A SHOCK TO THE SYSTEM: Social Security Reform

Monday, June 23, 2003

In 2001 President Bush established a bipartisan commission to study and report recommendations for restoring fiscal soundness to the current Social Security program. All three of the commission's models for reforming the system included the creation of individually controlled retirement accounts—a process commonly referred to as "privatizing Social Security." Some critics of the proposals argue that Social Security is not in as much trouble as the president's commission would have us believe and that major reform is unnecessary. Other critics say that creating private accounts will compound Social Security's problems rather than solve them. Who's right, the president's commission or its critics?

Recorded on Monday, June 23, 2003

Peter Robinson: Today on Uncommon Knowledge: privatizing Social Security--a solution in search of a problem?

Announcer: Funding for this program is provided by the John M. Olin Foundation.


Peter Robinson: Welcome to Uncommon Knowledge, I'm Peter Robinson. Our show today: Social Security--how much trouble is the system in and can private accounts bail it out? In 2001, President Bush established a bipartisan commission to study Social Security. Now the commission has recommended three ways of reforming the system and at the center of each lies the creation of individually controlled retirement accounts, a process commonly referred to as privatizing Social Security. Some critics charge that Social Security isn't in as much trouble as the President thinks. Others charge that although Social Security is in plenty of trouble all right, creating private accounts is not the way to go. Who's right?

Joining us, two guests. Alan Auerbach is a professor of law and economics at the University of California at Berkeley. And John Cogan is a senior fellow at the Hoover Institution who served on the President's Commission on Social Security.

Title: That's Mister Ponzi to You

Peter Robinson: Two quotations. The first from the interim report of the President's Commission to Strengthen Social Security on which you, John Cogan, served. "Social Security has been one of the most successful government programs of the 20th century." Second quotation from Nobel Prize-winning economist Milton Friedman, "In the words of the Social Security Administration," Friedman notes, he's quoting the Social Security Administration, "Workers contribute to their own future retirement benefit by making regular payments into a joint fund." Friedman says, balderdash. "The link between the payroll tax and benefit payments is part of a confidence game." One of the most successful government programs in the 20th century or a con game? Alan?

Alan Auerbach: Well, it's not a con game.

Peter Robinson: It's not?

Alan Auerbach: No, it's not a con game. It's got problems and indeed the way it's run with some generations helping other generations instead of really putting money away for their own retirement, does exacerbate the current situation.

Peter Robinson: Since it was enacted in 1935, Social Security has been sold to the public as an insurance program. You're putting a little money away for your own retirement. Isn't that a fraud in and of itself?

Alan Auerbach: Well, you might say it's a fraud or you might say it's an act of political genius. It's one of the ways that the people who started and put forward Social Security and tried to keep it going and expanding have sold it to a heterogeneous group of voters. If they had simply said this is a program which will help the elderly poor more than it'll help people who are better off and it's also something that we're going to do without funding so that you're really not paying for yourself but for previous generations, people might have been more skeptical of it.

Peter Robinson: So FDR, and every President since, has hoodwinked us and it's been to our own benefit?

John Cogan: Point one; Social Security has been successful, phenomenally successful at reducing poverty among the elderly. Milton Friedman's right. It has been sold on grounds that are not really right. In effect, the Ponzi scheme is about to end. Social Security has been financed as a Ponzi scheme and the Ponzi scheme is about over. In the next 25 years, we will have to raise taxes by about 50% in order to finance the promised benefits.

Peter Robinson: How come? Give us the demographic background.

John Cogan: Very simple. It's a very simple demographic argument. Right now there are about three workers for every retiree. In 25 years, there'll be two workers for every retiree. Moreover, retirees are going to live longer and longer. And so the burden will increasingly fall on workers to finance this benefit.

Peter Robinson: So there are just too many baby boomers to go on being supported by their own children and grandchildren at the levels at which Social Security promises. It can't work.

John Cogan: That in a nutshell is the financing problem.

Peter Robinson: Okay. Now let me push back--do you go for that?

Alan Auerbach: Yeah, I agree with that.

Peter Robinson: Okay. Let me push back a little bit. Of course, I have to quote other people because I don't know. Economist Dean Baker, "If real wage growth increased by 1% more than currently projected, that is if wage growth reverted to the rate that actually took place throughout the 1950s and 1960s," so it's not a chimera, it's part of American experience, "it would make Social Security solvent until 2060." That is to say, you're being a doomsayer, John. When you tell us the system won't work, you're giving us pessimistic projections. How do you handle that argument?

