Thursday, November 5, 2015

Social Security Reform—Some Solutions are More Sustainable than Others

As discussed in my posts of March 1 and May 3 of this year, I occasionally get drawn into commenting on US Social Security System financing issues. While these issues are somewhat technical, I believe they are important and, in the long run, can affect many of the individuals who visit my site looking for advice regarding budgeting in retirement.  Therefore this post will be another Social Security financing article with the purpose  of warning my U.S. readers  about frequently made claims regarding the long-term sustainability of specific reform proposals.  As we get closer to 2034 (the trust fund exhaustion date expected for Social Security under the intermediate assumption set selected by Social Security actuaries and the System’s Trustees in the most recent Trustees’ report), we are seeing a rash of proposals to solve the System’s financial problems.  Many of these proposals quantify just how much of the System’s “funding problem” will be solved by a specific reform proposal.  For example, in the American Academy of Actuaries recently released “Social Security Game,” the Academy states that raising the payroll tax from 6.2% to 7.4% (for both employees and employers) “will solve 85% of the problem".  Further, if you combine that change with a 1% decrease in the cost of living increase, the Social Security Game will tell you, “Congratulations, You have won the game by fixing Social Security.” 

While I understand the Academy’s desire to engage the public in a discussion about Social Security’s reform options, I am concerned that statements such as these can mislead the public and our policymakers.  I was frankly surprised (and more than a little disappointed) that my profession (a profession that claims to serve the public, one that stresses sustainability in our financial systems and one that has stated it “believes that any modification to the Social Security system should include “sustainable solvency” as a primary goal) is ignoring the concept of “sustainable solvency” and is claiming in this “Game” that eliminating Social Security’s current 75-year actuarial deficit will solve Social Security’s financial problems.  It should be noted that the Academy is not the only organization to utilize the 75-year actuarial deficit in this manner.  

While reducing the 75-year actuarial deficit is a reasonable first step, there are two problems with any proposed reform
options that simply reduce Social Security’s 75-year actuarial deficit to zero: 

  1. Given the projected costs of the program, limiting the actuarial balance calculation to 75 years ignores projected annual deficits expected to occur after the end of the 75-year projection period.  Over time, these deficits will emerge in the actuary’s annual calculations.
  2. There exists no process in current law to automatically adjust the System’s tax rates to maintain a balance between system assets and system liabilities.  Imbalances (in the form of deficits in the annually calculated 75-year actuarial balance) may occur as a result of the previously unrecognized deficits mentioned in Problem #1 above, or because of changes in assumptions, experience losses or gains, or from other sources. 

We need look no further than the 1983 Amendments to Social Security (which eliminated the 75-year actuarial deficit in existence at that time) for an example of how these two problems interacted to put us in the financial position in which we presently find ourselves.   Social Security Administration Actuarial Note Number 2015.8 tells us that of the total increase in the 75-year actuarial deficit of 2.69% of taxable payroll since 1983, 70% of the increase (or 1.90% of taxable payroll) was attributable to changes in the valuation date (problem #1 above), leaving 30% (or .79% of payroll) attributable to all other causes.  Since no action was taken in response to these emerging deficits over the past 31 years (problem #2 above), we are now looking at projected trust fund exhaustion in 2034 under the best estimate assumptions. 

As a result of these two problems, Social Security is now looking at a shortfall of projected revenues compared with projected expenditures.  And we have unlimited supply of possible actions that Congress can adopt to address this shortfall, generally involving some combination of revenue increases and expenditure decreases.  Because it was discussed on page 25 of this year’s annual Trustees’ Report, I’m going to focus on two alternative reforms involving only tax increases.  I’m doing this to illustrate reform option concepts, not to recommend that reform options should only involve tax increases.   The same concepts generally apply if expenditure reductions or combinations of revenue increases and expenditure decreases are adopted. 

