Long Term Fiscal Issues: The Need for Social Security Reform
Released: 2005-02-09T00:00:00

Letter

Social Security Reform Is Part of a Broader Fiscal and Economic Challenge

In my role as lead partner on the audit of the U.S. government’s consolidated financial statements and the de facto Chief Accountability Officer of the United States government, I have become increasingly concerned about the state of our nation’s finances. In speeches and presentations over the past several years, I have called attention to our large and growing long-term fiscal challenge and the risks it poses to our nation’s future. Simply put, our nation’s fiscal policy is on an unsustainable course, and our long-term fiscal imbalance worsened significantly in 2004. GAO’s simulations—as well as those of the Congressional Budget Office (CBO) and others—show that over the long term we face a large and growing structural deficit due primarily to known demographic trends and rising health care costs. Continuing on this unsustainable fiscal path will gradually erode, if not suddenly damage, our economy, our standard of living, and ultimately our national security. Our current path also will increasingly constrain our ability to address emerging and unexpected budgetary needs.

Regardless of the assumptions used, all simulations indicate that the problem is too big to be solved by economic growth alone or by making modest changes to existing spending and tax policies. Nothing less than a fundamental reexamination of all major spending and tax policies and priorities is needed. This reexamination should also involve a national discussion about what Americans want from their government and how much they are willing to pay for those things. This discussion will not be easy, but it must take place.

In fiscal year 2004 alone, the nation’s fiscal imbalance grew dramatically, primarily due to enactment of the new Medicare prescription drug benefit, which added $8.1 trillion to the outstanding commitments and obligations of the U.S. government. The near-term deficits also reflected higher defense, homeland security, and overall discretionary spending which exceeded growth in the economy, as well as revenues which have fallen below historical averages due to policy decisions and other economic and technical factors.

While the nation’s long-term fiscal imbalance grew significantly, the retirement of the baby boom generation has come closer to becoming a reality. In fact, the cost implications of the baby boom generation’s retirement have already become a factor in CBO’s baseline projections and will only intensify as the boomers age. According to CBO, total federal spending for Social Security, Medicare, and Medicaid is projected to grow by about 25 percent over the next 10 years—from 8.4 percent of gross domestic product (GDP) in 2004 to 10.4 percent in 2015. Given these and other factors, it is clear that the nation’s current fiscal path is unsustainable and that tough choices will be necessary in order to address the growing imbalance.

There are different ways to describe the magnitude of Social Security’s long-term financing challenge, but they all show a need for program reform sooner rather than later. A case can be made for a range of different measures, as well as different time horizons. For instance, the shortfall can be measured in present value, as a percentage of GDP, or as a percentage of taxable payroll. The Social Security Administration (SSA) has made projections of the Social Security shortfall using different time horizons. (See table 1.)

While estimates vary due to different horizons, both identify the same long- term challenge: The Social Security system is unsustainable in the long run. Taking action soon on Social Security would not only make the necessary action less dramatic than if we wait but would also promote increased budgetary flexibility in the future and stronger economic growth.

Although the Trustees’ 2004 intermediate estimates project that the combined Social Security Trust Funds will be solvent until 2042, within the next few years, Social Security spending will begin to put pressure on the rest of the federal budget. (See table 2.) Under the Trustees’ 2004 intermediate estimates, Social Security’s cash surplus—the difference between program tax income and the costs of paying scheduled benefits— will begin a permanent decline in 2008. (See fig. 1.) To finance the same level of federal spending as in the previous year, additional revenues and/or increased borrowing will be needed in each subsequent year.

By 2018, Social Security’s cash income (tax revenue) is projected to fall below program expenses. At that time, Social Security will join Medicare’s Hospital Insurance Trust Fund, whose outlays exceeded cash revenues in 2004, as a net claimant on the rest of the federal budget. The combined OASDI Trust Funds will begin drawing on the Treasury to cover the cash shortfall. At this point, Treasury will need to obtain cash for those redeemed securities either through increased taxes, and/or spending cuts, and/or more borrowing from the public than would have been the case had Social Security’s cash flow remained positive.