John Cogan: Very simply. Every actuary that's looked at this issue, the Social Security Commission, which the President appointed, that looked at this issue, the Social Security trustees have looked at this issue. They have all concluded that principally because of demographics, the Social Security program will not be able to deliver the promised benefits, even with higher real wage growth.

Peter Robinson: Oh so that's just...

John Cogan: Flat out wrong.

Peter Robinson: It's just mistaken. Just flatly mistaken. You go with that as well?

Alan Auerbach: Well, it's a question of how one puts the statement. He said 2060. One way of thinking about the way Social Security typically measures solvency--they do it over 75 years. You might think 75 years is a long time but actually given what's happening over that period to life expectancy and birth rates and things like that, even if we're solvent through 2060, we've still got an enormous problem because immediately after 2060, everything completely falls apart.

John Cogan: Alan makes a very good point. A lot of people think because this is a demographic problem that it's a temporary problem. When you combine the demographics with the increase in life expectancy, the Social Security problem is a permanent problem. It doesn't go away after the baby boom passes through.

Peter Robinson: A few questions now about the mechanics of Social Security.

Title: Trust Us

Peter Robinson: So the Social Security Administration reports in the spring of 2003 that it'll run a surplus until the year 2018. Between 2018 and 2028, the trust fund, which I cannot understand, will earn enough interest to pay the difference between money coming in and money being paid out. And after 2028, they have to start spending down the capital in the trust fund. And by 2042, the trust fund will be bust. The trust fund, the trust fund, the trust fund. But it's not real money that goes into the trust fund, is it?

John Cogan: Well, a lot of people think that surplus Social Security funds are in fact invested.

Peter Robinson: Right.

John Cogan: Well, they're not. The reality of government is when those surplus monies come into the treasury not to Social Security, when they come into the Treasury Department...

Peter Robinson: Right.

John Cogan: ...they are used to finance other activities of government. And for the vast majority of Social Security's history, that has been the case.

Peter Robinson: So the actual surplus that's not paid out to Social Security recipients goes whooshing off to the Pentagon or to Amtrak or to anything else the government funds.

John Cogan: Exactly.

Peter Robinson: Okay. So what's the trust fund?

John Cogan: The trust fund is merely an accounting device. It has no real financial assets. It has nothing that can be drawn down upon when the Social Security fund needs it. And so it's merely an accounting device.

Peter Robinson: Okay. And so this trust fund, which they're going to start spending down in 2018, where does that money come from?

Alan Auerbach: That comes from the general revenues of the government. That's an obligation.

Peter Robinson: So they have to tax us again.

Alan Auerbach: If the Social Security system were a private pension plan, then the pension plan would have a real trust fund and the trust fund would have bonds issued by the rest of the federal government. And so when they start needing the money, the government's got to come up with it.

John Cogan: Alan's got a good point.

Peter Robinson: What's that?

John Cogan: The way to think about what's in that trust fund is that it's a political claim on future general fund revenues. It's not an economic asset that's sitting in there that can be cashed but it is an important political claim that the system has made and it remains to be seen whether the politicians...

Peter Robinson: I don't want to push the Ponzi scheme aspect of this too hard but I do want to push one more time. First the government tells us that our Social Security payroll deductions are being set aside for our retirement and it's not true. They're being used to pay for...

Alan Auerbach: Mostly.

Peter Robinson: All right. Then they tell us that there's actually a trust fund that's building up. And that's not true either. When it comes time to spend that money from the trust fund, they'll have to tax us again to raise the revenues. That's a scam on a scam. You still like this program? I can understand that you feel you need to save it but you think that's the right way for the government to deal with the American people?

Alan Auerbach: The question is, given the situation we're in, what do we do?

Peter Robinson: Alan asked the question, given the situation Social Security is in, what should we do?

Title: To Each His Own

Peter Robinson: The President's Commission on Social Security has advanced three different ways of fixing Social Security but the centerpiece, as I read it, of each is a private account, an individually controlled retirement account. I have a feeling you like this idea better than Alan, but first explain what it means.

John Cogan: Essentially the idea behind the President's proposal that he asked the commission to devise ways of implementing--the essential idea is that individuals would be allowed, if they wish, to place a portion of their payroll taxes into broad-based stock and bond funds, thereby creating what we call personal Social Security accounts.

Peter Robinson: And that's real money? That's not a phony trust fund. That's real money in my account, in your account, Alan's account?

John Cogan: That's exactly right.

Peter Robinson: Okay.

John Cogan: So instead of having the system solely as a tax and transfer system, a portion of the payroll taxes would be invested in real financial assets. That is the nub of the President's proposal.

