Social Security 101:
The Program and the Problem
Social Security University
February 19, 2003
Michael Tanner, Director of Health and Welfare
Andrew G. Biggs, Social Security Analyst
The Cato Institute, Washington, D.C.
Challenges Facing Social Security
•It‟s going broke: Social Security will begin running payroll
tax deficits within 15 years. By 2041, it will be legally and
financially unable to pay full promised benefits, resulting in
cuts of 25 percent or more.
•It‟s unfair: Social Security often discriminates against
working women; divorcees; African Americans; and younger
•It hurts wealth creation: asset ownership brings a host of
economic and social benefits. Social Security discourages
saving by the poor, reducing wealth accumulation and
increasing economic inequality.
•It‟s risky: workers have no legal right to their benefits, even
after a lifetime of contributions. The lack of a legal obligation
encourages the government to make promises it cannot keep,
and to delay action on reform.
What is Social Security?
•The Social Security Act was passed in 1935 and the
first benefits paid in 1940.
•A contributory social insurance program: everyone pays
in and everyone receives benefits. Not a welfare
•Financed by a 12.4 percent tax on wages up to $85,000
(increases annually); the biggest tax most households
• Provides retirement, survivors and disability benefits to
eligible workers and their families.
•The largest government program in the world; takes up
almost one-quarter of the total federal budget.
Social Security and the Budget
Social Security is already the biggest single item in the budget.
Without change, it could eat up 29 percent of the budget by 2020, 34
percent by 2030, and 36 percent by 2075.
Payments from the Old Age, Survivors, and
Disabilities Insurance (OASDI) program
Most Social Security benefits go to retirees, but survivors
and the disabled make up substantial shares as well. Reform
centers on the retirement portion of Social Security.
Disability $60 billion
How are benefits calculated?
• Determine worker‟s “average indexed monthly wage” (AIME).
– Index each year‟s past earnings for wage growth. (This effectively pays
“interest” at the rate of wage growth, around 1 percent.) Years after
age 60 are not indexed.
– Select 35 highest earning years and add together.
– Divide the sum by 35 (to produce an annual average), then by 12 (to
produce a monthly average).
• Run the monthly AIME amount through Social Security‟s “bend points.”
– Bend points replace 90 percent of the first $592 of worker‟s average
indexed monthly earnings, plus 32 percent of earnings between $592-
$3,567, plus 15 percent of earnings above $3,567. This produces a
“primary insurance amount” (PIA).
• For a single individual, the PIA is their monthly benefit. It is also the basis
for spousal, disability and survivors benefits.
(For more information, see http://www.ssa.gov/OACT/COLA/BenForm.html)
Social Security Revenues
Most of Social Security‟s revenues come from payroll taxes. A
smaller amount is from taxes on benefits, while the trust fund is
credited with interest each year.
Payroll Taxes $516 Billion
General Revenues1 $13 Billion
Interest on trust fund2 $73 Billion
Total $602 Billion
1 Credited from income taxes on benefits.
2. No actual cash changes hands. Interest to the trust fund‟s bonds is paid by
issuing new bonds.
•Social Security is a “pay-as-you-go” system.
Contributions from today‟s workers are not saved to
pay their retirement benefits, but immediately used
to pay benefits to today‟s retirees.
•A pay-as-you-go program can begin paying benefits
quickly. (System started in 1935, first benefits paid
•Pay-as-you-go financing provides big windfalls to
early retirees, who only paid in for a few years.
(First retiree, Ida May Fuller of Ludlow, Vermont,
paid $24.75 in taxes; lived to age 100 and collected
$22,889 in benefits.)
Downsides of Pay-as-you-go
But a system that transfers money rather than
investing it is very sensitive to the number of
people paying in vs. the number of people collecting:
the ratio of workers to retirees.
Demography is turning these ratios against Social
•People are having smaller families, meaning fewer
new workers paying into Social Security.
•Seniors are living longer, and collecting for more
•And the Baby Boom generation is about to retire…
Increasing life expectancies mean
more retirees to support…
Total life expectancy for individual reaching age 65
Future retirees will live years longer than
86 today‟s 65-year-olds, and collect
thousands more in benefits.