Today Social Security spending exceeds federal spending for Medicare and Medicaid, but that will change. While Social Security is expected to grow about 5.6 percent per year on average over the next 10 years, Medicare and Medicaid combined are expected to grow at 8.5 percent per year. As a result, CBO’s baseline projects Medicare and Medicaid spending will be about 30 percent higher than Social Security in 2015. According to the Social Security and Medicare trustees, Social Security will grow from 4.3 percent of GDP today to 6.6 percent in 2075, and Medicare’s burden on the economy will quintuple—from 2.7 percent to 13.3 percent of the economy.

GAO’s long-term simulations illustrate the magnitude of the fiscal challenges associated with an aging society and the significance of the related challenges the government will be called upon to address. Figures 2 and 3 present these simulations under two different sets of assumptions. In figure 2, we begin with CBO’s January baseline, constructed according to the statutory requirements for that baseline. Consistent with these requirements, discretionary spending is assumed to grow with inflation for the first 10 years and tax cuts scheduled to expire are assumed to expire. After 2015, discretionary spending is assumed to grow with the economy, and revenue is held constant as a share of GDP at the 2015 level. In figure 3 two assumptions are changed: discretionary spending is assumed to grow with the economy after 2005 rather than merely with inflation and the tax cuts are extended. For both simulations Social Security and Medicare spending is based on the 2004 Trustees’ intermediate projections, and we assume that benefits continue to be paid in full after the trust funds are exhausted. Medicaid spending is based on CBO’s December 2003 long- term projections under mid-range assumptions.

Both these simulations illustrate that, absent policy changes, the growth in spending on federal retirement and health entitlements will encumber an escalating share of the government’s resources. Indeed, when we assume that recent tax reductions are made permanent and discretionary spending keeps pace with the economy, our long-term simulations suggest that by 2040 federal revenues may be adequate to pay little more than interest on the federal debt. Neither slowing the growth in discretionary spending nor allowing the tax provisions to expire—nor both together—would eliminate the imbalance. Although revenues will be part of the debate about our fiscal future, the failure to reform Social Security, Medicare, Medicaid, and other drivers of the long-term fiscal gap would require at least a doubling of taxes—and that seems implausible. Accordingly, substantive reform of Social Security and our major health programs remains critical to recapturing our future fiscal flexibility.

Although considerable uncertainty surrounds long-term budget projections, we know two things for certain: the population is aging and the baby boom generation is approaching retirement age. The aging population and rising health care spending will have significant implications not only for the budget but also for the economy as a whole. Figure 4 shows the total future draw on the economy represented by Social Security, Medicare, and Medicaid. Under the 2004 Trustees’ intermediate estimates and CBO’s long-term Medicaid estimates, spending for these entitlement programs combined will grow to 15.6 percent of GDP in 2030 from today’s 8.5 percent. It is clear that, taken together, Social Security, Medicare, and Medicaid represent an unsustainable burden on future generations.

The government can help ease future fiscal burdens through spending reductions or revenue actions that reduce debt held by the public, thereby saving for the future and enhancing the pool of economic resources available for private investment and long-term growth. Economic growth can help, but given the size of our projected fiscal gap we will not be able to simply grow our way out of the problem. Closing the current long-term fiscal gap would require sustained economic growth far beyond that experienced in U.S. economic history since World War II. Tough choices are inevitable, and the sooner we act the better.

Some of the benefits of early action—and the costs of delay—can be illustrated using the 2004 Social Security Trustees’ intermediate projections. Figure 5 compares what it would take to keep Social Security solvent through 2078 by either raising payroll taxes or reducing benefits. If we did nothing until 2042—the year SSA estimates the Trust Funds will be exhausted—achieving actuarial balance would require changes in benefits of 30 percent or changes in taxes of 43 percent. As figure 5 shows, earlier action shrinks the size of the necessary adjustment.

Both sustainability concerns and solvency considerations drive us to act sooner rather than later. Trust Fund exhaustion may be nearly 40 years away, but the squeeze on the federal budget will begin as the baby boom generation begins to retire. Actions taken today can ease both these pressures and the pain of future actions. Acting sooner rather than later also provides a more reasonable planning horizon for future retirees.

