduced in 1935, the Social Security Act is one of the largest and most enduring mandates of the federal government. While the system has grown to include other social welfare programs, Garrett and Rhine focused specifically on the program's old-age retirement benefits and disability benefitsor OASDI. More than 47 million Americans, roughly 16 percent of the U.S. population, receive benefits through OASDI.
The reasons for the rapid rise in Social Security expenditures include increases in payroll taxes, an increase in coverage, the increasing longevity of the U.S. population, and an increase in the share of elderly people as a percentage of the overall population.
While the system is solvent at the moment, Social Security's "pay-as-you-go" approach does not bode well for future recipients. Garrett and Rhine emphasized that in 1950 there were 16.5 workers paying Social Security taxes for every retired person receiving benefits. Today, the number is 3.31 and by 2030, there will be 2.17 workers paying taxes for every recipient and there will be 70 million Americans of retirement age, compared with about 35 million today.
Social Security's board of trustees estimates that preserving the current Social Security System for the next 75 years would require an immediate increase in the payroll tax to 14.3 percent, vs. the current level of 12.4 percent, or a 13 percent reduction in all current and future benefits.
Proposals to reform Social Security have ranged from maintaining the current system to allowing individuals to invest their payroll tax contributions in private retirement accounts. Garrett and Rhine argued that "a crucial factor of any Social Security reform proposal is analysis of the actual benefits received from Social Security compared with the benefits that would have been gained with a system of private retirement accounts during retirees' working years."
Garrett and Rhine made several assumptions to easily compare individuals at a more aggregate level. The assumptions are: four average levels of annual income (low earners, average earners, high earners and maximum earners); the number of years of contributions to the Social Security system; the opportunity cost of Social Security contributions; and retirement age.
They also weighed two different private investments: the S&P 500 and 6-month CDs, the latter being a relatively safe investment, which is assumed to roll over at maturity.
Garrett and Rhine compared the real monthly benefit paid by Social Security and the real monthly benefit from the two amortized private portfolios for three different retirement ages. Regarding taxes, their analysis assumes that private investment accounts are tax deferredthat is, taxes are paid only on distributions during retirement years.
Their analysis suggests that, on average, less than 5 percent of current retirees would receive a higher monthly benefit under Social Security than if they had invested their payroll taxes in private investments.
"Given the political nature of Social Security reform," Garrett and Rhine said, "it is unlikely that any initial reform would allow individuals to invest all of their payroll tax contributions in private investment accounts. Nevertheless, our findings suggest that an initial Social Security reform plan could include at least some investment in private retirement accounts."
They cautioned, however, that if some or all of payroll tax revenue were diverted over time to private funds, the federal government would have to increase debt issuance, raise taxes or reduce benefits to continuing traditional Social Security for America's seniors.
"Higher payroll taxes may restore the solvency of the system, but large increases in this tax are likely to have distortionary effects on labor supply and productivity," they said.
While decreased benefits may also continue to keep the system solvent, Garrett and Rhine observed this could be detrimental to individuals who rely solely on Social Security for their income. In addition, they noted that transferring revenues from the general fund to the trust fund may require an increase in other taxes to maintain the size of the general fund.
"In short," they said, "the general equilibrium effects of any Social Security reform plan should be fully understood when evaluating any change to the system."
While any of the proposals that have been put forth publicly would have costs, Garrett and Rhine concluded that "both the public and elected officials must decide whether the cost of doing nothing to the current Social Security system is more than the cost of fixing it."
With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.
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