Tuesday, December 30, 2008

More on Social Security as a Ponzi scheme

Business Week's Michael Mandel talks up the Ponzi scheme angle, then proposes his solution:

But there is one enormous difference between Social Security and a Ponzi scheme: Technological change. Over the past century, new technologies have enabled the output of the country to grow much faster than its population. To be more precise, the U.S. population has more than tripled since the early 1900s, while the U.S. economic output has gone up by more than 20 times.

This long track record of technology-powered growth has enabled the enormous rise in living standards in the U.S. and other developed countries. In fact, this increase in productivity—output per worker—is the key fact which gives us our way of life today.

Assuming that technological progress continues over the next 70 years, and output productivity growth continues over the next 70 years, the finances of Social Security are relatively easy to fix. A fairly minor cut in benefits, combined with a relatively small increase in taxes, will bring the system back into balance again. (the latest Social Security report projects a 75-year deficit of $4.3 trillion. That sounds like a lot of money, but over 75 years it's roughly $60 billion a year…not chicken feed, but not overwhelming).

But here's the rub. Ultimately our ability to make good on the "Ponzi-like" nature of Social Security depends on the continued march of technological progress—and in particular, innovation which boosts output and living standards. If we leave the younger generation a good legacy—a sound scientific and technological base, combined with an innovative and flexible economy and an educated workforce—then Social Security is not a Ponzi scheme. The economy grows, and there's more than enough resources for everyone.

But if instead we—the current generation—invest in homes, flat-screen televisions and SUVs, then we don't leave the next generation with the technological "seed corn" they need. If the technological progress slows, then Social Security does turn out to be Ponzi-like—with unfortunate consequences for everyone.

I'm all for technological progress – though unlike Mandel I personally think flat-screen televisions are a pretty mean technological feat – yet Mandel seems to have a bit of a technology fetish, such that it's the cure for everything.

In this case, technological progress – which affects Social Security by increasing productivity, thereby increasing wages – doesn't have that much to offer. The reason is that retirement benefits in the future are based on wages today; if technology raises worker's wages today, it also increases the amount Social Security promises to pay them in the future. On a person-for-person basis, it's roughly a wash.

Technology/productivity/wage growth can help because benefits paid to current retirees aren't indexed to wage; they rise year-to-year only with inflation. So if wages rise, the cost of paying current benefits falls relative to the wage base. Roughly speaking, the system's actuarial deficit – currently around 1.7% of payroll over 75-years – improves on a one-for-one basis with rising wage growth. The baseline rate of wage growth is 1.1%, so this implies that if wages grew at 2.8% then the program would be solvent for 75-years (though not beyond).

The spreadsheet I posted here lets you play around with different economic/demographic assumptions. The key takeaway for me is that we shouldn't bank too much on productivity growth to bail us out of the Social Security problem.


William said...

Ah, the economy has grown faster with new technology. What a fallacy this is. Productivity growth is the result of ideas and investment. They belong to whom, the government or the investor? Productivity growth is the result of hard work and improves the standard of living. In essence you are saying that this productivity growth needs to be taxed in order to perpetuate the Social Security Ponzi Scheme. In even more terms, any increased out put by the worker or the investor needs to go to those who created the Social Security Ponzi Scheme, thus reducing the incentive to work harder and better.

Here is something to think about;

1. There will be no new workers born for the next 18 years. The next cohort to be born who can begin paying full time SS-OASI taxes begins in one day.

2. There will be no new SS-OASI beneficiaries born for the next 62 years. This number is known because we are now in 2008 soon to be 2009. The next cohort to be born who can begin receiving SS-OASI benefits begins in one day.

3. Many will say you cannot predict the demographics of tomorrow. The entire problem is that SS-OASI has been trying to do that and for no good reason. The only reason to rely on future demographics is that you want someone else to pay your benefits that you are not willing to pay for today.

4. In 1983 SS-OASI had major changes; increase in payroll tax, payroll base, increase in full retirement age from 65 to 67 and the taxing of SS-OASI benefits. However, even after these hug tax increases the program was projected to go belly up in 2064 at the latest.

Many people say there is no problem with Social Security. They state it is running a surplus and will be for the next ten to twelve years. Afterwards, Social Security will need to redeem United States Treasury Notes it purchased in the past to pay benefits. After about twenty years, the Treasury notes will be gone, but Social Security will be able to pay 75% of benefits.

In a lot of ways these people sound a lot like the people who said the Titanic could not sink. Who would book passage on the Titanic knowing it had two good days of floatation before running into trouble and then could provide life boats for 50% of the passengers?

