CBO releases new Social Security projections

The Congressional Budget Office has released new projections for the Social Security program's long-term finances. Here's how CBO summarizes the current situation:

In calendar year 2010, Social Security's outlays will exceed tax revenues (that is, the trust funds' receipts excluding interest) for the first time since the enactment of the Social Security Amendments of 1983. Over the next few years, the Congressional Budget Office (CBO) projects, the program's tax revenues will be approximately equal to its outlays. However, as more of the baby-boom generation (that is, people born between 1946 and 1964) enters retirement, outlays will increase relative to the size of the economy, whereas tax revenues will remain at an almost constant share of the economy. Starting in 2016, CBO projects, outlays as scheduled under current law will regularly exceed tax revenues.

Looking at the longer term, here's a chart showing possible paths for Social Security's net cash flow – that is, its tax income minus the benefits the program owes. The middle line is CBO's "best guess," while the upper and lower lines represents what CBO thinks could happen in the 10^th and 90^th percentiles of a distribution of possible outcomes. In other words, there's around a 10 percent chance that Social Security's cash flows could be better than the upper line and a 10 percent chance they'll be worse than the lower line. (For what it's worth, this approach is FAR better than the "low cost" and "high cost" scenarios used by SSA, since it assigns a probability to different outcomes rather than rather arbitrarily calling them "low" and "high.")

So while there's around a 10 percent chance that long-term deficits won't be so bad, there's also a 10 percent chance they'll be really bad – think 2.5 percent of GDP as of 2050. Most people would want to insure against the really bad outcomes by fixing the program today. If we end up with a really good outcome we can give everyone a tax cut or a benefit increase, which is better than having to give everyone a sudden tax increase or benefit cut if things turn out badly.

Read more!

Barron’s: The Myth of 2016

Barron's Gene Epstein argues that rising labor force participation by older workers will put off Social Security's insolvency:

Last month, the media flashed the latest grim news on Social Security: Its trustees had concluded that the money pouring out of the system will start exceeding the tax dollars flowing in by 2016, a year earlier than previously forecast. Unreported, however, was a curious fact: The calculations effectively deny the existence of a longtime trend that probably will delay the arrival of Social Security's doomsday. That trend is Americans' growing propensity to work beyond traditional retirement age. In doing this, the agency could be making a $200 billion mistake in its assessment of Social Security revenue over the next 10 years. That sum is the likely unanticipated income from payroll taxes levied on older workers who remain on the job, based on the projections of demographer Peter Francese, who has had an excellent record predicting such trends. A hundred billion here, a hundred billion there, and pretty soon you're talking real money -- enough to keep this system in the black until at least 2018. While such a delay might not sound too impressive, it does give Washington two more years to come up with a viable solution for the nation's most sacred entitlement program.

The full text of the article seems to be available here. Here's the author talking about his article on video:

Overall, I suspect that Epstein may be overestimating increases in labor force participation by older workers and underestimating the degree to which the Trustees already include data on the current upsurge in work by older Americans. In any case, even Epstein isn't arguing that this will cause a significant delay in Social Security's coming deficits.

The issue of labor force participation by older individuals came up during the deliberations of the 2007 Technical Panel on Assumptions and Methods. As I recall, many on the panel argued that labor force participation by older workers would rise, such that over 75 years the labor force participation rate of people in their late 60s would rise to that of folks in their early 60s today, but I don't believe the panel as a whole made such a recommended change in assumptions. In any case, the increases Epstein is arguing for go well beyond this.

Read more!

SSA actuaries briefing materials on 2009 Trustees Reports

I've posted below materials the Social Security Office of the Chief Actuary used in briefing Congressional staff on the results of the new Trustees report. These are helpful, as they highlight key indicators and how they've changed over the past year.

09 Trustees Report - Trust Fund Status

Publish at Scribd or explore others: arizona public servi sec filings

Goss Briefing on 09 Trustees Report

Publish at Scribd or explore others: Brochures & Catalogs report rakon

Read more!

CBO presentation on decline in Social Security surplus

The Congressional Budget Office yesterday made a presentation to the Social Security Advisory Board regarding the recession-induced decline in the Social Security surplus. I don't believe the presentation is available online, but I've uploaded a copy here.

The viewer below shows the charts, which focus on tax revenues and costs, the total Social Security surplus (including interest) and the primary surplus (which does not include interest payments) and the trust fund balance. Each chart tells the same story in a different way: that Social Security's finances have received a pretty significant hit from the recession. Cash flow-wise, it puts the program three to four years behind where it otherwise would have been. The impact on trust fund solvency will depend upon a combination of these reduced cash flows and changes in interest rates going forward.

SSAB Presentation - 2009 04 - Trust Fund Charts

Publish at Scribd or explore others: Research fund funds

Read more!

Recession could cut life of Social Security trust fund by five years

I was asked yesterday how the current recession, which has significantly reduced the Social Security surplus, might affect the life of the trust fund. I put together some back-of-the-envelope numbers that at least guestimate the effects. These are necessarily approximations and mix CBO and SSA projections together (CBO, because they have they latest data available; SSA, because the Trustees projections for solvency remain the most prominent and well-understood). Take them with a grain of salt, but qualitatively I believe they should get in the ballpark.

Here's how CBO summarizes the differences in Social Security cash flow – meaning tax income (payroll tax revenues plus income taxes levied on retirement benefits) minus benefits and administrative costs – between their March 2008 budget projections, which also formed the basis for their August 2008 long-term Social Security projections, and their current March 2009 projections:

Even as of 2018, cash flow is almost $50 billion per year lower than was previously projected. I'm assuming this difference declines to zero within 10 years following 2018, although it's possible that the effect is permanent.