Demographic Trends Drive Both the Long­ term Fiscal Outlook and Social Security’s Financing Challenge

The Social Security program’s situation is but one symptom of larger demographic trends that will have broad and profound effects on our nation’s future in other ways as well. As you are aware, Social Security has always been a largely pay-as-you-go system. This means that the system’s financial condition is directly affected by the relative size of the populations of covered workers and beneficiaries. Historically, this relationship has been favorable to the system’s financial condition. Now, however, people are living longer and spending more time in retirement.

As shown in figure 6, the U.S. elderly dependency ratio is expected to continue to increase.The proportion of the elderly population relative to the working-age population in the U.S. rose from 13 percent in 1950 to 19 percent in 2000. By 2050, there is projected to be almost 1 elderly dependent for every 3 people of working age—a ratio of 32 percent. Additionally, the average life expectancy of males at birth has increased from 66.6 in 1960 to 74.3 in 2000, with females at birth experiencing a rise from 73.1 to 79.7 over the same period. As general life expectancy has increased in the United States, there has also been an increase in the number of years spent in retirement. Improvements in life expectancy have extended the average amount of time spent by workers in retirement from 11.5 years in 1950 to 18 years for the average male worker as of 2003.

A falling fertility rate is the other principal factor underlying the growth in the elderly’s share of the population. In the 1960s, the fertility rate, which is the average number of children that would be born to women during their childbearing years, was an average of 3 children per woman. Today it is a little over 2, and by 2030 it is expected to fall to 1.95—a rate that is below what it takes to maintain a stable population. Taken together, these trends threaten the financial solvency and sustainability of Social Security.

The combination of these factors means that annual labor force growth will begin to slow after 2010 and by 2025 is expected to be less than a fifth of what it is today. (See fig. 7.) Relatively fewer workers will be available to produce the goods and services that all will consume. Without a major increase in productivity or increases in immigration, low labor force growth will lead to slower growth in the economy and to slower growth of federal revenues. This in turn will only accentuate the overall pressure on the federal budget.

The aging of the labor force and the reduced growth in the number of workers will have important implications for the size and composition of the labor force, as well as the characteristics of many jobs, throughout the 21st century. The U.S. workforce of the 21st century will be facing a very different set of opportunities and challenges than that of previous generations.

Increased investment could increase the productivity of workers and spur economic growth. However, increasing investment depends on national saving, which remains at historically low levels. Historically, the most direct way for the federal government to increase saving has been to reduce the deficit (or run a surplus). Although the government may try to increase personal saving, results of these efforts have been mixed. For example, even with the preferential tax treatment granted since the 1970s to encourage retirement saving, the personal saving rate has steadily declined. Even if economic growth increases, the structure of retirement programs and historical experience in health care cost growth suggest that higher economic growth results in a generally commensurate growth in spending for these programs in the long term.

In recent years, personal saving by households has reached record lows while at the same time the federal budget deficit has climbed. (See fig. 8.) Accordingly, national saving has diminished but the economy has continued to grow in part because more and better investments were made. That is, each dollar saved bought more investment goods and a greater share of saving was invested in highly productive information technology. The economy has also continued to grow because the United States was able to invest more than it saved by borrowing abroad, that is, by running a current account deficit. However, a portion of the income generated by foreign-owned assets in the United States must be paid to foreign lenders. National saving is the only way a country can have its capital and own it too.

Initial Social Security benefits are indexed to nominal wage growth resulting in higher benefits over time. consequences for the living standards of future generations. The financial burdens facing the smaller cohort of future workers in an aging society would most certainly be lessened if the economic pie were enlarged. This is no easy challenge, but in a very real sense, our fiscal decisions affect the longer-term economy through their effects on national saving.

The persistent U.S. current account deficits of recent years have translated into a rising level of indebtedness to other countries. However, many other nations currently financing investment in the United States also will face aging populations and declining national saving, so relying on foreign savings to finance a large share of U.S. domestic investment or federal borrowing is not a viable strategy in the long run.

