Common Sense on Social Security

A Centrist Strategy for Social Security Reform

Social Security Reform: Breaking the Stalemate

Section 13. Are Any of the Strategies Affordable?

Conceptually, a two-track solution appears to be a worthwhile compromise. PRA's help finance the early years of retirement; a strong Trust Fund aids in financing the later years. When teamed with PRA's, the Trust Fund's natural disadvantages can be overcome; when paired with a strong Trust Fund, PRA's become substantially less risky.

But the next critical test is the financial one. What do the cost comparisons show? Which strategy is the most affordable?

To answer the affordability question properly, each of the likely options must be driven through the same grueling obstacle course, subjected to the same financial pounding, modeled against the same spreadsheet parameters.2 The year-by-year figures from Social Security's most recent Intermediate Cost scenario are used as the common forecasting base, beginning with 1999 and extending through 2075. The retiree benefit test must be realistic and consistent. The average replacement rate declines slowly from 42%, today, to 38.2%, four decades from now, at a time when total benefits will be worth roughly twice as much as they are now. A more realistic GDP growth forecast will be used, 1% higher than Social Security's overly pessimistic estimate, and a more likely inflation forecast will also be used, 1% lower than Social Security's current estimate. Incautiously high return estimates for the stock market will not be used. Instead, real stock market returns are assumed to average 5% through 2045, dropping then to 4.5%, thanks to slowing population growth. A 50-50 portfolio mix is also assumed, half stocks, half bonds, which yields an average portfolio return rate of 4.0% through 2045 and 3.75% thereafter.

Except for the warm-up scenarios, the lasting solvency test is also brutally rigorous, firmly based on a capital stability definition of lasting solvency. The Trust Fund ratio must be just as large in 2075 as it is in 2070, not a whit smaller. If the ratio in 2070 stands at 5.31, say, then the Trust Fund ratio must still be at least 5.31 in 2075.

With these assumptions serving as the obstacle course, seven different scenarios will be modeled and tested.

1) The Do Nothing Base Case. Suppose the nation decides to do nothing in response to Boomer retirements, and waits passively to see what happens. GDP grows 1% faster than the Social Security forecast; inflation rates are 1% slower. The Trust Fund becomes insolvent in 2043. Just as the Trust Fund runs dry, Social Security Retiree benefits are cut, deeply enough to keep Social Security from going in the red. What do the costs turn out to be? By 2075, total benefit losses are at $ 33 trillion and counting.

2) An Expanded Tax Base. In this option, we imagine that the Social Security tax base has been expanded, an assumption which raises the earned income cap, extends Social Security coverage to all state and local government new-hires, and ends the tax diversion to Medicare. Under these assumptions, Social Security remains solvent throughout the forecasting period, but its Trust Fund, which peaked at 29% of GDP in 2025, is down to only 7.6% of GDP in 2075 and insolvency seems almost certain by 2085.

An expanded tax base now becomes part of standard scenario against which the remaining five options will be tested.

To help Social Security achieve lasting solvency, a start-up federal subsidy will be added to each of the remaining options, as needed, and adjusted up or down until the Trust Fund ratio in 2075 exactly matches the Trust Fund ratio in 2070. For each option, the question to be answered is a simple one. How big must the front-end subsidy be?

3) Stock-Rich Trust Fund. In the Stock-Rich Trust Fund option, the Trust Fund is allowed to invest 50% of its assets in the stock market, with no arbitrary limit placed on the Trust Fund's ultimate stock holdings. Recall the conditions. All retiree benefits must be paid, as described. Prudent return rates for the stock market must be used. Lasting solvency must be achieved. In order to pass the solvency test, a start-up federal subsidy of $500 billion ($0.5 trillion) is called for, spread out over 14 years and paid in equal installments of not quite $36 billion a year. The Stock-Rich Trust Fund option yields a Trust Fund with a value equal to 49% of GDP.

4) No Stocks Trust Fund. The No Stocks Trust Fund scenario differs from the previous option only in that the Trust Fund is not allowed to invest in stocks. With real portfolio returns of only 3%, a Trust Fund equal to 49% of GDP is far too small. Under this scenario, the Trust Fund must be capitalized at 93% of GDP. The subsidy price tag is many times higher: $ 6.4 trillion, over 14 years ($457 billion a year). The No Stocks Trust Fund is an expensive option indeed.

5) Jump-Started PRA Strategy. (PRA Carve-Out) In this option, we want to determine the subsidy launching cost for a pure PRA solution. The same basic conditions must again be met. All benefit obligations must be met, without any further reductions. Lasting solvency must be achieved.

The assumption list is somewhat detailed. The payroll tax is kept at 12.4%, with 3.4% of that amount used to finance PRA's. A 50-50 stock/bond portfolio mix is used, earning weighted real returns of 4% through 2045, then 3.75% thereafter, from which a PRA management fee of 0.1% is subtracted. PRA portfolios shift to an all-bond mix once their owners reach the age of 62. Inheritance leakage drains away about 2.5% of all PRA assets by the time of retirement. For every PRA annuity dollar paid to retirees, Social Security monthly benefit checks are reduced by ninety cents, giving owners an extra ten percent incentive that doesn't count as part of their regular Social Security benefits. Senator Kerrey's Birth PRA's are added, endowing every newborn with a starter PRA, and allowing a modest cut in the payroll tax in 2073.