Next I calculate the present value of these new-found losses to tax income. Discounted at a nominal interest rate of 5.4 percent, which is a rough average of the 10-year Treasury bond rate from CBO's latest economic projections, this produces a present value as of 2009 of $621 billion. In other words, these future declines in payroll tax revenues are roughly equivalent to the trust fund balance simply being $621 billion lower as of today.

Next, I compound this present value forward to the year 2040 at a 5.2% interest rate, which is closer to the longer-term rates used in CBO's August 2008 Social Security update. This produces a value as of 2040 of $2.99 trillion. This shows the rough lost value to the trust at the point in which the fund is near exhaustion. In CBO's projections, the program is running annual nominal deficits of around $550 billion at that point (that's around $300 billion in today's dollars, for anyone interested).

Now, I simply divide $2.99 trillion by $550 billion, which gives me a value of 5.45. This indicates that the lost income to the trust fund today is worth around five and one half years of solvency in the 2040s. The Social Security Trustees currently project the program will become insolvent in the year 2041, so the current recession could push that insolvency date forward to around 2036.

Bear in mind that these numbers are approximate – you wouldn't want to do brain surgery this way. We will know more when the next Trustees Report is released. Moreover, lower wages today due to the recession can lead to lower promised benefits in the future, although I suspect the offset won't be on anything close to a one-to-one basis. (Losing a year of earnings due to unemployment would reduce benefits only if that year were among the worker's highest 35 and if he doesn't make it up by extending his work life later. In addition, if unemployment is concentrated among low earners, their benefits may become more progressive and partially make up for any losses.)

In any event, though, this gives a rough feeling for the scale of the effects of the recession on long-term Social Security financing.

Read more!

CBO explains why future GDP growth will be slower than in the past

It's a very common argument on the left that the Social Security Trustees underestimate future rates of economic growth, and that if only the economy would grow in the future as fast as it did in the past then Social Security's solvency would be assured. (I mean you, Economic Policy Institute; and you, American Prospect; and you, David Langer.)

I've tried to explain elsewhere why the Social Security Trustees project lower economic growth in the future. This difference comes down to the fact that the Trustees don't think about "GDP growth" as a single thing, but break it down into its components and project how those components will change over time. In fact, despite Langer's claim that "The Gross Domestic Product (GDP) is the key economic assumption in estimating costs," it actually plays no direct part in estimating Social Security's finances: Social Security doesn't collect taxes based on GDP, nor does it pay benefits based on GDP. Projections of GDP growth are really a byproduct of the other estimates the Trustees and actuaries do; they could easily project Social Security's finances without ever calculating future GDP.

In any case, since my explanations are apparently tainted, here's how CBO director/blogger Doug Elmendorf explained their projections for future GDP growth:

Projected growth from 2015 to 2019 is also below historical average growth rates, a difference that is more than accounted for by slower growth in the labor force because of the retirement of the baby boom generation. Over the postwar period, the labor force grew at an average annual rate of 1.6 percent; by contrast, we project it to grow only 0.4 percent per year in the period from 2015 through 2019. As a result, potential GDP grew 3.4 percent per year on average in the postwar period, but CBO expects that it will grow by only 2.4 percent annually (allowing for a tad more productivity growth) in the 2015-2019 period.

In other words, the economy will grow more slowly in the future because the labor force will grow more slowly in the future. No conspiracy needed. Click here to read Elmendorf's full blog post.

Update: For those interested in playing around with the economic/demographic assumptions to see how they'll affect Social Security's long-term financing, a while back I put together a simple Excel-based model that lets you choose your own inputs. You can read about it and download the file here.

Read more!

Illustrating the effect on Social Security of new CBO assumptions regarding income tax policy

In this post discussing the new CBO projections for Social Security financing, I noted that one big change relative to the Trustees approach and to prior CBO practice was to assume a literal "current law" approach to income tax policy. Current law for income taxes implies that the Bush tax cuts expire over the next several years, the AMT remains un-indexed for inflation, and "real bracket creep" pushes more and more taxpayers into higher tax brackets. (See this op-ed for discussion of this topic.) This is a major issue for income tax policy, but also affects Social Security because the program derives part of its revenues from income taxes levied on retirement benefits. These flow back to Social Security to help finance benefits. While the formula is complex, roughly speaking individuals with incomes greater than $25,000 may have to pay income taxes on part of their Social Security benefits. Currently, around one third of retirees pay taxes on their Social Security benefits.

The Social Security Trustees assume that income taxes will remain roughly constant relative to GDP, which is consistent with how Congress has tended to modify taxes in the past. However, revenue from benefit taxation will rise, because the $25,000 income exclusion isn't indexed to inflation. As a result, a larger share of retirees in the future will pay taxes on their benefits. So both CBO and the Trustees correctly project that more retirees will pay taxes on their benefits, but CBO differs in assuming that the tax rates retirees pay will also increase significantly.

One way of illustrating this difference is to treat the taxation of retirement benefits as a de facto reduction or means test of benefits. Today, revenues from benefit taxation equal around 0.35% of taxable payroll while benefit payments equal around 11% of payroll. So the taxation of benefits can be treated as around a 3% reduction in the average retirement benefit.

The chart below shows the size of the effective reduction in average retirement benefits going forward, under 2008 Trustees projections, 2008 CBO projections and 2006 CBO projections (the last full projection done prior to 2008). Under Trustees projections and the 2006 CBO projections, which followed the Trustees practice of assuming that income taxes remain steady relative to GDP, benefit taxation rises from around 3.3% of average benefits to around 5-5.5% of average benefits over 75 years. Under the new CBO projections, which assume that future average income tax rates will be almost double those of today's, benefit taxation amounts to over 8 percent of total benefits. This increase improves the CBO 75-year actuarial balance projections by around 0.24% of taxable payroll, or around 18.5%.