Peter Robinson: Okay.

John Cogan: Couple points are worth making. One...

Peter Robinson: Get ready because I wanted to ask you to comment, in principle, then we'll go into detail.

John Cogan: One is that the accounts would be voluntary. People who do not feel comfortable about investing could remain in the Social Security system as it now stands and take their chances with the political system. Individuals would, as you said Peter, they would own their own accounts. They would be able to control their accounts by investing those funds in a limited number of broad-based stock and bond funds. If they...

Peter Robinson: You have a menu of five options or three options, something like that.

John Cogan: Right. Right.

Peter Robinson: Okay.

John Cogan: And when they passed on, if they had some excess funds still in their portfolio, they could pass them onto their heirs.

Peter Robinson: So it's property.

John Cogan: And so it's their own property.

Peter Robinson: Behaves like property. It's theirs.

John Cogan: And so it's fundamentally different than the existing Social Security program where despite what we've heard, there is no property that that individual owns in their Social Security benefit.

Peter Robinson: Now the government tells people they're putting money aside for their own retirement and they are. It's true.

John Cogan: Right.

Peter Robinson: In principle, you like? Give us a reaction.

Alan Auerbach: A little, little voice in my head keeps saying there's no such thing as a free lunch and--which is something to which I think Milton Friedman would also subscribe.

Peter Robinson: Yes.

Alan Auerbach: And the first question one should ask in thinking about the privatization and setting up of these accounts, which would typically, at least in two of the three cases recommended by the commission, would come solely from payroll taxes. Where will the money come to pay for the current retirees? Remember we have this system. And the answer is it's got to come from somewhere else. So whatever the benefits might be of setting up these private funds and I think there are benefits that John has mentioned. I think there are also costs. There's the additional problem that we have to keep in mind, which is that we're talking about a shift from a public to a private system but we haven't overcome the basic problem of the public system, at least the funding problem of the public system, which is that one generation is paying for a previous generation. If that generation starts paying for itself, who's going to pay for the previous generation?

Peter Robinson: Let's explore this issue of transition costs a little bit more.

Title: The Short End of the Stick

Peter Robinson: Your colleague at Berkeley, Janet Yellen, "If Social Security is privatized so that the younger generation diverts part of its taxes into individual accounts, then the government must finance at enormous cost the retirement of the older generation. It's like a family that hands down clothes from one brother to the next, if somewhere along the way one brother gets to keep his clothes, then the other brother has to go to the mall." So, John, are we all going to have to go to the mall? Is the younger generation going to have to set aside money for its own retirement and that of grandma and grandpa?

John Cogan: The problem that Alan's identified and Janet has identified is a real one. There is no free lunch. But the way to think about what we're doing is transforming a retirement system from a tax and transfer system to a system that is investment based. And anybody who knows anything about setting up a retirement program knows that the better system is one that's investment based. And so yes there is a cost in some sense. In the President's proposal, we weren't privatizing Social Security. The President's plan envisions about 25% of the current payroll tax being put into personal accounts.

Peter Robinson: You have a cap of up to $1,000...

John Cogan: Per individual.

Peter Robinson: Per individual and that's in all three of your plans.

John Cogan: Yes I believe it's in all three of the plans.

Peter Robinson: I think it's in all three. Right. Okay.

John Cogan: And so the 75% that still remains in the traditional part of Social Security would go towards financing the current retirees' benefits.

Peter Robinson: Right.

John Cogan: So what the commission was doing was in a sense, using the fact that we now have a surplus, a surplus in Social Security and we're expected as you said, to have a surplus for another ten to fifteen years.

Peter Robinson: Right.

John Cogan: Use those surplus funds as a way of at least financing part of the transition costs. Those funds are funds that are not needed to pay the retirement benefits...

Peter Robinson: He still hasn't funded all the transition costs.

Alan Auerbach: No, and other ways of doing it would include cutting back, in one way or another, cutting back on the benefits of the existing Social Security system as we make a transition.

Peter Robinson: Is it possible to pay for some of those transition costs just by lengthening the period before you can start collecting Social Security benefits--what I've seen is if you lengthen that period just very modestly...

Alan Auerbach: Of course.

Peter Robinson: ...even by six months but you can get over the hurdle, right?

Alan Auerbach: But I think to clarify, there are two separate issues here.

Peter Robinson: Okay.

Alan Auerbach: One is the funding problem of the current Social Security system.

Peter Robinson: Right.

Alan Auerbach: The other is whether we should move to a private system.