…And low birth rates mean fewer
new workers to support them
Fertility Rate (number of children per woman)
The Baby Boom
Continue at Low
The Baby Bust
Worker-retiree ratio falling
When the ratio of workers to retirees falls, each worker
must bear a greater financial burden. As a matter of simple
math, this will raise the required tax rate: from around 6
percent in 1960, to 10.5 percent today, to around 17
percent in 2030.
1960: 5.1 to 1 Today: 3.4 to 1 2030: 2.1 to 1
Social Security taxes are already high…
The Social Security payroll tax is 12.4 percent of
•An eighth of the average worker‟s total wages…
•The biggest tax the average household will pay.
That‟s enough to pay…
•Six months rent on a $700 per month
•A full year of student loan payments at $350
per month, or…
•A keg of Budweiser every weekend (plus chips!).
And if today‟s payroll tax seems high, wait „til
you see tomorrow‟s!
…and without reform, costs will reach
20 percent of payroll.
Today, Social Security is running a
20 surplus. But deficits will begin in
2017 and grow ever-larger.
Percent of Taxable Payroll
Social Security‟s deficits grow with
each passing year
The date of trust fund exhaustion has $23.87
75-year cash flow deficit, in trillions of
$24 moved back several years, to 2041. But
each year, Social Security‟s long-term
$23 deficit has grown by trillions.
1999 2000 2001 2002
Year of Trustees' projections
Social security will dominate
Social Security's Share of Federal Spending
Many Democrats favor reform
because they fear that Social
30% Security will squeeze out other
28% programs they care about. Social
26% Security, Medicare and other
senior-related programs could
swallow the entire federal budget
22% by mid-century.
Source: 2001 Trustees Report. Federal spending is assumed to maintain current share of GDP.
But won‟t the trust fund help pay
Technically, the government bonds in Social Security‟s
trust fund will help pay full benefits until 2041.
But the Social Security trust fund is merely a debt the
government owes to itself.
And the only way to turn those IOUs into cash is to raise
taxes, cut spending, or borrow. Those are the same
choices we‟d face if there were no trust fund at all!
The fund cannot put off the need for action.
That is why non-partisan analysts agree that Social
Security‟s financing problems begin with payroll tax
deficits in 2017, not when the trust fund runs out in
Experts say: Trust fund can‟t pay
The Congressional Budget Office: “Although there is no money in the Treasury to pay for future obligations, the
obligations to people eligible for Social Security benefits are real. And most important, those obligations are a
direct result of federal law, not a consequence of whatever may or may not be credited to the Trust Funds. In
particular, the size of the balances in the Social Security Trust Funds – be it $2 trillion, $10 trillion, or zero – does
not affect the obligations that the federal government has to the program‟s beneficiaries. Nor does it affect the
government‟s ability to pay those benefits.” (CBO Director Dan L. Crippen and Deputy Director Barry B. Anderson,
testimony before the House Ways and Means Committee, Feb. 23, 1999)
Rep. Robert Matsui and Sen. Bob Graham: “Trust Fund reserves are growing at the pace of a billion dollars a
week. But these billions won‟t be available to the next generations of America‟s retirees. As quickly as the surpluses
amass, they are being siphoned off to help finance the deficit. Bluntly put, the federal government is spending more
than $1 billion a week of the Social Security surplus as though it were general revenues. All that the Trust Fund
gets for these expenditures are chits from the U.S. Treasury. (The Washington Times, September 12, 1990)
Social Security‟s Public Trustees: While the bonds held by the trust funds are assets from the vantage point of
the Social Security and Medicare programs, from the viewpoint of the unified budget they are liabilities of the U.S.
Treasury. No one doubts the U.S. Government will honor the bonds. But since the U.S. Treasury is the ultimate
payer of the programs‟ benefits and the trust fund assets are also debts of the U.S. Treasury, neither the interest
paid on the bonds, nor their redemption, provides any net new income to the U.S. Treasury. When annual revenues
from earmarked taxes for Social Security and Medicare begin to fall short of annual expenditures, such shortfalls
inevitably must be made up by increased taxation, increased borrowing (i.e., the sale of more U.S. Treasury bonds to
the public) and/or a reduction in other government expenditures. This fact is the basis for the view that trust fund
assets have no "real" economic value. From a unified budget viewpoint, the trust fund surpluses are a budget
accounting device and make no meaningful contribution to funding future Social Security or Medicare expenditures.