The point of all this is simply that this methodological change is consistent with the literal reading of current law and with CBO practice in other documents, but is also probably not anyone's "best guess" of what will actually happen in the future. When we think qualitatively about the size of the future Social Security shortfall, this methodological choice should be borne in mind.

Read more!

More on how the future deficit is caused by over-generosity to past participants

This is a long post, so be sure to hit the 'read more' link to see the whole thing.

We’ve talked a bit here (and here, over at Angry Bear) about how Social Security’s large future shortfalls are a function not of over-generosity to future retirees, but to over-generosity to past ones. This sounds strange and it’s been a bit hard to explain given the data available. But I’ve spent a bit of time converting data in this paper by SSA economist Dean Leimer into a form that might help things make some more sense.

To start, this table shows the program’s deficit over the infinite horizon, measured in the 2008 Trustees Report as $13.6 trillion, or 3.2 percent of taxable payroll over that period. Folks who think the infinite horizon figure is crazy often focus on the, well, infinite part; how can we know, and why should we care, what will happen in the infinite future?

Those of us who think the infinite horizon measure has merit sometimes point out that the deficit isn’t a function of what we project will happen in the way off future, but of what happened in the past. Early participants received much, much more in benefits than they paid in taxes. As a result, the trust fund balance is much lower than it would have been had these early cohorts received only an actuarially fair return (defined as their benefits being equal in present value to their taxes; put another way, it means they would receive a return on their taxes equal to the interest rate paid on bonds on the trust fund).

To back this view, we sometimes point to this table, which breaks the infinite horizon shortfall down more finely. It shows that the $13.6 trillion deficit through the infinite horizon is fully accounted for by the fact that past and present participants received $15.2 trillion more in benefits than they paid in taxes. Future participants are projected to receive $1.5 trillion less in benefits than they’ll pay in taxes, even if Social Security were fully solvent. Add those two numbers together, subtract the current value of the trust fund ($2.2 trillion) and you have the $13.6 trillion deficit.

One question that’s been raised, however, is that the figures for past and present participants includes everyone currently over the age of 16. This means that the earliest participants are lumped together with people just entering the system now, so it’s not clear whether the $15.2 net transfer is really a function of over-generosity to past cohorts or to future ones.
I requested from the Social Security actuaries a cohort-by-cohort breakdown of the figures above, but they weren’t able to provide it. So alternately, I worked with data from Dean Leimer’s paper to convert it to a form more comparable to that show in Table IV.B7. Dean is probably the leading expert on how different cohorts have been treated under the Social Security program and he constructed his figures from SSA data, so I fully trust they’re technically correct. The issues was simply converting them for comparability, which I did.

I should note, however, that the numbers don’t exactly match up because Leimer’s projections of future taxes and benefits was based on the 2002 Trustees Report, which showed a significantly larger deficit than the 2008 Report. I discounted future dollar amounts based on the interest rates in the 2008 Report to keep things as comparable as possible, but the overall deficit is larger in Leimer’s figures due to his matching an older set of Trustees projections. Also note that all individuals born prior to 1900 are lumped together in Leimer’s data.

In any case, first here’s a chart showing real internal rates of return from Social Security for different birth cohorts. As you can see, early cohorts received very high returns while later cohorts received lower ones. Once a cohort is receiving a return below the trust fund interest rate (around 3 percent) the present value of that cohort’s taxes will exceed their benefits. These later cohorts will be net contributors to the system, meaning that they actually help keep the system solvent even if they’ll be the ones holding the bag when it’s going broke.


You may notice that for later cohorts returns tend to rise. Why is this? It’s because these figures are shown under scheduled taxes and benefits, which assumes (unrealistically) that full benefits can be paid at all times. As future cohorts will live longer and longer in retirement, they’ll receive more benefits and so returns will rise. But again, this is unrealistic; in real life, returns will inevitably stabilize.

Now here’s the second chart. It shows net transfers from Social Security by cohort, expressed in present value dollars to make them comparable to the numbers in Table IV.B7. If the dollar figure is positive that means that a given birth cohort received more in benefits than it paid in taxes (all in present value form); if the number is negative, it means they pay more in taxes than they’ll receive in benefits. Again, all this is under scheduled benefits, so solvency doesn’t come into play here.


What the table shows is that early cohorts – particularly those born prior to 1900 – received much more in benefits than they paid in taxes. For the pre-1900 cohorts, the bonus was around $14 trillion. The bonuses decline over time until they’re actually negative beginning with people retiring in the late 1990s. They stay negative for quite a while, and then some distant cohorts are actually slightly positive again (also due to the assumption that they live longer and collect more benefits).

If you add all the cohort figures up, they total around $22 trillion in present value. If you then subtract the current value of the trust fund, the total is around $20 trillion. This is larger than the current infinite horizon shortfall of $13.6 trillion, because the 2002 Trustees projections were more pessimistic.

But I think this basically shows the point we were discussing earlier. The so-called “infinite horizon” deficit has very little to do with what will happen hundreds of years from now and everything to do with what happened in the first 25 years or so that the Social Security program was running. Participants, rich and poor alike, were paid much more in benefits than they contributed in taxes. As a result, the trust fund balance – which should be somewhere around $16 trillion – is only around $2 trillion. This is what drives the long-term deficit.

I think in a way this makes reform easier to understand and resolve. We’ve inherited a ‘legacy debt’ due to over-generosity to prior generations. Whether this over-generosity was justified is an academic question. (Some say yes, to help reduce poverty; I agree there, but much of the legacy debt is due to over-generosity to high income participants, which is harder to justify.) In any case, though, it’s a done deal: the shortfall is what it is, and our only choices are how to deal with it. My argument, which I’ll expand on more fully in the future, is to treat this legacy debt more like a real debt: find the best, fairest and least economically damaging way to pay it off, which may be a way outside of the current Social Security financing structure. But that’s a question for another day.

