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A Magazine of Ideas

Why Expanding Social Security Is a Bad Idea

Tuesday, April 16, 2013

A New America Foundation proposal would cost 3.7 percent of GDP and crowd out the private saving that drives our economy.

“Expanded Social Security,” a New America Foundation (NAF) policy white paper by Michael Lind, Joshua Freedman, Robert Hiltonsmith, and Steven Hill, argues for expanding Social Security by paying each retiree a flat annual benefit of $11,669 in addition to their traditional Social Security benefits. The idea is to provide the typical retiree with a guaranteed “replacement rate” of 60 percent of his pre-retirement earnings, with higher replacement rates for low earners. The supplement would cost around 3.7 percent of GDP. Added to Social Security’s forecasted cost of 5.6 percent of GDP in 2035, total outlays would reach 9.3 percent of GDP.

I like anyone who is willing to look at Social Security reform, and I have some affinity for the simplicity and universality of flat benefits. But the NAF paper misses a few important factors in thinking about Social Security reform and the pros and cons of expanding the program. Some of these may seem obvious — for example, if we can’t afford the entitlements we have now, where do we get almost 4 percent of GDP for a new expansion? — so I’ll focus on two things they have not given due attention.

First, Social Security is more generous than you think. No, I don’t mean that you’ll live in style on Social Security benefits. But in terms of their main purpose — replacing pre-retirement income so individuals can smooth consumption between work and retirement — it’s more adequate than the NAF folks assume.

The NAF authors base their calculations on “replacement rate” figures published by the Social Security Administration. The SSA states that “most financial advisors say you’ll need about 70 percent of your pre-retirement earnings to comfortably maintain your pre-retirement standard of living. Under current law, if you have average earnings, your Social Security retirement benefits will replace only about 40 percent.” Using these SSA figures, the NAF team calculates the size of a flat supplementary benefit that would push a medium earner to a replacement rate of 60 percent — within spitting distance of financial advisors’ 70 percent target.

Few people in the real world seek to replace 70 percent of the average of their 35 highest years of wage-indexed earnings when they retire.

But here’s the problem: financial advisors measure replacement rates relative to final earnings — say, your benefit at age 65 divided by your salary at age 64 — while the SSA measures replacement rates relative to the wage-indexed average of your highest 35 years of earnings. This latter figure is higher than final earnings, so it makes Social Security’s replacement rates look lower. Thus, the SSA’s talking point is simply inconsistent — apples and oranges.

More importantly, there’s no economic rationale for how the SSA calculates replacement rates. No person in the real world seeks to replace 70 percent of the average of their 35 highest years of wage-indexed earnings when they retire. The SSA took this approach only because, when it adopted more realistic earnings patterns for its stylized low, middle, and high earners in 2001, replacement rates calculated relative to final earnings — as the SSA had done for years — would have looked a lot higher. Government agencies like nothing more than consistency, so the SSA changed the denominator of its replacement rate calculation to maintain the 40 percent replacement rate they advertise for the typical worker. But this is not something to base policy on.

In a 2008 paper, the SSA’s Glenn Springstead and I calculated actual Social Security replacement rates relative to final earnings. The typical household had benefits equal to 69 percent of their earnings immediately preceding retirement — very close to the 70 percent mark — while low-income households were well above that level. The 70 percent of final earnings benchmark may not be the best way to measure retirement income adequacy (we looked at several in our paper), but it is a widely used rule of thumb, and the one the NAF authors seem to rely on. And by that standard, Social Security benefits aren’t nearly as stingy as you’d think.

So is there a prima facie case for nearly doubling the size of the Social Security program? I don’t see it.

Second, the New America Foundation plan would drastically reduce private saving. The current Social Security program already decreases the amount that people save for retirement, since Social Security benefits substitute for “real” saving. The problem is that real saving provides the capital that businesses use to build factories, buy computers, conduct research and development, and more. Tax-and-transfer “saving” doesn’t, as there isn’t any actual saving going on.

Social Security already owes around $24 trillion in benefits that have been earned but not yet paid. A 1998 literature review by the Congressional Budget Office concluded that one dollar of future Social Security benefits crowds out between zero and 50 cents of private saving; more recent research using better data settles on the higher end of that range. Let’s assume that, in the absence of Social Security, individuals would have saved around half of that $24 trillion on their own. If the return to capital is around 8 percent, then the current Social Security program reduces annual GDP by almost $1 trillion. I would think carefully about doubling down on that bet.

Current private retirement savings for Americans total somewhere around $20 trillion, according to the Investment Company Institute. When you raise Social Security benefits significantly, Americans will be less inclined to save. Let’s say private savings are reduced by half — in that case, you’re losing another $800 billion or so in GDP each year, and around a quarter of that amount in federal tax revenues. And, of course, the higher taxes levied to finance the additional benefits would also depress economic activity.

Real saving provides the capital that businesses use to build factories, buy computers, conduct research and development, and more. Tax-and-transfer saving doesn’t.

The authors of “Expanded Social Security” lament that our current system is “skewed toward private savings.” But it should be, since private saving is what helps drive the economy. To the degree that Americans need to save more for retirement, we should promote more private saving by improving 401(k)s or introducing new savings vehicles, not by increasing a tax-and-transfer approach that subtracts from national saving.

Social Security accomplishes many things well, but nevertheless falls short in a lot of areas. Its progressive benefits do raise many Americans out of poverty, but far fewer than could be helped if the benefits were more reliable and better targeted. Moreover, in many ways Social Security works at cross-purposes with itself. As a pay-as-you-go program, it relies upon a strong economy to finance the benefits it provides. Yet there is good reason to believe that Social Security depresses savings, reduces the labor supply, encourages early retirement, and even lowers the birth rate. Moreover, the unnecessary complexity of the program makes it difficult to understand — even many near-retirees have no idea what they’ll receive from Social Security — and complicates Americans’ decisions on how much to save and when to retire.

We won’t fix these problems by doubling the size of Social Security, as the New America Foundation authors propose. Most of them would be made even worse. But we also won’t fix these problems merely by cutting Social Security benefits, whether through the chained consumer price index, raising the retirement age, or other oft-proposed reforms. Social Security needs imaginative, far-reaching reforms to improve its social insurance value to low- and middle-income Americans while reducing the drag it places on the economy. Watch this space over the next several months to read about some.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute.

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FURTHER READING: Biggs also writes “Teachers and the License Raj,” “Public-Sector Pensions: The Transition Costs Myth,” and “Liberals or Conservatives: Who’s Really Close-Minded?” Alex J. Pollock asks “Would You Settle Your Claims on Social Security for 80 Cents on the Dollar?” Aspen Gorry and Sita Nataraj Slavov suggest “To Protect Future Generations, Fix Social Security.” James Pethokoukis notes “The Problem with Social Security Disability Insurance Is Worse Than You Think.”

 

Image by Dainna Ingram / Bergman Group