Health Care Is a Larger and More Difficult Challenge Than Social Security

As figure 4 showed, over the long term Medicare and Medicaid will dominate the federal government’s future fiscal outlook. Medicare growth rates reflect not only a burgeoning beneficiary population but also the escalation of health care costs at rates well exceeding general rates of inflation. Health care generally presents not only a much greater but a more complex challenge than Social Security. The structural changes needed to address health care cost growth will take time to develop, and the process of reforming health care is likely to be an incremental one.

While the long-term fiscal challenge cannot be successfully addressed without addressing Medicare and Medicaid, federal health spending trends should not be viewed in isolation from the health care system as a whole. For example, Medicare and Medicaid cannot grow over the long term at a slower rate than cost in the rest of the health care system without resulting in a two-tier health care system. This, for example, could squeeze providers who then in turn might seek to recoup costs from other payers elsewhere in the health care system. Rather, in order to address the long­ term fiscal challenge, it will be necessary to find approaches that deal with health care cost growth in the overall health care system.

Although health care spending is the largest driver of the long-term fiscal outlook, this does not mean that Social Security reform should be postponed until after health is addressed. On the contrary, it argues for moving ahead on Social Security now. The outlines of Social Security reform have already been articulated in many Social Security reform proposals. These approaches and the specific elements of reform are well known and have been the subject of many analyses, including GAO reports and testimonies. Reform approaches already put forward can serve as a starting point for deliberations.

Considerations In Assessing Reform Options

As important as financial stability may be for Social Security, it cannot be the only consideration. As a former public trustee of Social Security and Medicare, I am well aware of the central role these programs play in the lives of millions of Americans. Social Security remains the foundation of the nation’s retirement system. It is also much more than just a retirement program; it pays benefits to disabled workers and their dependents, spouses and children of retired workers, and survivors of deceased workers. In 2004, Social Security paid almost $493 billion in benefits to more than 47 million people. Since its inception, the program has successfully reduced poverty among the elderly. In 1959, 35 percent of the elderly were poor. In 2000, about 8 percent of beneficiaries aged 65 or older were poor, and 48 percent would have been poor without Social Security. It is precisely because the program is so deeply woven into the fabric of our nation that any proposed reform must consider the program in its entirety, rather than one aspect alone. To assist policymakers, GAO has developed a broad framework for evaluating reform proposals that considers not only solvency but other aspects of the program as well. Our criteria aim to balance financial and economic considerations with benefit adequacy and equity issues and the administrative challenges associated with various proposals.

GAO Framework For Evaluating Reform Proposals

The analytic framework GAO has developed to assess proposals comprises three basic criteria:

Financing Sustainable Solvency—the extent to which a proposal achieves sustainable solvency and how it would affect the economy and the federal budget. Our sustainable solvency standard encompasses several different ways of looking at the Social Security program’s financing needs. While a 75-year actuarial balance has generally been used in evaluating the long-term financial outlook of the Social Security program and reform proposals, it is not sufficient in gauging the program’s solvency after the 75th year. For example, under the trustees’ intermediate assumptions, each year the 75-year actuarial period changes, and a year with a surplus is replaced by a new 75th year that has a significant deficit. As a result, changes made to restore trust fund solvency only for the 75-year period can result in future actuarial imbalances almost immediately. Reform plans that lead to sustainable solvency would be those that consider the broader issues of fiscal sustainability and affordability over the long term. Specifically, a standard of sustainable solvency also involves looking at (1) the balance between program income and costs beyond the 75th year and (2) the share of the budget and economy consumed by Social Security spending.

Balancing Adequacy and Equity—the relative balance struck between the goals of individual equity and income adequacy. The current Social Security system’s benefit structure attempts to strike a balance between these two goals. From the beginning, Social Security benefits were set in a way that focused especially on replacing some portion of workers’ preretirement earnings. Over time other changes were made that were intended to enhance the program’s role in helping ensure adequate incomes. Retirement income adequacy, therefore, is addressed in part through the program’s progressive benefit structure, providing proportionately larger benefits to lower earners and certain household types, such as those with dependents. Individual equity refers to the relationship between contributions made and benefits received. This can be thought of as the rate of return on individual contributions. Balancing these seemingly conflicting objectives through the political process has resulted in the design of the current Social Security program and should still be taken into account in any proposed reforms.