Read more!

Treatment of uncertainty in new CBO Social Security projections

There is a great deal of uncertainty in projecting Social Security’s finances out over 75 years or more. We know the basic economic and demographic building blocks that determine Social Security’s finances, but we can’t know for sure the value of each over coming decades. In the Social Security Trustees Report, this uncertainty has traditionally been primarily addressed using “high cost” and “low cost” scenarios to complement the best-guess “intermediate cost” projections. For a number of reasons, I think these high/low cost scenarios aren’t particularly helpful. (The recent Technical Panel agreed.)

CBO doesn’t use high/low cost scenarios. Instead, they illustrate uncertainty using a “stochastic” or “Monte Carlo” simulation which assigns probability distributions to each of the main economic or demographic variables and then illustrates the range of outcomes we could expect. (The Trustees also use a stochastic model, but unfortunately it’s not yet the primary descriptor of uncertainty in the Report.)


But even given a model that can calculate the range of possible outcomes, there’s the important question of how you describe this range. You can’t simply do a data dump, you need to find ways that are easily understandable. The new CBO report has a number of very effective ways of portraying uncertainty in Social Security financing. I’ll run through them here.

CBO's Figure 1 shows the 80 percent probability range for Social Security's annual income and costs. The dark lines indicate the median outcomes for each, while the shaded areas denote the range of outcomes. Only 20 percent of outcomes would fall above or below these shaded ranges.

CBO's Figure 3 is similar, except that it focuses on uncertainty in the value of the trust fund ratio (the ratio of the trust fund's balance in a given year to the system's costs in that year). The dark line indicates the median outcome; it hits zero in the year in which the trust fund is projected to become insolvent. The advantage of Figure 3 over Figure 2 is that it also accounts for uncertainty in interest rates, which do not affect annual income and costs. However, many believe that annual cash flows have more substantive importance than the trust fund balance.

Figure 4 is a new chart that I believe is very helpful. It shows the probability that the trust fund will have been exhausted by a given year. Up through the mid-2020s there is almost a zero chance of the fund being exhausted. By the mid-2040s, the likelihood is around 50 percentg. This probability rises until by the 2070s there is only around a 15 percent chance of the trust fund not having been exhausted. One advantage of this chart is that allows an easy comparison of how much a reform plan might improve Social Security's finances. We could say, for instance, that under current law there is a 50 percent chance of the trust fund being exhausted by 2049, but under the reform plan this drops to 25 percent, etc.

Table 3 is also a new addition to the CBO report. It focuses on the probability of the program running deficits of a given size in a given year. For instance, the chart shows that in the year 2050 there is an 87 percent chance that Social Security will be running a cash deficit, a 53 percent chance that the deficit will exceed 1 percent of GDP, and a 16 percent chance it will exceed 2 percent of GDP.

These figures all derive from the same underlying model, but show different ways of describing different aspects of the model's output. I believe the two new figures constitute a significant improvement to how uncertainty is described and should be considered for inclusion in the Socail Security Trustees Report. Read more!

My birthday wish for Social Security

I have a posting at the Hill newspaper's Congress Blog on Social Security's 73^rd anniversary. Short story: my wish for Social Security reform is less wishful thinking from both sides. Once they realize what's really involved in fixing the system, they'll be more likely to reach a compromise.

Today is the 73rd anniversary of the Social Security program, which provides retirement, survivors and disability benefits to over 50 million Americans. While there is reason to celebrate the past, we should also focus on the future. The retirement of the baby boomers and aging of the population will put pressure on Social Security's finances. Between today and 2040, the U.S. population will add three seniors over age 65 for each American under age 20. Social Security is already the largest program of the federal government, and over the next 30 years its costs will rise by 50 percent relative to its tax base.

Click here to read the rest.

Read more!

Responding to Angry Bear: Where does the $17 trillion deficit come from?

Over at Angry Bear, Bruce Webb has a post on the so-called $17 trillion "legacy debt" inherited from early participants in the program. I've argued here, as has Jim Glass in the comments, that the future "infinite horizon" shortfall is basically caused by "over-generosity" to early cohorts of Social Security participants. It's a bit hard to summarize Bruce's argument, and harder for me to respond in the comments section at Angry Bear, so here I'll try to lay out what the legacy debt means and how it affects the system's financing going forward.

Ordinarily, we think about Social Security's finances in cross-section – e.g., how do all taxes paid by all workers in a given year compare to all benefits owed to all retirees or disabled in that year? That's obviously very relevant.

But another way of measuring things is by birth cohort: how did all the taxes paid by individuals born in a given year compare to all the benefits they have or will receive? This approach, best known as "generational accounting," was first proposed by Gokhale, Auerbach and Kotlikoff (see this backgrounder by the Tax Policy Center) and has become a standard way of analyzing how the program treats individuals in different birth cohorts. It's through a generational accounting approach that we can see where the long-term shortfall comes from.

So for each birth cohort taking part in Social Security, we can calculate (or, for future beneficiaries, project) how their total taxes will compare to their total benefits. If we discount all these values to 2008, add them up and then subtract the current value of the Social Security trust fund, we get the total infinite horizon shortfall for the program. Currently, that amount is projected at $13.6 trillion in present value.

Now, how does the claim come about that these future shortfalls are due to over-generosity to past generations? How can this make sense – the system is still in positive cash flow, and it still has a significant trust fund balance?