Peter Robinson: Okay.

Alan Auerbach: Anything that will--for example, lengthening the working term before you can retire--anything that will help you solve the transition problem--doing that, indexing benefits to the price level instead of wages, those things will help you pay for a transition to private system. They'll also help you pay for the current system as it is.

Peter Robinson: Okay, but in principle then--let's isolate this one question. In principle, would you favor a transition to a private system or is there some notion and some way in which you find that offensive or risky or...

Alan Auerbach: First of all, I think it's better to talk about, as the commission has, talking about partially moving to a private system because I don't think politically we're ready for it and I don't think we've thought about all the consequences of moving entirely to a private system. Even so, with moving to a private system and leaving aside the fact that with no free lunch, we still have to come up with a way of solving the financial problem just as we would under the existing system.

Peter Robinson: Right.

Alan Auerbach: There are other problems. And I'll give you an example. We're talking about a quasi-governmental program, more private than Social Security but one where the government is still standing behind the program. It's your account but it's under the aegis of the government and Social Security system. Now you can think of many scenarios where different people make investment choices even within the range of assets that will be carefully arranged to keep dangerous investments out.

Peter Robinson: Right.

Alan Auerbach: Maybe the market will go up. Maybe the market will go down. And if the market goes up during--it does very well in the period before retirement, the people who've invested in equity, they're going to love it.

Peter Robinson: You're golden.

Alan Auerbach: And unfortunately then the people who invested in bonds are going to be very unhappy and they're going to ask the government why they weren't advised to invest in equities. You can flip it around and ask what happens if the market goes down, you're going to have a group of unhappy people and a group of happy people. This happens in the private sector too but in the private sector, you can't go to the government and say, make me whole.

Peter Robinson: Alan brings up an important point, just how would risk be managed under a regime of individual retirement accounts?

Title: Risky Business

Peter Robinson: What happens when under your system of private accounts the market tanks and you get a group of people who are going into retirement with less--and they suddenly get on the phone to their congressman and the taxes go up to make them whole, right?

John Cogan: Right. Easy answer. Turns out that no one who has proposed a system of personal accounts that I'm aware of within the congress or with the previous administration or certainly the commission--proposed that individuals be allowed to pick individual companies. The idea is only permit individuals to invest in broadly diversified stock and bond funds to minimize that risk. What our analysis of the history of the market has indicated quite strongly is that if you invest in a broad based stock or bond fund, you can minimize the risk. The lowest return in real terms, after inflation, the lowest return on a 30-year investment in the stock market in the last 200 years is 2.6% real, which is better than what a Social Security recipient who retires today with a fully funded system today, can expect to get. Now...

Peter Robinson: Feel better?

Alan Auerbach: I live on the Hayward Fault; we haven't had an earthquake in 150 years.

John Cogan: Some of us over on this side of the peninsula would say we just had an earthquake with the collapse of the stock market, the end of the bubble. Well before this show, I went back and I looked at how would an individual who retired last year have done if they had invested in the stock market starting 20 years ago and then starting 30 years ago?

Peter Robinson: So they'd retire just after the bubble burst?

John Cogan: Right.

Peter Robinson: All right.

John Cogan: After inflation, real rate of return for a person who invested 20 years ago in the S&P...

Peter Robinson: Beginning in the '80s so that's a good time to start.

John Cogan: Good time to be putting in. 9.6% real, which is...

Peter Robinson: After the bubble.

John Cogan: ...which is about 12% with inflation in annually. Well, the 1970s we would say was not a good decade to be in the market at all. So if you put your money in in 1972, how much...

Peter Robinson: You spent a whole decade making nothing, right?

John Cogan: Right.

Peter Robinson: Right. Okay.

John Cogan: Again the after inflation real rate of return 5.7%, more than twice what an individual could expect to get.

Peter Robinson: If you're going to poo poo him, poo poo him fast because it's television. We've got to move. Go ahead.

Alan Auerbach: Look, you buy insurance for your house in the event that it burns down. Houses don't burn down very much, very often. You can go 200 years and look at an old house and the house has never burned down. That doesn't mean it's not going to burn down. And the same thing is true of equity markets. You've talked about the 1970s and '80s in the U.S. You haven't talked about Japan. You could probably have done pretty badly in Japan. So leaving aside the political sense of loss that maybe people have done okay but they think they should have done better--there really is a chance that you could go through a depression or you could go through a very, very serious downturn in the stock market, more prolonged than we've had in recent years.