They simply reflect the fact that in the past, surplus Social Security and Medicare revenues have been used by the
U.S. Treasury to fund other government programs or to reduce outstanding Federal debt.” (John Pal mer and
Thomas Saving, Social Security Public Trustees, 2002)
Annual repayments to the fund will equal
the size of whole cabinet departments
The question isn‟t whether we‟ll honor the trust fund‟s bonds – no
reform legislation in existence would default on them – but how we‟ll
do it. The “how” is to raise taxes, cut spending or run a budget deficit.
•By 2018, Social Security‟s cash flow deficit would equals Head Start
and the Special Supplemental Nutrition Program for Women, Infants
and Children (WIC).
•By 2021, the shortfall is equivalent to the Departments of Education,
Interior, and Commerce and the Environmental Protection Agency, in
addition to those listed above.
•By 2035, Social Security‟s cash needs equal all of the above, plus
NASA, the Departments of Veteran‟s Affairs, Energy, Housing and
Urban Development (HUD), Justice and the National Science
And this is all before the trust fund runs out. In the end, the federal
budget would consist of little more than a pension plan with an army.
We can‟t borrow our way out…
• Some people think we can borrow to get Social Security
“over the hump” of Baby Boomer retirements.
• But Social Security‟s problems continue and grow larger
even after the Boomers are gone.
• Borrowing doesn‟t reduce Social Security‟s deficits, it is
just a stealth tax increase on our children and
grandchildren. That‟s what Social Security reform is
supposed to avoid.
• If we borrowed to cover Social Security‟s deficits, the
debt would exceed $7 trillion (in today‟s dollars) by
2040, $14 trillion by 2050, and over $47 trillion by
2075. This would be larger than the national debt at
the end of World War II (as a percent of GDP) and
would cripple the US economy.
The solution: a funded system
•A funded system invests contributions from today‟s
workers to pay their future benefits.
•A funded system‟s return equals the return on economic
capital. (Only part of this return goes to stock-holders;
the rest flows to the government as taxes.)
•The return to capital averaged 8.5 percent after inflation
from 1960 to 1996. Social Security‟s “pay-as-you-go”
return (labor force growth plus wage growth) averaged
just 2.7 percent during that period.
•A funded system can pay the same benefits at just one-
quarter the cost of a pay-as-you-go program, reducing the
need for tax increases or benefit cuts.
•Funding can be done centrally by the government or
individually through personal accounts.
Return to Capital and Paygo Return
Pre-Tax Return to Capital. Average: 8.5 Percent
10 Social Security "Paygo" Return. Average: 2.7 Percent
Real annual return, in percent
1960-69 1970-79 1980-89 1990-96
Why does a capital-based system
•In economics, “capital” means the tools, factories and
machines that are used produce goods and services.
•When there is more capital in the economy, workers
become more productive, increasing economic output.
•With increased economic output we can support
growing populations of seniors without raising taxes on
•The details are complex but the principle is simple: A
funded Social Security system aims to strengthen the
economy through increased saving and investing. A
larger economic pie means bigger slices for everyone.
So what‟s the catch?
•A funded system pays higher benefits at lower cost than the
current unfunded program. But to get to funded system, we have
to put up the funds.
•Funding means higher costs in the short term. That‟s true
whether we fund through personal accounts, government
investment of the trust fund, or by retiring existing public debt.
Personal accounts are no more “expensive” than any other means of
pre-funding Social Security.
•Moreover, “transition costs” bring “transition benefits” – reduced
burdens on workers, higher benefits for retirees, a stronger
economy and higher wages.
•Fund transition with existing government spending. Cut corporate
welfare, reduce pork, slow the growth of other programs. This
money would be used more productively as private capital, and
would channel the gains to something important: Social Security.
Should the government invest?
Government investment of the trust fund in stocks was
supported by the Clinton administration and by many
opponents of personal accounts.
But the public is opposed: In the latest Cato Institute/Zogby
International poll, likely voters supported personal accounts
over government investment by 62 to 24 percent.
“Raids” could continue: the current trust fund has been
“raided” to pay for other programs, and a central fund of
stocks could be too. Personal accounts are tougher to raid, a
stronger “lock box.”
