REFORMING SOCIAL SECURITY

Social Security may be the most popular of all government programs, but it is not without critics. One Nobel laureate in economics dubbed the program a "government sponsored Ponzi scheme." Surveys indicate that more young people believe in UFOs than the likelihood that they are ever going to collect Social Security benefits.

The current funding crisis in Social Security may have taken decades to unfold, but the problems were evident from the very beginning. Ida Mae Fuller was a Vermont secretary with the distinction of being the program's first beneficiary. Ida Mae lived to be 100 years old. Her first check in January 1940 was for $22.54, and her last monthly check in 1975 was $112.60. On a total contribution of $44, Ida Mae received over $20,000 in Social Security benefits.

As a social insurance program, Social Security has been a great success. Without Social Security, almost 50 percent of all retired persons would live below the poverty line. Social Security not only provides a measure of independence to a large and growing pool of senior citizens, it also reduces the potential financial burden on their middle-aged children. However, if Social Security is judged as a retirement program, it fails the most important test which is that benefits must be strictly linked to contributions. The Rand Report on Wealth and Saving found that median-income households will be able to replace only 69 percent of pre-retirement income and that the largest component of retirement income is Social Security (see pie chart). The challenge is to preserve the social insurance aspect of the program while moving toward a fully funded system.

Initiated in 1935, Social Security tax on workers was 2 percent of the first $3,000 of income with 1 percent paid by the employer and 1 percent by the employee. The combined tax rate and income threshold have since increased to 12.4 percent on the first $65,400. The Social Security "contribution" was envisioned as a "deposit" belonging to the employee that could be withdrawn after retirement.

In 1939 the program was redefined as a pay-as-you-go system whereby the payments of current workers would be used to fund the benefits of the retired, while the benefits of tomorrow's retirees would be funded from the wages of tomorrow's workers. This system worked well as long as there were plenty of people paying into the system, worker income was growing and benefits did not increase. However, not only have demographic and income trends conspired against the system, but government expanded Social Security liability by attaching a cost-of-living adjustment.

In 1983, a Social Security Reform Commission was convened to make necessary changes. One reform was to raise the normal retirement age from 65 years to 66 for those born after 1943 and to 67 for those born after 1960. Despite the changes, actuaries believe that the next solvency crisis will occur 20 years earlier than previously anticipated. By the year 2012, expenses are expected to exceed income, and the trust funds are expected to exhaust their surplus in 2029 -- 30 years earlier than expected.

In January 1997 yet another Social Security Commission released its conclusions. Unable to agree, the commission settled on three alternatives, all of which included a recommendation that some portion of Social Security funds be invested in the stock market. Stock market investment would be made by either a government investment board or through personal retirement accounts. The best alternative recommended the creation of Personal Security Accounts similar to a 401(k) or IRA. The employer's contribution would continue to go to Social Security to finance a flat benefit that would equal about 50 percent of 1996 benefit and increase at the rate of wage growth. The employee contribution would supplement the flat benefit at retirement.

The changes would be phased in to protect existing retirees as well as those with a lot of years in the current system. The advantage of the PSA is that is moves toward a fully funded system, while personal ownership provides a savings incentive. Since the PSA account is managed in the private sector, it alleviates the potential conflict of interest of the government as pension fiduciary and public interest regulator.

Opponents of the PSA argue that many people are unable to manage their retirement in a responsible manner. Advocates assert that one would say the same thing about the federal government. The lion's share of Social Security entitlement is paid to the middle class, most of whom already participate in self-directed retirement programs.

The highly touted Moynihan proposal would eventually raise the retirement age to 70 years and increase the tax threshold to $97,500. Rather than personal savings of 6.2 percent, Moynihan would limit it to the 2 percent cut in the tax rate (from 12.4 to 10.4), which would then be restored to 12.4 percent in 24 years. Without a significant savings component, Social Security is a regressive tax on labor. The $97,500 threshold may sound like a lot of money now, but adjusted for annual inflation of 3.5 percent it has an equivalent value of $69,000 in year 2008 and $49,000 in 20 years. Moynihan would balance Social Security by taxing posterity and the middle class. His plan also restores the pay-as-you-go model that is the source of the program's problems.

Despite President Clinton's success using the issue as a political stick against Republican opponents, Social Security has a credibility problem, especially among the young. "Reforms" that resolve the Social Security shortfall by shifting the burden to future generations are fundamentally dishonest. Baby boomers can only hope that Social Security reform commissions convened by their grandchildren do not someday return the favor.

Mike Devaney is a professor of finance in the Donald Harrison College of Business at Southeast Missouri State University.