The Basics of Social Security

What's the matter with Social Security ?

The fundamental problem is demographic. In 1960, there were five workers for every Social Security beneficiary. Today there are slightly more than three. In 30 years, there will be only two. That means fewer tax-paying workers to support more benefit-receiving retirees.

If tax rates and benefits remain as they are under current law, the system will begin paying out more in benefits than it collects in taxes around 2018, according to Social Security actuaries.

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Today, Social Security collects more in taxes than it spends in benefits. It invests the surplus in U.S. Treasury bonds to be cashed in when the big baby boom generation retires, a way of prefunding their benefits. Cashing in bonds will allow the system to pay promised benefits until about 2042 or 2052, depending on whose estimates one uses. If changes aren't made sooner, benefits at that point would have to be cut about 30% so they don't exceed revenue devoted to the program.

A typical worker born during the 2000s is promised about $24,300 (in today's dollars) in initial Social Security benefits at retirement, the Congressional Budget Office estimates, but there would be money to pay only $18,300.

So what's the urgency?

Although Social Security can pay promised benefits for many years, changing retirement programs abruptly is a bad idea. Workers need time to save more from their paychecks if government benefits are to be reduced, and they deserve notice about changes to the retirement age.

President Bush and members of Congress are promising that any changes they make will leave current retirees largely untouched; the same goes for workers older than 55. But the longer the government delays, the bigger the eventual tax increases or benefit cuts have to be. And putting off changes until the baby boomers are collecting benefits risks unpleasant political conflict between generations.

Over 75 years, the usual metric for Social Security , the agency's actuaries say the government has made promises that cost about $3.7 trillion (in today's dollars) more than projected tax revenue. Any such projection relies heavily on assumptions about life spans, economic growth, wages and immigration. Some critics say the Social Security actuaries are too pessimistic, particularly in forecasts about the pace of economic growth and immigration. Others counter that the trustees' expectations about life spans underestimate medical progress; if they're wrong on that, the hole is bigger.

How big a tax increase would stabilize Social Security ?

Social Security today depends on the payroll tax, income taxes collected on benefits paid to the highest-income elderly and interest on agency's holdings of government bonds. The system could be financed by other federal taxes. An immediate 15% increase in the payroll tax -- from today's 12.4% on wages to about 13.9% -- would stabilize the system for 75 years, according to Social Security's trustees (four government officials and two outsiders).

The tax rate would have to go much higher if the increase were phased in over several years. Today's payroll tax applies only to the first $90,000 of wages, a ceiling adjusted annually for inflation. That's about 85% of all wages. An alternative to higher tax rates is taxing 90% of wages -- that is, moving the ceiling to $140,000 over a decade -- which would solve about 40% of Social Security's problem.

How much would benefits have to be cut to stabilize the program for 75 years?

The Social Security trustees say it would take an immediate and permanent reduction in benefits of 13%. If the changes were phased in gradually, the cuts would have to be bigger. And fixing the program so it would be sustainable after 75 years would take even bigger changes.

There are lots of ways to reduce benefits promised by current law. The formula used to calculate a retiree's initial benefit could be altered. The annual cost-of-living adjustment could be reduced. The age of eligibility for full benefits -- which is rising gradually for workers born after 1938 and will reach 67 for workers born after 1959 -- could be increased. Benefits for upper-income retirees could be reduced. (Today, benefits of the highest-income retirees are subject to federal income taxes.)

What is President Bush proposing?

Nothing specific yet. He has ruled out raising taxes and insists on private accounts. Aides make clear that he will also seek other reductions in benefits from levels promised in current law, arguing that the promises made in current law are unaffordable.

The White House has praised an option crafted by a commission he appointed in his first term. (See the chart.) This plan would allow workers to voluntarily divert four percentage points of payroll taxes into private accounts -- up to $1,000 a year -- in exchange for smaller benefits in the future. In addition, it would reduce Social Security benefits promised to all future retirees by tweaking the formula by which wages are used to compute initial retirement benefits. And to help people at the bottom, it would sweeten benefits promised to some low-wage and disabled workers and widows.

What would private accounts do to stabilize Social Security's finances?

In the short run, they would cause a problem. Social Security depends on taxes paid by today's workers to pay today's retirees. If those taxes are diverted to private accounts, then the government has to find another way to cover those retirees' benefits. Mr. Bush proposes to borrow the money, perhaps $1 trillion or $2 trillion over 10 years.

Over the long run, private accounts are a wash, at best, for the system. Diverting payroll taxes to private accounts would reduce the flow of tax money into the system in exchange for reducing government benefits when workers with private accounts retire. That's why the White House, to the consternation of some Republicans, says the president will seek other money-saving changes to the program.