All told, it's a vigorous PRA option, with PRA capital growing to 55% of GDP by 2075. The price tag for the launch? A $ 5.4 trillion front-end federal subsidy, spread over 14 years.

6) The Archer-Shaw Approach (PRA Add-On). The Archer-Shaw approach can also be tested against the same set of basic assumptions ? a more realistic GDP growth rate, an expanded tax base, prudent real return estimates for the stock market, retiree benefit obligations met.

The Archer-Shaw envisions a 60-40 Stock/Bond mix for PRA's, and the weighted-average portfolio return rate is adjusted accordingly. No PRA incentive is assumed; every PRA annuity dollar received lowers the Social Security benefit check by a full dollar. Since Archer-Shaw is an add-on plan, the payroll tax is raised to 14.4%, with the final 2% used to finance PRA's.

As a PRA add-on plan, Archer-Shaw is capable of achieving lasting solvency without requiring a front-end federal subsidy. However, because the Archer-Shaw plan uses tax credits to compensate employees for the full cost of their PRA contributions, its long-run subsidy cost is quite substantial nonetheless. Not until 2041 are PRA's mature enough to allow the payroll tax to drop back to 12.4% from 14.4%. By the time the Archer-Shaw subsidy expires, it racks up a total cost of $ 9.6 trillion. (Note: If the replacement rate remains at 42% with no phased-in reductions, the Archer-Shaw tax rate must stay at 14.4% for several more decades. By 2075, the Archer-Shaw tax credit will have cost at least $50 trillion.)

7) Two-Track Savings Strategy. The two-track centrist option combines PRA's with a strong Trust Fund. In this option, the combined employer-employee payroll tax remains at 12.4%, with 10% going straight to Social Security, while 2.4% is used to finance PRA's. PRA portfolio returns are equal to Trust Fund returns until PRA owners reach the age of 62, at which time PRA real returns drop to an all-bond rate of 3%. Management fees of 0.1% are assumed for PRA's, along with an inheritance leakage rate totaling 21/2%. On retirement, PRA's are converted into ten-year fixed annuities. For every annuity dollar received, Social Security benefits are trimmed by ninety cents. A modest additional subsidy, equal to two-tenths of one percent of taxable payroll, launches Senator Kerrey's dream of endowing every newborn with a Personal Retirement Account. In 2073, once Kerrey's Birth PRA's have fully matured, the payroll tax falls from 10% to 9.6%.

The results? In time, the Trust Fund levels off at 25% of GDP, while PRA capital tops out at 42% of GDP. The Two-Track Savings Strategy passes the lasting solvency test with a front-end federal subsidy of $ 1.8 trillion, stretched over 14 years ($138 billion a year).

Let's review the outcomes. The liberals' dream, the Stock-Rich Trust Fund, bears a start-up subsidy cost of $500 billion ($ 0.5 trillion). The centrist compromise, a Two-Track Savings Strategy, has a subsidy price tag of $ 1.8 trillion. The conservatives' dream, a Jump-Started PRA Strategy, requires a launching subsidy of $ 5.4 trillion. And the liberals' deep fallback position, the No-Stocks Trust Fund, demands a front-end subsidy of $ 6.4 trillion. Meanwhile, tax credits for the Archer-Shaw plan end up costing $9.6 trillion over the next 41 years.

Several important lessons can be derived from this analysis. First of all, the order of finish is crystal clear. Spreadsheet analysis is a superb technique for testing several options against the same financial assumptions and determining their rank order. The Stock-Rich Trust Fund Strategy is the cheapest. The No Stocks Trust Fund Strategy is almost twelve times more expensive. And the centrist compromise, a Two-Track Savings Strategy, is only a third as expensive as the Jump-Started PRA Strategy.

The Stock-Rich Trust Fund Strategy, although relatively inexpensive, is too deeply flawed to merit serious consideration. It eventually grows the Trust Fund into the gorilla that ate Wall Street. Meanwhile, a No Stocks Trust Fund is far too costly. With a 14-year price tag of $457 billion a year, it instantly turns the Trust Fund into the gorilla that wants to eat the Federal Budget. A Jump-Started PRA Strategy is also quite pricey. A 14-year start-up cost of $386 billion a year is far steeper than the nation can afford.

On the other hand, the centrist compromise, a two-track savings strategy, is almost a trillion dollars less expensive than President Clinton's proposed subsidy. With a price tag of $129 billion a year, spread out over 14 years, its total cost is relatively reasonable, and it averts much deeper long-run benefit cuts running into tens of trillions of dollars.

In the final analysis, the success of a two-track strategy in achieving lasting solvency for Social Security will depend heavily on the integrity of the federal government's launching subsidy. It would be pure folly to structure such a subsidy as a 14-year string of voluntary appropriations, knowing that Congress could pull the plug at any moment, especially if the GOP decides to hand out tax cuts, or the Democrats get excited about other priorities. Better to have Social Security receive a note at the outset for the entire $1.8 trillion, with Congress obligated to pay down the note in equal cash installments. Should Congress be late on any of its payments, the interest rate owed to the Trust Fund should reflect the real returns the Trust Fund would have earned, had Congress made its Trust Fund payments in a timely manner. The point, of course, is simply to ensure that Congress lives up to its promise and stays current on its payments to Social Security.

A copy of the author's solvency modeling spreadsheet (Excel, Microsoft Office 97, 1.8 MB) can be obtained by writing us at

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Revision Date April 13, 2006