One way to illustrate is purely mechanically:Based on data from Dean Leimer, an economist at SSA who's probably the leading expert on these issues, the 1885 birth cohort – who retired at 65 in 1950 – received an average rate of return on their taxes of around 25% above inflation. This translates to their receiving roughly 15 times more in benefits than they paid in taxes. As late as the mid-1980s, a typical retiree received returns equaling those paid on stocks, but with none of the risks. (If you want an answer why Social Security was so popular for so long, there it is.)

Now think about future retirees: even if we could pay full scheduled benefits – that is, even if the Low Cost projections came true and we had no solvency problem – future retirees will receive less in benefits than they paid in taxes.

I can sum up the argument in this way:

1. the infinite horizon shortfall is the sum of the net taxes or benefits paid by each cohort, from 1935 through the infinite future; and
   
2. the infinite horizon shortfall is calculated under scheduled benefits; and
   
3. we know that early cohorts received more in benefits than they paid in taxes, and current/future retirees will receive less in benefits than they pay in taxes; therefore we can conclude:
   
4. that the infinite horizon shortfall is entirely attributable to the fact that early cohorts of retirees received far more in benefits than they paid in taxes.
   

Now let's give a little more detail and tackle some questions.

Some will argue that since Social Security is still solvent today, and has a large trust fund balance, that it's not possible that we gave large net transfers to early generations. This is confused. A fully funded pension program – on in which each cohort saves while working, earns interest on its savings, and draws them down to pay their retirement benefits – will always have a running trust fund balance. But it would be a lot larger than the one we currently have. Look at it this way: if early cohort hadn't been paid returns so far above the trust fund bond rate, what would have happened to that extra money? It would have gone into the trust fund and earned interest. How much larger would the trust fund balance be today if those early cohorts hadn't gotten such larger returns? Around $17 trillion larger. That extra balance today would be enough to pay full benefits forever (since future cohorts will receive returns below the trust fund bond rate even if we paid full scheduled benefits, they're effectively adding to the trust fund balance in any case).

Bruce Webb also raised the question of the tables in the Trustees Report. These break down Social Security's unfunded obligations between past/present participants and future participants. This isn't the greatest distinction (and I'll see if I can get a better break-down from the actuaries) because it includes in one group everyone from the first retiree in 1940 to the youngest worker participating in the system today, with the second group being people who will start working and paying taxes in the future. The better breakdown would be between past and current beneficiaries (i.e., people who have already died plus those already collecting benefits) versus future beneficiaries. As we saw in the chart, until relatively recently, retirees tended to get returns above the trust fund bond rate and thus were net beneficiaries of the system (benefits > taxes); going forward, most retirees will tend to be net taxpayers (taxes > benefits).

Now, as Bruce warned in his Angry Bear post, some will suspect this formulation of being some sort of right wing trick. Hardly. The first people to stress the importance of the legacy debt for policy questions were actually Democrats, Peter Diamond and Peter Orszag. Here's how they put it:

The benefits paid to almost all current and past cohorts of beneficiaries exceeded what could have been financed with the revenue they contributed, including interest. This history imposes a "legacy debt" on the Social Security system. That is, if earlier cohorts had received only the benefits that could be financed by their contributions plus interest, the trust fund's assets would be much greater today. If those expanded assets existed, they would be earning interest that could contribute to benefits.

I believe this is an important concept for thinking about how to formulate Social Security policy for the future, and I'll be working on it more. But hopefully this at least starts to explain where the idea of the "back transfer" comes from.

I'm sure this will provoke some push back, and I'm also sure I haven't addressed everything, so happy to answer objections either here or at Angry Bear.

Read more!

Tech Panel report on Low/High Cost scenarios

We've discussed in the past the use of the Low/High Cost scenarios for system financing, as the Low Cost are often cited as reason to believe the program will remain solvent in perpetuity without policy changes. Given that, the discussion of the Low/High Cost scenarios in the report the 2007 Technical Panel on Assumptions and Methods may be appropriate. What follows is from the executive summary:

The current approach to uncertainty of projections in the Trustees Report, using high-, medium- and low-cost "scenarios" or "variants" to indicate the range of plausible outcomes is a traditional one whose limitations are well-known. The current practice of assuming that all variables could simultaneously move in a low- or high-cost direction produces estimates that lack both an intuitive and a statistical interpretation. The temptation to assign probabilities to the scenarios or to suggest their degree of likelihood should be resisted. Previous Technical Panels have consistently drawn attention to the limitations of the variant approach. For example, the 1999 Technical Panel noted that using high and low alternatives: (1) assumes trajectories are always high or always low; (2) combines trajectories of various assumptions in rigid ways, for example, all are set at their high-cost value simultaneously; (3) ignores that different aspects of the high and low scenarios have different levels of uncertainty, and (4) does not assign any probability to the forecast ranges. We offer one additional observation: there is no requirement for symmetry of uncertainty—that the forecast be plus-or-minus an equal amount along the projection. Indeed, many key drivers have asymmetrical uncertainty as succeeding chapters will show, and the nature of the uncertainty may well change with the forecast horizon.

Stochastic analysis, on the other hand, produces uncertainty bands that are much easier to interpret. Critically, stochastic analysis can incorporate correlations between variables, and allows ranges to be given a probabilistic interpretation. Although, the actuaries have developed a stochastic model that is used to augment the use of scenarios to analyze uncertainty in the Trustees Report, those results appear more as an addendum than as an integral part of the analysis. The Panel therefore recommends using the results of the stochastic analysis to augment if not supplant the high- and low-cost scenarios, and to communicate the range of uncertainty around the intermediate projections.

This discussion mirrors part of the answer to Angry Bear's questions I posted a while back, in particular the argument that the stochastic model, while not perfect, represents a better way of displaying uncertainty than the Low/High Cost scenarios.

Read more!