Implementing and Administering Proposed Reforms—how readily a proposal could be implemented, administered, and explained to the public. Program complexity makes implementation and administration both more difficult and harder to explain. Some degree of implementation and administrative complexity arises in virtually all proposed changes to Social Security, even those that make incremental changes in the already existing structure. Although these issues may appear technical or routine on the surface, they are important issues because they have the potential to delay—if not derail—reform if they are not considered early enough for planning purposes. Moreover, issues such as feasibility and cost can, and should, influence policy choices. Continued public acceptance of and confidence in the Social Security program require that any reforms and their implications for benefits be well understood. This means that the American people must understand why change is necessary, what the reforms are, why they are needed, how they are to be implemented and administered, and how they will affect their own retirement income. All reform proposals will require some additional outreach to the public so that future beneficiaries can adjust their retirement planning accordingly. The more transparent the implementation and administration of reform, and the more carefully such reform is phased in, the more likely it will be understood and accepted by the American people.

The weight that different policymakers place on different criteria will vary, depending on how they value different attributes. For example, if offering individual choice and control is less important than maintaining replacement rates for low-income workers, then a reform proposal emphasizing adequacy considerations might be preferred. As they fashion a comprehensive proposal, however, policymakers will ultimately have to balance the relative importance they place on each of these criteria. As we have noted in the past before this committee and elsewhere, a comprehensive evaluation is needed that considers a range of effects together. Focusing on comprehensive packages of reforms will enable us to foster credibility and acceptance. This will help us avoid getting mired in the details and losing sight of important interactive effects. It will help build the bridges necessary to achieve consensus.

Reform’s Potential Effects on the Social Security Program

A variety of proposals have been offered to address Social Security’s financial problems. Many proposals contain reforms that would alter benefits or revenues within the structure of the current defined benefits system. Some would reduce benefits by modifying the benefit formula (such as increasing the number of years used to calculate benefits or using price indexing instead of wage indexing), reduce cost-of-living adjustments (COLA), raise the normal and/or early retirement ages, or revise dependent benefits. Some of the proposals also include measures or benefit changes that seek to strengthen progressivity (e.g., replacement rates) in an effort to mitigate the effect on low-income workers. Others have proposed revenue increases, including raising the payroll tax or expanding the Social Security taxable wage base that finances the system; increasing the taxation of benefits; or covering those few remaining workers not currently required to participate in Social Security, such as older state and local government employees.

A number of proposals also seek to restructure the program through the creation of individual accounts. Under a system of individual accounts, workers would manage a portion of their own Social Security contributions to varying degrees. This would expose workers to a greater degree of risk in return for both greater individual choice in retirement investments and the possibility of a higher rate of return on contributions than available under current law. There are many different ways that an individual account system could be set up. For example, contributions to individual accounts could be mandatory or they could be voluntary. Proposals also differ in the manner in which accounts would be financed, the extent of choice and flexibility concerning investment options, the way in which benefits are paid out, and the way the accounts would interact with the existing Social Security program—individual accounts could serve either as an addition to or as a replacement for part of the current benefit structure.

In addition, the timing and impact of individual accounts on the solvency, sustainability, adequacy, equity, net savings, and rate of return associated with the Social Security system varies depending on the structure of the total reform package. Individual accounts by themselves will not lead the system to sustainable solvency. Achieving sustainable solvency requires more revenue, lower benefits, or both. Furthermore, incorporating a system of individual accounts may involve significant transition costs. These costs come about because the Social Security system would have to continue paying out benefits to current and near-term retirees concurrently with establishing new individual accounts.