John Cogan: Well, your idea of having this and the idea of others of having a two-tiered system where you retain the traditional part of Social Security, shore up its anti-poverty capabilities and allow only a portion of the payroll taxes, the financed personal cap, is a way of guarding against that kind of risk.

Peter Robinson: Final topic, the politics of Social Security reform.

Title: The Third Rail Unplugged

Peter Robinson: Used to be this horrible old cliché, that Social Security was the so-called third rail of American politics, any politician who mentioned it would be electrocuted. And here you have George W. Bush, is he going to make much of this in a reelection campaign or wait for a second term?

John Cogan: I suspect he will make a lot of it and I...

Peter Robinson: In 2004?

John Cogan: Yes, and I believe that his Democratic opponents will make a lot of it.

Peter Robinson: So what on earth has changed? Why is it that now we're talking about Social--and you've got a President who appoints Cogan here and the late Patrick Moynahan and 14 other people to spend months and months coming up with this program and it calls for reform. And some people, including you--but he's doing it.

Alan Auerbach: I'm more skeptical that there's going to be a lot of discussion of Social Security during the campaign. I think particularly given the problems we've had in the stock market in recent years, a lot of the enthusiasm that supporters of privatization have will have cooled, perhaps irrationally so. But I really don't think it's going to be on the agenda. I think he's going to--if he brings it up, Democrats will emphasize it and use it against him. And I really don't think it's going to be a campaign issue.

Peter Robinson: But you believe as someone who's advised George W. Bush personally during the last presidential campaign, served on this commission, you believe as a political matter that this is a winner for him?

John Cogan: More importantly since I couldn't get elected dogcatcher, the President believes that it's a political winner. Not only does he see...

Peter Robinson: What's he thinking? He's got young people that it appeals to? What's he thinking?

John Cogan: Yes. In fact, if you look at the polls--there is a national public radio poll of about a year and a half, two years ago. What it showed was that support for personal accounts among individuals less than age 45, 2 to 1...

Peter Robinson: Really?

John Cogan: ...among individuals age 45 to 55, I believe...

Peter Robinson: 2 to 1 the other way?

John Cogan: ...is about 1 to 1.

Peter Robinson: Oh, 1 to 1.

John Cogan: The only group that opposes Social Security reform significantly is those individuals over the age of 65.

Peter Robinson: So we wait 20 years, they're gone, no? Go ahead.

John Cogan: There will be another group of people age sixty-five to replace them. Now what I think accounts for that is the fact that individuals over the age of 65 are worried that reform means a reduction in benefits.

Alan Auerbach: They have nothing to gain. They have nothing at all to gain.

John Cogan: And a prospect there's something to lose.

Peter Robinson: It's television so this is the last question. Give me a prediction. 2008, let's assume--you may wrestle with this assumption if you want to, but let's assume George W. Bush gets reelected--2008 as he leaves office after a second term, will one of your three proposals, each of which calls for private accounts, have been enacted?

John Cogan: We will see personal accounts as part of a modernized Social Security program. Whether it'll be one of the specific recommendations of the commission or not, unclear.

Peter Robinson: But that'll happen before George W. Bush leaves office if he's elected.

John Cogan: Absolutely. He had three main domestic priorities when he campaigned in 2000, tax cuts, education reform, Social Security reform. We've had tax cuts; we've had education reform. There's only one reform left.

Peter Robinson: And that Texan means what he says?

John Cogan: You got it.

Peter Robinson: Alan, what do you think?

Alan Auerbach: I think it's possible and I think we're just as likely to have little changes...

Peter Robinson: Let me ask you two questions and then the show's over. Question number one is, has George W. Bush made a mistake? He's got this commission, he's got results here, he's got models and so forth, proposals, is he going to say wait a minute or is Karl Rove his political advisor going to say wait a minute, let's just put this in the top drawer and bring it out as something to include in your memoirs when you start writing them in 2009 as a former President. Will he back pedal a little bit on this?

Alan Auerbach: I think that's the most likely outcome.

Peter Robinson: You do?

Alan Auerbach: Yes.

Peter Robinson: Okay. So by 2008, we got nothing?

Alan Auerbach: I think that's most likely. I think we may have something in the form of changes in the calculation of benefits and other things like that to make the system more solvent but nothing as major as this.

Peter Robinson: Gentlemen, in 2008 we will reconvene this panel and discuss what actually happened. Alan Auerbach, John Cogan, thank you very much.

John Cogan: Thank you, Peter.

Alan Auerbach: Thank you.

Peter Robinson: I'm Peter Robinson, for Uncommon Knowledge, thanks for joining us.