David Francis on the latest Trustees Report

If only for completeness (and because I'm quoted), here's the latest from Christian Science Monitor columnist David France on the 2008 Social Security Trustees Report. The article is available online here. While I don't agree with Francis's views, he is correct that the improvement in Social Security's long-term financing was generally missed in press reports. The reason, I believe, is that the press focuses on the years in which the program begins to run cash deficits (2017) and the year of trust fund exhaustion (2041), neither of which changed in this year's Report. The total 75-year deficit, however, did fall significantly, but this improvement was largely overlooked.

Social Security sounder than you might think:The latest report from the trustees of the system show improvement in its finances, despite some grim coverage.

By David R. Francis | columnist

from the April 7, 2008 edition

The 1 in 4 American families who receive some form of Social Security benefits should be cheered by the latest annual report of the system's trustees.

That report, issued March 25, shows "a really significant improvement" in the finances of the system, says Andrew Biggs, who helped draft the report while serving as deputy commissioner of the Social Security Administration (SSA).

That's not the way some in the press saw this report. One headline used the word "grim." That description would be true in regard to the report of the Medicare trust fund that pays hospital benefits. While the four trustees signing the report foresaw "enormous challenges" for both programs, they expected Medicare's financial difficulties to come sooner and be "much more severe" than any problems tied to Social Security.

What perhaps caused some confusion among the public is that the report calculated that benefits paid would exceed revenues from taxes on payrolls in 2017, same as last year's report. That prospect is based on the fact that the nation's 80 million baby boomers have now begun to retire.

But the reserves of special Treasury bonds in the system's trust fund will not be exhausted until 2041, as was also stated last year. Yet any fix for the Social Security system should be financially easier, the report indicates.

The system's actuaries now project that an increase in immigrants and their children mean that the number of tax-paying workers in relation to retirees will be higher after 2041 than previously estimated. More immigrants paying taxes means that the actuarial deficit over the next 75 years has dropped from $4.7 trillion in last year's report to $4.3 trillion in the 2008 report.

Those numbers may seem huge, but they are "manageable," says Paul Van de Water, an economist with the National Academy of Social Insurance (NASI) in Washington. "Social Security is structurally sound and does not require drastic changes."

It would take a permanent boost in the payroll tax from 12.4 percent of wages to 14.1 percent (half paid by the employee, half by the employer) to keep the program fully solvent for the next 75 years. Or benefits could be cut a little.

But the important message here is that the system is not bankrupt. Tax revenues will still be rolling in after 2041. If Congress fails to pass remedial legislation and the long-term forecasts of the SSA are correct, the system will still have enough revenue to pay 78 percent of the benefits promised in 2041.

Because of rising productivity over the decades, retirees in 2041 would reap greater Social Security benefits in real terms than the average $1,081 per month that today's retirees receive.

But some analysts hold that the most relevant number for future retirees is the replacement rate – what typical workers would receive in Social Security benefits relative to what they had earned before retiring. That rate would drop from 36 percent today to 28 percent in 2041.

Alicia Munnell, director of Boston College's Center for Retirement Research, finds that drop troubling, especially since many corporations are replacing standard pension plans that carry fixed benefits with 401(k) plans, in which benefits often hang on trends in the stock market or other financial markets.

As of 2004, the typical 401(k) or Individual Retirement Account for a male, head of household age 55 to 64, had only $60,000 in assets. That sum would do little to improve the living standard of most Americans over many years of retirement.

In any case, the analysts interviewed agree that current declines in stock and home prices have enhanced the perceived value of Social Security. Only half of American workers are covered by pensions of any kind outside of Social Security.

Moreover, the recent stock market and real estate woes have further diminished any possibility for privatization of Social Security. The Bush administration proposed partial privatization of Social Security (or private accounts), but public reaction and the last federal congressional election decidedly shot down that plan.

Even Mr. Biggs, who several years back worked for a leading advocate of privatization, the Cato Institute, concedes that the only feasible political possibility at present would be government-encouraged private accounts on top of the existing Social Security system, not carved out of it. That, plus a cut in benefits, might be a "reasonable compromise" between Republicans and Democrats, suggests Biggs, now at the American Enterprise Institute, a conservative think tank in Washington.

Republican presidential candidate Sen. John McCain of Arizona ducks the Social Security privatization issue by proposing a commission led by former Federal Reserve Commission Chairman Alan Greenspan. His somewhat ambiguous words suggest he might support an add-on system of private accounts.

The Democratic candidates oppose privatization. But no action on Social Security is likely until after the November election.

Read more!

Nancy Altman on reform (with editorial comments)

In today's Los Angeles Times, Nancy Altman outlines her proposal for Social Security reform, modeled after the plan put forward by the late SSA Commissioner Robert Ball. (Click here for more details on Ball's plan and here for the actuaries' analysis.)

Following her piece, I've pasted in a letter to the editor I wrote this morning which argues that her proposal appears easy simply because she lowers the bar on what is considered success in reforming Social Security. While due to space restrictions the letter confines itself to the core criticism, I do believe that anyone who argues that Social Security needs prompt action and who is willing to put concrete reform options on the tables deserves credit. Following the letter is some additional detail on what it means for a reform plan to be "solvent."

The right fixes for Social Security

Along with baseball and cherry blossoms, spring in the nation's capital brings a ritualized dance over Social Security. Every year for the last two decades, Social Security's trustees have issued a report alerting Congress that action is needed to keep the program solvent. And every year, Congress answers with silence.

It was not always this way. In 1973, the trustees projected a deficit. By 1977, Congress had responded with corrective legislation. In 1981, when that action proved insufficient, Congress began work on a new solution. President Reagan announced his own set of reforms, including a proposal to cut benefits sharply for people about to retire early. That set off a firestorm of protests. To quell the uproar, Reagan quietly dropped the plan and called for the formation of a bipartisan commission. The commission developed a package that Congress passed and Reagan signed into law in 1983. Subsequent trustees' reports again showed Social Security in balance.