Political risks: Many fear that federal ownership of American
companies opens to the door to political control over the
economy, and could bias investment decisions to help or harm
Greenspan and Gore Oppose Government
Investment of the Trust Fund
“I think it's very dangerous... I don't know of any way that you can
essentially insulate government decision-makers from having access
to what will amount to very large investments in American private
industry... I know there are those who believe it can be insulated
from the political process, they go a long way to try to do that. I
have been around long enough to realize that that is just not
credible and not possible. Somewhere along the line, that breach will
Alan Greenspan, Senate Banking Committee, July 21, 1998
“The magnitude of the government‟s stock ownership would be such
that it would at least raise the question of whether or not we had
begun to change the fundamental nature of our economy. Upon
reflection, it seemed to me that those problems were quite serious.”
Al Gore, New York Times, May 25, 2000
How would personal accounts be
•Workers could invest part or all of their payroll taxes in
accounts holding diversified stock and bond mutual funds.
Higher returns on market investments would increase
expected benefits for the worker.
•Workers choosing accounts would give up part of their
traditional benefits, reducing pressure on the current
•At retirement, workers could purchase an annuity or take
gradual withdrawals of their money.
•If the worker died before the account was exhausted,
the remainder would pass onto his spouse, children or a
Greenspan Supports Personal Accounts
"I do think that the notion of moving some funds into private accounts
is the appropriate thing to do. And I think we're going to be moving in
that direction inexorably because of the way the economy is
developing; that is, more out of defined benefit into defined
contribution, with, presumably, some form of safety net for individuals
who turn out to have not had the best of experiences."
Senate Budget Committee, January 2001
“My own preference is strongly in the direction of moving towards a
privately financed system because I believe that's the quickest way to
get to full actuarially sound funding and get programs which will work…
In my judgment, [restoring Social Security to solvency] can be most
effectively be done in the context of gradually moving toward a
Senate Budget Committee, January 1998
Insolvency isn‟t the only problem…
Social Security‟s benefit structure can…
• Discriminate against working women and two-earner
• Deny benefits to many divorced individuals
• Disadvantage minorities and low-wage workers with
shorter life expectancies, increasing inequality of
wealth over generations
• Discriminate against younger workers, who will
receive low returns
• Deny workers a legal right to their benefits.
Personal accounts can help address these problems…
Social Security and the Modern Family
Social Security‟s benefit structure is stuck in the past: it
assumes that husbands will earn the wages while wives will
remain at home, and it punishes couples who do not accord
with this 1930s norm.
•Dual entitlement rule: A spouse is entitled to her own
benefits or benefits equal to one-half of the higher earning
spouse – but not both.
•As a result, 63 percent of working women receive no
additional benefits for the taxes they pay . They could have
received just as much by not working and simply accepting the
•The dual entitlement rule is one of the most regressive
aspects of Social Security. According to the SSA, a high-
income single earner couple receives higher returns from
Social Security than a low-income single worker or dual-earner
Identical Earnings Can Mean Very
Tom and Beth Green (age 35) Mike and Sue Smith (age 35)
Tom earns twice the average wage, Mike and Sue both work and each
Beth doesn‟t work outside the home. earns the average wage.
•The Greens‟ monthly benefit: •The Smiths‟ monthly benefit:
•$2098 for retirement, plus $1049 •$1447 for Mike plus $1447 for Sue,
spousal benefit = $3147 total. equals $2894 total.
•That‟s $253 less per month than the
Greens, who have the same household
•If Tom dies, Beth receives $2098 •If Mike dies, Sue receives $1447 in
monthly in widow‟s benefit, 66% of the widow‟s benefit, 50% of the Smith‟s
initial benefit. Sue receives just 69%
Greens‟ initial benefit.
of Beth Green‟s benefit, even though
Sue paid into the system while Beth
Source: Urban Institute
Personal Accounts and Marriage
Under a system of personal accounts
•Both husband and wife would have personal accounts
of their own.
•Any work performed would increase the account
balance and raise benefits at retirement.
•Single workers and dual-earner couples would no
longer be discriminated against.
Social Security and Divorce
To qualify for spousal and survivor benefits a marriage must last
10 years. But marriages ending in divorce have a median length of
just 7 years, and fully one-third of all marriages end prior to the
10 years needed for benefit eligibility.
•George and Rita Ball are divorced after 10 years and 1 day of
marriage. Rita is entitled to full spousal and survivors benefits
based on her ex-husband‟s earnings.
