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.

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NBER Summer Institute: Papers available online

Last week I attended the Social Security section of the NBER's annual summer institute up in Boston. A number of interesting papers were presented, some of which are available online. The links are available below. A couple of quick comments on a few of the papers:

• The Auerbach/Lee paper covers much of the same ground as the working paper on resiliency of Social Security financing I put out through AEI a few weeks ago, though they take the extra step of evaluating how the reduction in uncertainty affects the welfare of different cohorts.
  
• The Liebman/Luttmer/Seif paper looks at how well people understand the fact that their Social Security benefits are linked to the taxes they pay, and how this understanding may affect their behavior. They concluded that we can reject the idea that people have no understanding of the benefit formula, but couldn't conclude how firm an understanding they actually do have. This has policy implications, in that one argument for personal accounts has been that it would encourage work by making the tax/benefit link clearer. (In most personal account plans to date that actually wouldn't be the case, since they're built on top of the current benefit formula, but it could be relevant for certain types of reform plans.)
  
• The Delavande/Rohwedder presentation (unfortunately not available online) looked at an experimental online poll in which individuals were asked how they would react to a Social Security benefit reduction, by saving more, working longer, delaying claiming, etc. A very interesting exercise.
  

WEDNESDAY, JULY 23:

JOINT SESSION WITH AGING AND PUBLIC ECONOMICS

ENRICO PEROTTI, University of Amsterdam; The Political Origin of Pension Funding and State Ownership

JUSTINE HASTINGS, Yale University and NBER, LYDIA TEJEDA-ASHTON, Yale University; Financial Literacy, Information, and Demand Elasticity: Survey and Experimental Evidence from Mexico

ALAN AUERBACH and RONALD LEE, UC, Berkeley and NBER; Welfare and Generational Equity in Sustainable Unfunded Pension Systems

GIOVANNI MASTROBUONI, Collegio Carlo Alberto; Labor Supply Effects of the Recent Social Security Benefit Cuts: Empirical Estimates Using Cohort Discontinuities

ERZO LUTTMER and JEFFREY LIEBMAN, Harvard University and NBER, DAVID SEIF, Harvard University; Labor Supply Response to the Social Security Tax-Benefit Linkage

ADELINE DELAVANDE and SUSANN ROHWEDDER, RAND; Individuals' Responses to Social Security Reform

GAOBO PANG and MARK WARSHAWSKY, Watson Wyatt Worldwide; Optimizing the Equity-Bond-Annuity Portfolio in Retirement: The Impact of Uncertain Health Expenses

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New paper: Policies to reduce uncertainty in Social Security financing

I have a new working paper that examines auto-correction policies for Social Security taxes and benefits that would help adjust for uncertainty regard future demographics. (I talk a bit about adjusting for economic uncertainty, but will do some more detailed work on that in the future.) Here's the basic story, in pictures.

Figure 2 shows the probability distribution of Social Security's net cash flow (income minus outgo), programmed to match the stochastic simulations contained in the Social Security Trustees Report. The median outcome matches the Trustees intermediate projections, but there's obviously a ton of variability. There's about a 1 percent chance we'd be almost in positive cash flow in 2080, but an equal 1 percent chance of cash deficits of 12 percent of payroll. What can policy do about this?

Figure 2: Stochastic simulation of Social Security cash flows, SSASIM model

One policy option is to index initial benefits to price growth rather than wage growth. This will definitely improve expected outcomes for solvency – based on the intermediate projections, this chance alone would fix financing in perpetuity. However, price indexing also increases uncertainty regarding system financing, because benefits no longer adjust to changes in wages (higher wage growth equals higher benefits, lower wage growth equals lower benefits). Figure 4 below illustrates: the median outcome is a lot better than current law, but the level of uncertainty is actually higher.

Figure 4: Stochastic simulation of cash flows under price indexing, SSASIM model

So here's an alternate idea: index changes in taxes and benefits to changes in the ratio of workers to beneficiaries. Long-run, demographics are the biggest sources of variation in system financing (because most of the economic uncertainty gets handled through wage indexing of benefits). The worker-beneficiary ratio accounts for both changes in fertility (workers) and mortality (beneficiaries). If we index to that, we'll account for much of the uncertainty in the long run.

Figure 6 illustrates indexing of benefits to the worker-beneficiary ratio, although the paper also contains a similar chart showing tax indexing. I set things up so that the average affect of the change on solvency would equal that of price indexing – that is, sustainable solvency based on cash flows. However, the level of uncertainty is far smaller.

Figure 6: Stochastic simulation of cash flows under dependency indexing of benefits, SSASIM model

This approach has several advantages. First, it helps deal with the folks who claim the Trustees are pessimistic and there's no real problem lurking in the future. If so, there's no danger in implementing auto-correction policies, since they only make changes as needed. This might help get reform enacted sooner, which is important. Second, auto-correction policies keep financing on a stable basis, which helps smooth burdens more reliably between generations. Without auto-correction, policymakers are likely to wait until the last minute to make changes, which inevitably pushes larger burdens off onto later generations. Third, auto-correction policies give future generations the chance to change Social Security as they wish, from a baseline of solvency rather than insolvency.

There are some other issues to address, such as indexing for economic uncertainty, how to deal with uncertainty regarding how future outcomes are modeled – e.g., the large change in Social Security solvency that occurred in the 2008 Trustees Report was principally due to changes in how immigration was modeled, not to assumptions regarding immigration levels. But as a general class of reforms, I think auto-correction policies have an important role to play.

Plus, Obama policy guru Jason Furman also likes them, which means we may see them sometime in the future.

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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.

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