Beginning in 1989, however, the trustees again started alerting Congress to deficits caused mainly by changing assumptions, including those about the economy and disability rates. Why didn't President George H.W. Bush, President Clinton or Congress offer serious solutions? Why did President George W. Bush promote a privatization proposal that would have made Social Security's deficit larger? Where did the political courage go?

In fact, political courage was in no greater supply in the 1970s and early 1980s than it is today. The circumstances were simply different. Back then, Social Security faced a short-term deficit: inadequate funding to pay full benefits by the early 1980s. Congress and the White House were willing to make some hard decisions to avert the political catastrophe of millions of beneficiaries not receiving their promised benefits, perhaps just before the next election. Today, there is no such danger on the near horizon.

Social Security will run a surplus until 2027, when it will have accumulated $5.5 trillion. At that point, if no action is taken, the trust fund will begin to cash out the Treasury obligations it holds. That will allow all benefits to be paid until 2041, according to the latest trustees' report.

Despite the long time frame, the trustees are right to alert Congress, which should act without delay so changes can be modest and phased in. Moreover, the quicker Congress acts, the sooner it will restore an intangible benefit. As its name suggests, Social Security is intended to provide security -- peace of mind -- in addition to cash benefits. Peace of mind is lost when politicians and pundits make alarmist statements like "Social Security is going broke" or "it's unsustainable." Eliminating the projected deficit would end those frightening, hyperbolic claims.

But without an imminent crisis to force some action, what would give Congress and the president the backbone to make the necessary changes? Fortunately, it would take only three reforms and not much backbone to put the program back in balance.

First, instead of repealing the estate tax, as President Bush wants to do, Congress should dedicate its revenue to Social Security. The accumulation of huge fortunes depends, in part, on the productivity and infrastructure of the nation. Requiring heirs to contribute to the basic security of all Americans seems a reasonable minimum to ask of those who have benefited so greatly from the common wealth.

Second, Congress should restore the practice of subjecting 90% of aggregated wages nationwide (i.e., the sum of all wages, taken together, of corporate executives, janitors and everyone else) to Social Security taxes. Because the wages of the highest-paid workers have increased much more rapidly than average wages over the last several decades, only about 84% of all wages is currently subject to Social Security taxes, resulting in billions of dollars of lost revenue every year. Restoring the 90% level, by gradually increasing the maximum amount of earnings subject to taxing, would have no effect on workers earning less than the maximum -- currently $102,000 a year. If this proposal were now law, those earning more than $102,000 -- just 6% of the workforce -- would have paid a mere $120.90 in additional contributions this year.

Third, Congress should permit Social Security to improve earnings by diversifying its portfolio and investing some of its assets in equities, as just about all other public and private pension plans do.

These reforms would restore Social Security to balance -- without benefit cuts, without raising the retirement age and with only a very modest tax increase on 6% of the workforce. Politicians should leap at the opportunity to do so much good and reap so much political gain at such little cost.

Nancy Altman is the author of "The Battle for Social Security: From FDR's Vision to Bush's Gamble."

Following is a letter to the editor I drafted this morning:

Re. “The right fixes for Social Security,” by Nancy Altman; April 9, 2008

To the editor:

Nancy Altman endorses three steps to fix Social Security’s financing shortfalls: first, dedicate estate tax revenues to Social Security; second, increase the wages on which payroll taxes are applied from $102,000 to around $185,000; and third, invest part of the trust fund in stocks.

These steps would not come, as Ms. Altman believes, at “little cost.” Dedicating estate tax revenues to Social Security would break the historical link between taxes paid by workers and benefits received by them – a link that differentiates Social Security from so-called “welfare” programs. Increasing the maximum taxable wage would raise the top marginal tax rate by 12.4 percentage points, and, while it would hit only around 6% of workers each year, would affect over 20% of workers over their lifetimes. Investing the trust fund in stocks would involve so-called “transition costs” and the risk of market downturns in the same way as President Bush’s plan to introduce personal retirement accounts.

While Ms. Altman claims these steps would “restore Social Security to balance,” the Social Security actuaries found these three steps would leave around one-quarter of the program’s 75-year deficit unaddressed. To reach “sustainable solvency,” meaning that Social Security would be solvent through 75 years and financially healthy thereafter, would require changes roughly twice as large as those proposed by Ms. Altman.

Sustainable solvency has been a bipartisan goal of Social Security reformers for the last decade. Thus, Ms. Altman’s solution appears attractive relative to other reform plans only because it fixes much less of the problem. Fixing Social Security will depend on insight, compromise, and the ability to make difficult choices, not on lowering the bar for success.

Yours,

Andrew G. Biggs

The American Enterprise Institute, Washington DC

Here is some more background on the three measures of "success" for a reform plan:

• Sustainable solvency: Almost all current reformers aim to restore Social Security to "sustainable solvency." This means that the program is solvent through 75 years and ends the period on strong financial footing. Sustainable solvency was a standard devised by SSA's actuaries which enables plan designers to avoid the shortfalls of the 1983 reforms, in which the program was solvency for 75 years but fell off a financial cliff in the 76th year. Sustainable solvency has been a standard since the 1994-96 Advisory Council and reform plans across the spectrum have met this standard. Reaching sustainable solvency would require improvements in the actuarial balance of somewhere around 3 percent of payroll.
• 75-year solvency: Prior to the mid-1990s, reformers aimed to keep the program solvency for 75 years, but didn't pay much attention to whether the program ended the 75-year period on strong financial footing. This is a significant shortfall, since many of the individuals who paid taxes during the 75 years, and thus contribute to 75-year solvency, would be retired after the 75th year and thus face benefit cuts if the program were not sustainably solvent. Based on current projections, reaching 75-year solvency requires an improvement in the actuarial balance of around 1.7 percent of payroll.
• Close actuarial balance: Roughly speaking, this standard is met if the 75-year actuarial deficit is less than 5% of total 75 year costs. (The definition is available here.) Since the 75-year summarized cost rate is equal to 15.63% of payroll, 5% of which equals 0.78% of payroll, any reform plan with a 75-year deficit of less than that amount would meet the test of close actuarial balance. Thus, a plan could improve the 75-year balance by less than 1% of payroll and still meet this test.

