A Primer on Social Security

One of the hottest topics in the U.S. policy arena is the issue of Social Security reform. Social Security has traditionally been known as the third rail in American politics (whoever touches it meets his political demise), but its looming problems have become serious enough to generate debate. Unfortunately, some fundamental misunderstandings about the current financial condition of the system have complicated the discussion. Clarifying Social Security's financial situation will provide a frame of reference for evaluating alternative reform proposals.

The first thing to understand is that the so-called Social Security Trust Fund--representing the excess of accumulated Social Security tax receipts over benefits payments--is not a trust fund at all. There is no pool of cash or other assets. Workers' Social Security taxes go into the general fund of the United States, which creates an accounting entry on behalf of the Social Security Trust Fund representing an IOU, or a liability in the form of a specially created Treasury bond, from the U.S. government. While the Social Security trustees view these Treasury bonds debited to the Social Security Trust Fund as a real financial asset generating income that is calculated as revenue, this calculation does not change the fact that Social Security has no real financial assets.

Defining defined plans

The second important concept about Social Security is that the system, as presently structured, is a defined benefit plan with fixed (or relatively fixed) benefits to be paid upon retirement. So Social Security's plan stands in contrast to defined contribution plans, which pay benefits based on accumulated contributions and returns earned from investing the contributions over time. The actual benefits paid out will vary depending on the success of the investments. The risks associated with benefits from defined contribution plans are borne solely by the beneficiary: If the funds have been invested wisely, benefit payments may be high, but if the funds are invested unwisely, then benefit payments could be quite low. In contrast, a defined benefit plan like Social Security places the risk on future generations, who will be obligated to pay the promised benefits to retirees.

A third point to consider is that Social Security nowadays is a quasi pay-as-you-go system, in which current receipts are used to pay current benefits. The system is only partially pay-as-you-go because current receipts have exceeded benefit payments. The most recent report from the Social Security Administration projects that in 2017--only 12 years from now--benefit payments will exceed receipts. Thus, the key date for Social Security is 2017 and not 2045, when, according to some experts, all the IOUs will have been exhausted. At that time, the government will have to find another source of funds to make up the shortfall.

No easy answers

One might ask why the Trust Fund can't simply redeem the bonds it has accumulated to make up the shortfall. The fund can't redeem the bonds because they are not marketable. Thus, to generate additional funds the Treasury has only three options: print money, raise taxes, or borrow funds, the latter of which will increase the amount of federal debt outstanding and add to any federal budget deficit that may exist. So while 2045 is a widely discussed date, it is actually irrelevant for assessing Social Security's problem because of the partial pay-as-you-go nature of the current system.

A final notion to ponder is that when any eligible worker retires and begins receiving a benefits check, that person has a claim on a portion of the U.S. economy's gross domestic product (GDP) at that time. Presumably, the benefits check will be spent and used to consume a portion of the nation's real GDP, which is produced through use of the nation's capital stock and the efforts of existing workers. Defined benefit plans, such as the present Social Security system, transfer a fixed portion of real GDP to retirees, regardless of the returns realized on capital or the productivity of workers. Hence, future workers bear all the risks associated with the potential shortfall of receipts and benefit payments.

Staking claims on the future

Placing the risks of a shortfall on future workers is in many ways like taxation without representation. Depending on when the shortfall occurs, the future generation that will be obliged to cover any Social Security revenue shortfall is not even old enough to vote or perhaps has not yet been born. For a nation concerned about fairness and equity, this approach seems like one of the most unfair ways to provide benefit payments to current retirees. In contrast, while defined contribution plans also transfer a claim on a portion of future real GDP, the size of that claim depends only upon the plan's investment performance and does not shift risk to future generations. Also, investing the proceeds may actually cause the nation's capital stock to grow, increasing the size of the pie to be divided among workers and retirees.

Current reform proposals should be evaluated in this context. In the end, the issues center on devising an acceptable and fair way of sharing the risks inherent in any Social Security design between current and future generations.

Robert A. Eisenbeis is executive vice president and director of research of the Federal Reserve Bank of Atlanta.

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