What is the difference between these two history making events? Unlike Social Security, those booking passage on the Titanic did not know they would run into trouble. For those wanting to preserve Social Security, there must be more than words. There must be a plan. Where is yours? For those wishing to jump ship, we need to let congress know our position!

Some Basic Social Security Math
For all its complexity, Social Security’s underlying problems are governed by some basic math. Example: Today’s average Social Security benefit is equal to around 36 percent of the average worker’s wage. Since there are currently 3.4 workers per beneficiary, the cost to each worker to support today’s beneficiaries is around 10.5 percent of his earnings. (36/3.4 = 10.5) Since today’s payroll tax rate is set at 12.4 percent, Social Security currently runs a surplus.

What happens if the ratio of workers to beneficiaries falls?
If the worker-to-beneficiary ratio falls, then each worker bears the burden of more retirees. Example: If instead of 3.4 workers per beneficiary there are just 2, then the cost to each worker rises from 10.5 percent to around 18 percent of earnings. (36/2 = 18)

What level of benefits is affordable?
The same equation, recast to isolate the level of benefits, tells us what level of benefits a given
payroll tax rate can support:

Payroll tax rate x Worker-to-beneficiary ratio = Affordable benefits as percent of average wage

Example: With a 3.4-to-1 worker-to-beneficiary ratio, a 10.5 percent payroll tax rate can pay benefits equal to around 36 percent of the average wage (3.4 x 10.5 = 36). But when the worker-to-beneficiary ratio falls to 2-to-1, the same 10.5 percent tax rate can provide benefits equal to just 21 percent of average earnings.

What is “wage indexing” and what is its relationship to current projections?
Initial Social Security benefit levels are currently indexed to the growth in national wage levels. Consequently, even if there were no demographic problem, Social Security costs would grow almost as fast as the economy as a whole. Faster economic growth means more tax contributions in the short term, and higher benefit obligations in the long term. Though this faster growth helps, it does far less than many people believe. Mostly it creates the illusion of improvement because short-term revenue gains postpone the projected date of Trust Fund depletion, whereas increased costs would occur mostly after the projected depletion date.
Average benefits as percent of average taxable wage
= Program cost as percent of average wage
Worker-to-beneficiary ratio

Improvements in 75-year Actuarial Balance:

Social Security actuaries calculate the actuarial balance of the OASDI programs as the present value of Social Security system expected revenues minus present value of scheduled expenditures over the period in question. Social Security actuaries are required by Congress to make long-term calculations, and the Office of the Actuary has typically used a 75-year valuation period for this long-term analysis.

The current system is not in actuarial balance. The 75-year shortfall is equivalent, on average, to 1.86 percent of the nation’s taxable payroll. This measure is a convenient shorthand for quantifying the magnitude of the financing shortfall, averaged over the valuation period.

However, this measure suffers from many important disadvantages. First, the measure is largely indifferent as to the timing of the cash outlays and cash receipts. As such, it treats a dollar of Social Security revenue the same whether that dollar was spent on Social Security benefits, saved, or spent on non-Social Security spending.

A second disadvantage is that this measure conceals trends in shortfalls. For example, the 1.86 percent actuarial deficit of the current system hides the fact that Social Security has surpluses today but will experience even larger shortfalls in 75 years -- exceeding 6 percent of taxable payroll.

A third disadvantage is that the 75-year time horizon is arbitrary since it ignores what happens to system finances in years outside the valuation period. For example, we could eliminate the actuarial deficit by immediately raising the payroll tax by 1.86 percent of payroll. However, as we move one year into the future, the valuation window is shifted by one year, and we will find ourselves in an actuarial deficit once more. This deficit would continue to worsen as we put our near term surplus years behind us and add large deficit years into the valuation window. This is sometimes called the "cliff effect" because the measure can hide the fact that in year 76, system finances immediately "fall off the cliff" into large and ongoing deficits.

If you want demographics to bailout SS-OASI, then you will need a substantial increase in immigration. Then you will need each woman to have 5.7 babies to support this new immigration. Ever see a dog chasing its tail? Just think for a minute on the rate and size of the work force needed to support 80 million retires. The US may have just under 200 million workers by 2040, but needs 280 million workers to support beneficiaries. Relying on demographics is just as bad as relying on economic growth and being able to tax this increase in standard of living to pay the earlier investors in the ponzi scheme full benefits.

Jim Glass said...

Mandel is channeling his inner Paul Samuelson...

The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in -- exceed his payments by more than ten times (or five times counting employer payments)!