The graph below shows two alternative tax rate scenarios that would be expected, if all the intermediate assumptions made in the 2015 Trustees’ report were exactly realized over the next 75 years, to cover projected System benefits over the next 75 years, leaving almost no trust fund at the end of 2089.  Under the “wait for trust fund exhaustion” alternative, we would keep the tax rate at its current combined employer-employee level of 12.4% until 2034 at which time it would increase to 16.1% and then gradually increase thereafter (I have assumed straight-line increases) to 17.4% in 2089.  I have also assumed that the necessary tax rate for years thereafter would remain at the 17.4% level.   The second option shown in this graph is the “75-year solution (2015)” which reduces the 2015 75-year actuarial deficit to zero by increasing the current tax rate from 12.4% to 15.02% in 2015.  Since this solution only lasts for 75 years, the graph shows that the tax rate would also need to be increased in the year 2090 to 17.4% when the trust fund accumulated under this option would be expected to be depleted.  This graph illustrates a very important financial principle:  the magic of compound interest.  Even for a program that many experts claim is a pay-as-you-go system, you can pre-fund your liabilities.  By contributing 15.02% for 75 years, you can avoid higher tax rates for the period 2035 to 2089.  The concepts illustrated in this graph are also used by individuals who argue that fixing the system now can avoid higher tax rates or lower benefit levels later on.  Of course this same argument can be employed by those who would like to see smaller periodic adjustments to the program rather than infrequent large increases (to address Problem #2).


(click to enlarge)

In an effort to deal with Problem #1 above, the Office of the Actuary of the Social Security Administration developed the concept of “sustainable solvency.”  Under this concept, “the projected trust fund ratio is positive throughout the 75-year projection period and is either stable or rising at the end of the period (emphasis added).”  As with other ways to solve system problems, there are a number of ways that sustainable solvency can be achieved.  For example, in addition to a 75-year solution, you could adopt additional tax rate increases that take effect 65 or 70 years from now so that the relatively low trust fund ratios at the end of the period remain stable at the end of the 75-year period.  Because there exist many different ways to achieve sustainable solvency, the Trustees’ Reports do not quantify changes necessary to achieve it.  Also, for this reason, organizations like the American Academy of Actuaries focus only on communicating the presumably more quantifiable 75-year solutions.  It should be noted, however, that even though adoption of a reform package that achieves sustainable solvency will address Problem #1 above, it does not address Problem #2 above.  
The graph below modifies the graph above by inserting a third line, labeled “sustainable solvency solution (2015)”.  This line is estimated by me.  As discussed above, there are many different approaches that could achieve sustainable solvency, but I have selected one (a level tax rate similar to the approach used for The Canada Pension Plan) that I would expect to meet the criteria for sustainable solvency under the assumptions described above.  This approach would involve an immediate 3.6% of taxable payroll increase in the current tax rate of 12.4% to about 16%.  By comparison, the 2015 Trustees’ report indicates that the shortfall over the infinite projection period is 3.9% of taxable payroll.  Note also that this graph could have a fourth line representing a combination of the 75-year solution and periodic increases after 2015 to address the expected deficits that would occur as a result of Problem #1.  This line would be expected to start at about the 15% of pay level and slowly increase as deficits are recognized.  This fourth line would be expected to end above the sustainable solvency (2015) line and below the 75-year solution line. 


(click to enlarge)

Conclusion—Some Solutions are More Sustainable than Others

In its Public Policy White Paper, Sustainability in American Financial Security Programs, the Academy’s Public Interest Committee said, “Sustainability is enhanced when the funding source and the benefits promised remain balanced over the lifetime of the program.”  I agree and further believe that Social Security solutions that anticipate significant tax increases in the future (other than perhaps ones to phase in tax increases over a relatively short time period) to support promised benefit levels are less sustainable than approaches that don’t.  For this reason, I caution readers to question 75 (or lower)-year solutions, and, as part of the next round of system reform, I encourage policymakers to adopt an automatic approach designed to maintain the balance between system assets and liabilities in the future.  As suggested in my May/June, 2015 Contingencies article, we can learn a lot about sustainable solutions in the U.S. from the actions taken almost 20 years ago to reform The Canada Pension Plan.  In furtherance of its mission, I also encourage the Academy to advocate these more sustainable solutions rather than appearing to endorse problematic 75-year “solutions” in their “Game.”