•John and Judy Hill end their marriage after 9 years and 11
months. Judy is entitled to no benefits based on her husband‟s
earnings. If she did not work outside the home, she may have no
entitlement to any benefits or protections.
The Urban Institute says: Social Security “grants people who
signed divorce papers after being married nine years and eleven
months hundreds of thousands of dollars less than those who
waited another month to divorce.”
Personal Accounts and Divorce
Under a system of personal accounts…
•Couples who divorce would split their account assets
accumulated during their marriage 50-50.
•There would be no time requirement. Even spouses
divorcing prior to 10 years would receive benefits based
on their spouse‟s personal accounts.
•Example: A woman marries at age 25 to average earner
and divorces just prior to 10 years. Her share of account
assets, if left to accumulate until retirement, could result
in lump sums ranging from $10,000 to $40,000, increasing
her monthly income by $55 to $215. (Based on reform
proposals from President‟s Commission.)
African Americans and Social Security
Shorter Life Expectancies: One-third of black males will not live to collect
retirement benefits; others collect for fewer years. As a result, African
Americans receive nearly $21,000 less from Social Security over their
lifetimes than whites with identical incomes and family profiles. This
neutralizes much of Social Security‟s progressivity.
Lower Incomes: 75 percent of African Americans receive most of their
retirement income from Social Security; 37 percent receive all of it (that‟s
double the percentage for whites). Since Social Security can‟t be passed on,
inequality of wealth is increased.
Spousal Benefits: In 1998, only 36 percent of black females were married
(versus 58 percent of whites), meaning that most black women will be ineligible
for spousal benefits.
Divorce: Nearly half of all marriages among African Americans are disrupted
by divorce in less than 10 years, contributing to ineligibility for spousal
benefits. A greater number of African American women do not remarry after
Disability: African Americans do rely disproportionately on Social Security‟s
disability protections, but personal accounts can make the retirement program
more progressive and fair. (Many personal account plans also make the
disability program more progressive.)
Personal accounts and African
•Personal account plans increase Social Security‟s
progressivity versus the current system, often
•Workers who die prior to retirement would have an
inheritance to pass on, in addition to Social Security‟s
traditional survivors benefits.
•Bequests important to African Americans: The median
U.S. household owned $17,400 worth of financial assets in
1998, including retirement accounts. For African American
it was only $3,060.
•Personal accounts would allow spouses, children and the
community to retain wealth, disproportionately benefiting
African Americans and reducing wealth inequality.
Younger Americans Disadvantaged
Non partisan analysis shows: the popular
Social Security program that paid high
benefits with low tax rates no longer
exists. Most younger Americans will
receive lower returns than if they had
Real annual return
invested in risk-free government bonds.
Low returns mean lower retirement
incomes, less security, greater poverty in
Source: Dean R. Leimer, “Cohort-Specific Measures of Lifetime Net Social Security
Transfers,” Social Security Administration.
Social Security‟s Return
•Calculating Social Security‟s rate of return for individuals
is complex. But calculating the system‟s overall return is
•Social Security‟s return = the rate of growth of the
labor force + the rate of growth of wages. More
workers, earning higher wages, means more money to
distribute to retirees.
•From 1960 to 1996, Social Security‟s pay-as-you-go return
averaged roughly 2.7 percent after inflation. (Early
retirees earned higher returns, because they paid taxes
only for a few years.)
•Over the next 75 years, Social Security‟s return will be
only around 1.4 percent. That‟s not nearly enough to pay the
benefits it has promised.
Real Rates of Return Falling for All Retirees
(Assumes No Change in Law, Retirement at Age 65)
Birth Year Single Male Single Single Two-Earner
(Medium Female Earner Couple
wages) (Medium Couple (Medium/
wages) (Medium Low wages)
1970 1.13 1.59 3.42 2.24
1980 0.91 1.36 3.31 2.08
1990 0.88 1.29 3.14 1.97
2000 0.86 1.25 3.02 1.88
Source: May 27, 2001 calculation by the Social Security Office of the
Personal Accounts and Younger
Young Americans are the strongest supporters of personal
accounts: 75 percent support in July 2002 Zogby poll.