But for individuals, accepting smaller government benefits in exchange for the right to divert some payroll taxes to a private account could be a winner -- depending on the performance of the stock and bond markets. If the markets do well, growing private accounts could offset some of the likely cuts in government benefits. "Personal accounts," Mr. Bush said recently "are very important ... to make sure that young workers have got a shot at coming close to that which the government promises."

If markets do poorly, workers would be expected to absorb the losses, though there could be pressure for the government to provide a safety net.

Mr. Bush and other advocates of private accounts see them as much more than a financing scheme for Social Security . They say they would create an "ownership society" in which every worker has a stake in the economy.

Are there other sorts of private accounts?

Yes. Many Americans already have Individual Retirement Accounts or 401(k) retirement accounts. Several Democrats would expand those, creating private accounts alongside Social Security without diverting payroll taxes into them.

Brad DeLong, an economist at the University of California at Berkeley who writes a blog influential among Democrats, says: "Private accounts are a good idea. Most Americans save too little. Social Security was never intended to be all of anyone's retirement income: Everyone was supposed to have private pensions and personal savings as well. But private accounts funded by cutting Social Security contributions are a bad idea."

What are the leading alternatives to Mr. Bush's proposal?

All sorts of packages are circulating; none has garnered a critical mass of support. This is politically tricky because retirees tend to get scared even though they would be exempt. And it's always easy for politicians to postpone deciding on something that isn't an imminent crisis.

Economists Peter Diamond and Peter Orszag offer a detailed plan to raise payroll taxes to 14.2% (split between employer and employee) by 2055, increase the base on which taxes are levied, lift the age for the full retirement benefit, and trim benefits for higher-income recipients while increasing them for low-income workers.

Robert Pozen, a former Fidelity Investments vice chairman who served on Mr. Bush's Social Security commission, embraces the structure of the plan that the Bush administration praises -- but he would make it more generous to lower-income workers and less so to higher-income workers.

Sen. Lindsey Graham, a South Carolina Republican, would offer workers under age 55 a choice: Stay in today's Social Security program and pay two percentage points more in payroll taxes or accept lower benefits or divert four percentage points of payroll taxes into a personal account in exchange for accepting lower benefits. Full-time workers who took the private-account option would be guaranteed a retirement benefit 20% above the poverty line.

Two other Republicans, Rep. Paul Ryan of Wisconsin and Sen. John Sununu of New Hampshire, would allow workers to divert an average of 6.4% of wages (10% on the first $10,000 of wages and 5% on wages above that) to private accounts in exchange for accepting lower benefits. They say they would guarantee that all workers would get at least as much from combined government benefits and personal accounts as Social Security promises today. To pay for all this, they vow to restrain the growth in other government spending and count on a tax windfall from the added saving and corporate investment generated by private accounts.

What is the Social Security trust fund?

The trust fund is an accounting device, but one with enormous political significance. Franklin D. Roosevelt wanted a program that workers would see not as a welfare program, but as one into which they made contributions and got old-age pensions. "If I have anything to say about it," he once said, "it will always be contributed, both on the part of the employer and the employee, on a sound actuarial basis. It means no money out of the Treasury." The creation of a Social Security trust fund in 1939 to serve as a holding pen for worker contributions solidified this notion.

Social Security revenues began to exceed benefits after 1983 when President Reagan and Congress, accepting recommendations by a panel headed up by Alan Greenspan, then a private economist, increased payroll taxes, reduced benefits and began a gradual increase (to age 67) in the age at which workers are eligible for full benefits. This altered Social Security from a pay-as-you-go system into one that partially prefunds benefits. Last year, Social Security collected $151.1 billion more in taxes and interest than it paid out.

The growing Social Security trust fund, now about $1.5 trillion, is invested in interest-paying U.S. Treasury securities, or, essentially, lent to the rest of the government. This sometimes leads to charges that Congress is "spending" Social Security funds. But there isn't any safer investment.

If investing retirement funds in the stock market is such a good idea, why not invest the trust fund in the market?

President Clinton proposed just that, arguing that the higher returns on stocks would help solve the Social Security financial problem. The notion of putting Social Security assets into mutual funds supervised by an independent board continues to circulate. Opponents fear it would lead inevitably to undesirable government interference in business.

What about Medicare, the federal health-insurance program for the elderly and disabled?

Medicare faces even bigger long-term financial problems than Social Security and eventually will force Congress to contemplate tax increases and changes to benefits. But Medicare is even more complicated because it involves all of Social Security's demographic and intergenerational issues plus the vexing issues of rising health-care costs and ever-improving health-care technology.

Social Security "involves only money. People get a bit more, a bit less. Medicare, by contrast, involves medical treatments, which may involve risk of loss of life," says Edward Gramlich, a Federal Reserve governor who was chairman of a Social Security advisory panel a decade ago.

Write to David Wessel at david.wessel@wsj.com