How is it possible? It stems from the fact that the national product is growing at a compound interest rate and can be expected to do so for as far ahead as the eye cannot see. Always there are more youths than old folks in a growing population.

More important, with real income going up at 3% per year, the taxable base on which benefits rest is always much greater than the taxes paid historically by the generation now retired.

Social Security is squarely based on what has been called the eight wonder of the world -- compound interest. A growing nation is the greatest Ponzi game ever contrived.

-- in Newsweek, 1967

Andrew G. Biggs said...

Mandel replied to some comments in a new post here: http://www.businessweek.com/the_thread/economicsunbound/archives/2008/12/is_social_secur_1.html?campaign_id=rss_blog_economicsunbound but the math example he gives is wrong (see my comment lower in the page).

A paygo system unequivocally makes sense if the rate of aggregate wage growth -- roughly, labor force growth plus individual wage growth -- exceeds the interest rate. This may be what Samuelson was thinking, since it might have been true at the time. Yet over the long term this is very rarely the case, and certainly not expected in the U.S.

William said...

The present value of SS-OASI’s shortfall over the next 75 years is $4.7 Trillion. This means in year 76, SS-OASI will be right back where it was in 1983, unable to pay full benefits. Now some have stated this is not a large number, roughly $60 billion a year. Well that is if wage growth is zero. And interest rates are considerably higher. The $4.7 Trillion is the sum total of the shortfall today, not the accumulated shortfall over 75 years.

SS-OASI needs an additional $4.7 Trillion deposited in some income producing account that earns 5.5% a year. The annual cost of this $4.7 Trillion over 75 years is not $60 Billion, but ($240,843,099,052.10). This is just short of 50% of today’s 10.6% SS-OASI tax. In other words to pay the shortfall of SS-OASI over 75 years with increased payroll tax is a doubling of the SS-OASI tax.

With Interest rates of 0 to 0.25% the cost increases exponentially since the amount of work the SS-OASI trust fund would do diminishes to basically zero.

Now some will say this is just plain rubbish. However, take a look at today’s SS-OASI benefits paid, roughly $475 Billion a year (2008) with 38 Million beneficiaries. In 2040 when there are 75 million beneficiaries and the they state they can pay 73-75% of promised benefits under current law (keep in mind COLA ceases when the trust fund falls below 20% of expenses), then the short fall in today’s dollars alone, not including wage growth is simply $234,375,000,000. Now compound this from 2040 till 2083. Do you really think $60 billion is the cost per year?

William said...

Andrew G. Biggs said...

A paygo system unequivocally makes sense if the rate of aggregate wage growth -- roughly, labor force growth plus individual wage growth -- exceeds the interest rate. This may be what Samuelson was thinking, since it might have been true at the time. Yet over the long term this is very rarely the case, and certainly not expected in the U.S.

Interest rates do not affect a fully pay-as-go SS-OASI program since there is no trust fund. It is solely based on wages.

Wage growth is the replacement rate for determining the Initial OASI benefit. If wage Growth is 5% in 2009, then the initial OASI benefit will be 5% larger for those who turn 60. If the wage growth in 2009 were 100%, then the initial OASI benefit for those who turn 60 in 2009 will be 100% larger than had no wage growth taken place. CONVERSLY, if wage growth is zero or negative then that cohort that turns 60 in that particular year will see their initial SS-OASI benefit to be less than the previous years benefits.

The problem is do you have a steady growth in the work force? It is simple to calculate what rate of growth in the population you need to sustain a pay-go SS-OASI. The program needs 3.3 workers making the average wage, paying the average payroll tax to support 1 average beneficiary who's benefit is indexed by inflation (hopefully less than wage growth).

What population growth is needed to maintain 3.3 workers per beneficiary, roughly 5.7 babies per woman. The birth rate per woman has been dropping for the past 200 years. We are now at a zero population growth. To design a SS-OASI program based on the number of births a woman must have is terrible. To design a SS-OASI program based on an assumption that wage growth will always be positive is terrible.

A ponzi scheme is always based on bad assumptions or unrealistic assumptions. It always pays more to those early on, than those who come later. There is no way to create a program that rewards people who work hard and pay benefits to those who did not earn them.

When a person says “We Earned it!” what exactly do they mean?

To me, this phrase is a righteous euphemism for making the more truthful statement: "We were snookered by this Social Security Ponzi scheme, and now we are going to snooker the next generation!"

If Social Security benefits have been "earned" who is obligated to pay benefits to those who "earned" them? Workers? On a regressive tax basis? Why? Why perpetuate a fraud upon the innocent? Who is responsible for bearing the burden of a fraud? The person defrauded? Or an innocent or unborn child?