Even reform opponents‟ polls have found support: 69 percent of
Americans under 35 supported plan to require investment in
personal accounts. (2030 Center, 1999 poll; note that most
account plans are optional.)
Reform would pay young Americans higher benefits at lower cost
than the current program. Example: The SSA found that a low-
wage worker retiring in 2052 could expect benefits 26 percent
higher under one of the President‟s Commission‟s personal account
plans than under the current program, even if both plans received
the exact same amount of funding. An average-wage worker could
expect 16 percent higher benefits.
Individuals have no legal right to their benefits.
•Workers pay a tax based on their wages and retirees
receive a benefit based on their wages. However, there is
no direct link between taxes paid and benefits received, and
the tax and benefit formulas can (and have) been changed at
•For example, the 1977 and 1983 reforms increased taxes
and made large cuts in future benefits. What does this say
about the government “guarantee” of benefits?
•The lack of property rights gives “flexibility” to the
government but denies security to workers and retirees.
•It also encourages politicians to make promises today that
they may not be able to keep tomorrow.
The Supreme Court on Property Rights
“To engraft upon the Social Security system a
concept of „accrued property rights‟ would deprive
it of the flexibility and boldness in adjustment to
ever changing conditions that it demands.”
Flemming v. Nestor (1960)
“The proceeds of both employer and employee
taxes are to be paid into the treasury like any
other internal revenue generally, and are not
earmarked in any way.”
Helvering v. Davis (1937)
The SSA on Property Rights
“There has been a temptation throughout the program‟s
history for some people to suppose that their FICA payroll
taxes entitle them to a benefit in a legal, contractual sense.
That is to say, if a person makes FICA contributions over a
number of years, Congress cannot, according to this reasoning,
change the rules in such a way that deprives a contributor of a
promised future benefit.”
However, “Congress clearly had no such limitation in mind when
crafting the law…. Like all federal entitlement programs,
Congress can change the rules regarding eligibility--and it has
done so many times over the years. The rules can be made
more generous, or they can be made more restrictive. Benefits
which are granted at one time can be withdrawn, as for
example with student benefits, which were substantially
scaled-back in the 1983 Amendments.” Source:
www.ssa.gov/history/nestor.html (emphasis added).
Personal Accounts and Property Rights
Unlike the current program, personal accounts would give
workers a true legal property right to their contributions
Social Security would no longer be a political football.
Workers and retirees would not have to worry that
politicians would cut their benefits.
As property, personal account assets could be passed on
to a spouse, children or a charity.
Unlike the current system, contributions to personal
accounts couldn‟t be “raided” to pay for other programs.
Personal accounts are the ultimate “lockbox.”
Personal accounts are…
•Flexible: Your money works for you, whether you‟re
working or staying at home.
•Equitable: Resolve many of the inequities concerning
divorce, dual-earner families, widow‟s benefits, African
•Empowering: Low earners could create wealth without
paying higher taxes, and could pass that wealth on to
•Voluntary: Personal accounts would be voluntary – it‟s
your money, it‟s your choice. No one would be required to
invest in the stock market.
•Most of all, they‟re yours: you would own the account, you
could control it, and no politician could raid it to pay for
other programs. When you die, you could pass it on to your
Social Security reform should…
Increase economic growth: Smaller numbers of workers will support
larger populations of retirees. By raising national saving, Social
Security reform can boost worker productivity and increase economic
•Increase personal control: Reform should give workers true legal
ownership of their retirement savings, prevent the government from
“raiding” Social Security, and give all Americans the opportunity to
build wealth and pass it on.
Increase fairness: The current system can be unfair to African
Americans, who often do not survive to retirement age; to working
women, who often do not receive spousal benefits; to divorced workers,
who are often denied benefits; and to the young, who must pay high
taxes into a system that will be insolvent by the time they retire.
Reform should correct these flaws so all Social Security participants
feel they are treated fairly.
Where to from here?
There is no easy solution … but some solutions
are a lot easier than others.
Doing nothing is not an option. Without action,
benefits will eventually be cut by over 25
percent. If you don‟t have a reform plan,
you‟re for benefit cuts, because that‟s what
the law prescribes.
Every year that passes increases the cost of
reform by hundreds of billions of dollars. We
must act soon!
Every congressman – and every American – needs to learn
about Social Security, the problems it faces and the
solutions that have been proposed.