To my knowledge, only Altman and the late Robert Ball have applied this standard to a reform plan. In short, success by Altman's standards can require as little as one-third the tax increases or benefit reductions of a plan that aims to reach sustainable solvency. This seems, to me at least, to not move the debate in the right direction. Read more!

2008 Trustees Report released

Today the Social Security Trustees released the 2008 Report on the program's finances. The report is available here. The summary of the Social Security and Medicare Trustees Reports is available here.

The short story is that the short- and medium-term forecast is about the same, while the long (and extra long) term forecast is improved. The date at which social security begins to run cash deficits remains the same at 2017, as does the date when the trust fund is projected to become insolvent (2041).

However, the 75-year actuarial deficit improves significantly, from 1.95 percent of taxable payroll to only 1.7 percent of payroll. One way to think about this is that an immediate and permanent payroll tax increase of 1.7 percentage points -- from 12.4 percent to 14.1 percent -- would be sufficient to keep the program solvent for 75 years, though not beyond.

Beyond 75 years, the infinite horizon actuarial deficit also declined, from 3.5 percent of payroll in the 2007 Report to only 3.2 percent of payroll in the current Report.

These long-term deficit reductions reflect not changes in the Trustees' assumptions, but improvements in the methods the SSA actuaries use to project the program's finances. Specifically, the actuaries improved their modeling of immigration, particularly of individuals who immigrate to the United States but later emigrate, generally to their country of origin. These individuals would work and pay taxes into Social Security, but generally not collect retirement benefits. As a result, they are a net plus to system financing.

Commentary: While these new methods for modeling immigration clearly correct a shortcoming in previous methods, more remains to be done in modeling the earnings, fertility and mortality of immigrants, who often differ in all these respects from the native born. In general, the earnings, fertility and mortality of immigrants are not modeled distinctly from the native born. Lower earnings and lower mortality means that immigrants generally receive a higher return from Social Security. Lower earnings also means that individuals who work in the U.S. but return home are a smaller windfall, since their taxes would be lower than average American workers. However, higher fertility could mean that future population growth would increase, which would improve Social Security's finances. I believe these issues can best be analyzed using a microsimulation model in which individuals are modeled distinctly, rather than in the semi-aggregated cell-based model the SSA actuaries use for most of their analysis. Read more!

Gadgets: How will Social Security fare under different economic or demographic assumptions?

From scanning blogs and news stories, it's clear that a number of people believe the Social Security Trustees projections are overly pessimistic. They might be. (They also might be overly optimistic -- there's a great deal of uncertainty involved here.)

Leaving aside the question of whether the Trustees projections are reasonable -- I believe they are -- it's important to understand how differences in those projections might change outcomes for the system. In other words, if the Trustees ARE pessimistic, how much better will Social Security's finances be?

It's possible to estimate this using the Sensitivity Analysis contained in each year's Social Security Trustees Report. It reports high and low estimates for each demographic variable and how a high or low value for any given variable would by itself affect system financing. If all the variables are set to their high or low cost value, we get the overall high or low cost scenarios for the system.

To make this process easier, I created a simple spreadsheet that estimates how different values for a few of the major economic/ demographic variables affect Social Security's annual cash flows and trust fund ratio (the ratio of trust fund assets to benefit costs in a given year). I used the Policy Simulation Group's SSASIM model to estimate cash flows for the high/low cost values of four different variables: the total fertility rate (children per woman); net immigration; improvements in mortality; and real wage growth. These are the biggies in affecting annual cash flows. Other factors have smaller effects, and changes to interest rates affect only the trust fund ratio.

Using the SSASIM output, I calculated a simple linear function for each variable, which allowed me to estimate the change in annual cash flows for each variable. I then net these out so a number of changes can be combined to estimate the effects on the total system.

Please note: this simple model is designed for illustrative, educational purposes, to give a ballpark estimate of how different demographic/economic assumptions affect Social Security's financings. So it's a crude tool.

But it's also a useful tool. Consider that many people argue that the Trustees' economic assumptions are overly pessimistic. Well, the principal economic assumption is real wage growth; that's how productivity filters through to the program. What if we increase real wage growth from 1.1 percent, which is about its average over the past 40 years, to 1.7 percent?

The chart below shows the change in cash flows. The red line is the Trustees' intermediate projections, while the blue line is adjusted for higher wage growth. The difference is significant -- deficits are delayed for a few years past 2017 and are always smaller than under the lower-growth assumption. However, is higher wage growth -- 50% higher than projected or seen over the past four decades -- enough to fix the system, such that we don't need to bother with reform? No. By the 75th year the deficit is around 3.75% of payroll rather than 5.3%. In other words, economic growth -- while certainly helpful -- won't plausibly be high enough that we can safely ignore the problem.


You can play with other variables as well. Fertility is a big factor: if we can increase our fertility rate significantly then Social Security's problems really do become a lot easier. But if fertility falls to European levels, we're in big trouble. I hope this little tool is interesting. You can download the spreadsheet here.

Read more!