Individual accounts can contribute to sustainability as they could provide a mechanism to prefund retirement benefits that would be immune to demographic booms and busts. However, if such accounts are funded through borrowing, no such prefunding is achieved. An additional important consideration in adopting a reform package that contains individual accounts would be the level of benefit adequacy achieved by the reform. To the extent that benefits are not adequate, it may result in the government eventually providing additional revenues to make up the difference.

Also, some degree of implementation and administrative complexity arises in virtually all proposed changes to Social Security. The greatest potential implementation and administrative challenges are associated with proposals that would create individual accounts. These include, for example, issues concerning the management of the information and money flow needed to maintain such a system, the degree of choice and flexibility individuals would have over investment options and access to their accounts, investment education and transitional efforts, and the mechanisms that would be used to pay out benefits upon retirement. The federal Thrift Savings Plan (TSP) could serve as a model for providing a limited amount of options that reduce risk and administrative costs while still providing some degree of choice. However, a system of accounts that spans the entire national workforce and millions of employers would be significantly larger and more complex than TSP or any other system we have in place today.

Another important consideration for Social Security reform is assessing a proposal’s effect on national saving. Individual account proposals that fund accounts through redirection of payroll taxes or general revenue do not increase national saving on a first order basis. The redirection of payroll taxes or general revenue reduces government saving by the same amount that the individual accounts increase private saving. Beyond these first order effects, the actual net effect of a proposal on national saving is difficult to estimate due to uncertainties in predicting changes in future spending and revenue policies of the government as well as changes in the saving behavior of private households and individuals. For example, the lower surpluses and higher deficits that result from redirecting payroll taxes to individual accounts could lead to changes in federal fiscal policy that would increase national saving. On the other hand, households may respond by reducing their other saving in response to the creation of individual accounts. No expert consensus exists on how Social Security reform proposals would affect the saving behavior of private households and businesses.

Finally, the effort to reform Social Security is occurring as our nation’s private pension system is also facing serious challenges. Only about half of the private sector workforce is covered by a pension plan. A number of large underfunded traditional defined benefit plans—plans where the employer bears the risk of investment—have been terminated by bankrupt firms, including household names like Bethlehem Steel, US Airways, and Polaroid. These terminations have resulted in thousands of workers losing promised benefits and have saddled the Pension Benefit Guaranty Corporation, the government corporation that partially insures certain defined benefit pension benefits, with billions of dollars in liabilities that threaten its long-term solvency. Meanwhile, the number of traditional defined benefit pension plans continues to decline as employers increasingly offer workers defined contribution plans like 401(k) plans where, like individual accounts, workers face the potential of both greater return and greater risk. These challenges serve to reinforce the imperative to place Social Security on a sound financial footing which provides a foundation of certain and secure retirement income.

Regardless of what type of Social Security reform package is adopted, continued confidence in the Social Security program is essential. This means that the American people must understand why change is necessary, what the reforms are, why they are needed, how they are to be implemented and administered, and how they will affect their own retirement income. All reform proposals will require some additional outreach to the public so that future beneficiaries can adjust their retirement planning accordingly. The more transparent the implementation and administration of reform, and the more carefully such reform is phased in, the more likely it will be understood and accepted by the American people.

Conclusions

Social Security does not face an immediate crisis but it does face a large and growing financial problem. In addition, our Social Security challenge is only part of a much broader fiscal challenge that includes, among other things, the need to reform Medicare, Medicaid, and our overall health care system.

Today we have an opportunity to address Social Security as a first step toward improving the nation’s long-term fiscal outlook. Steps to reform our federal health care system are likely to be much more difficult. They are also likely to require a series of incremental actions over an extended period of time. As I have said before, the future sustainability of programs is the key issue policy makers should address—i.e., the capacity of the economy and budget to afford the commitment over time. Absent substantive reform, these important federal programs will not be sustainable. Furthermore, absent reform, younger workers will face dramatic benefit reductions or tax increases that will grow over time.

Many retirees and near retirees fear cuts that would affect them in the immediate future while young people believe they will get little or no Social Security benefits in the longer term. I believe that it is possible to reform Social Security in a way that will ensure the program’s solvency, sustainability, and security while exceeding the expectations of all generations of Americans.

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