Reforming Social Security to Boost Contributors’ Returns and Assure Retirement Income Security

Congress and the public are rightly concerned about the long term prospects of Social Security. Future revenues flowing into the system will fall short of expected benefit payments by about 15% over the next seventy-five years, a shortfall equivalent to 2.2% of taxable wages over the period. If no corrective steps are taken before 2030, benefit payments must be cut about one-quarter in that year to keep the OASDI Trust Funds from being depleted. This does not mean Social Security pensions will be eliminated after 2030, as some young workers fear. But it does mean contributions will have to be increased or benefits trimmed if the system is to be preserved.

The straightforward and traditional solution to Social Security’s funding problem is to shave promised benefits and increase payroll taxes moderately. One sensible way to reduce future benefits is to gradually increase the early eligibility age and normal retirement age for retirement pensions. This reform is justified by the substantial increase in life spans that has occurred since Social Security was established in the 1930s. Increasing the retirement age and boosting the contribution rate are of course unpopular with voters. Unfortunately, so are all other reforms that would restore Social Security to solvency, including reducing the annual cost of living adjustment and changing the formula for calculating full pensions.

Many people now propose novel and dramatic reforms in the system. Two proposals have received wide attention. The first is to invest some of the OASDI Trust Funds in private securities in order to improve Social Security’s long-term financial outlook. The second is to establish a new system of individual, privately managed retirement accounts that could be invested in high-return private securities. Either of these approaches can push up workers’ returns—in the long run. But this can only occur if we increase the level of reserves that back up future pension promises. In other words, our retirement system must move away from pay-as-you-go financing and toward greater advance funding. This in turn will require that some Americans accept a temporary reduction in consumption, either by making larger contributions to the pension system or accepting smaller pensions.

Individual accounts have no inherent economic advantages over the proposal to accumulate a larger reserve in the existing Social Security system. There are some political advantages to accumulating additional reserves in individual accounts, but there are efficiency advantages to accumulating reserves in a single collective account, such as the OASI Trust Fund. Accumulating private assets under either approach entails financial market risks. In one case the risks are borne collectively by the government (and ultimately by all taxpayers and pension recipients), whereas the financial market risks would be borne by individual contributors and pensioners under a system of individual accounts. Since the basic goal of a government mandated pension system is to ensure workers a predictable and decent income in old age, the reform plan we ultimately adopt should be one in which the collective, defined-benefit plan provides the bulk of mandatory pensions, especially for workers with average and below-average lifetime wages. A single collective fund exposes these contributors to far less financial risk than an alternative system in which most of their retirement income is derived from individual investment accounts. Rates of return in a pay-as-you-go and funded systems.

Members of Congress and most voters recognize that Social Security is a pay-as-you-go pension program. Almost all payroll taxes collected this month are needed to pay for benefit payments that will be sent out this month. Of course, many funded pension systems also collect roughly the same amount in contributions as they send out in monthly benefit payments. The important difference between pay-as-you-go and funded systems is that pay-as-you-go systems have not salted away enough reserves to pay for the accumulated benefit promises made to workers who contributed to the system. In contrast, funded systems have enough reserves to pay for their outstanding benefit promises.

Returns for early and late contributors. Pay-as-you-go systems have a big advantage over funded systems during the early years of their operation, a fact that Congress was quick to recognize in the late 1930s and 1940s shortly after Social Security was established. The pension plan can pay for generous pensions without imposing heavy taxes on contributors, because only a small number of workers are eligible to draw pensions. Once the system becomes mature, contributors find it much more costly to pay for generous pensions because virtually the entire population past the pension age qualifies for a full pension.

Early contributors to a pay-as-you-go system obtain excellent returns on their contributions. They may contribute a small percentage of their wages for only a few years and still receive very generous pensions. Later contributors do not fare as well. They contribute a higher percentage of their wages to the fund and may be forced to contribute for 40 or more years. Yet their ultimate pensions may be only slightly larger than the ones received by workers who retired 20 years earlier and made much smaller lifetime contributions.

Just because later contributors receive lower returns does not mean they get a bad deal. Economists Paul Samuelson and Henry Aaron have shown that contributors in a fully mature pay-as-you-go pension system can expect to earn an annual rate of return on their contributions equal to the sum of the annual growth rate in the work force plus the annual growth rate of real wages. In the 1950s and 1960s the labor force was growing 1½% to 2% a year and wages were rising 2½% a year. The real rate of return on contributions was expected to be 4% to 4½% a year. That was a better rate of return than most workers earned on other investments available to them.

In 1999 the expected return on contributions to a pay-as-you-go pension system is considerably lower for young workers. The labor force is growing 1% a year, and real wages have been climbing 1% a year or less. The predicted long-term rate of return for workers who will retire after 2015 may be below 1½% a year. Workers could earn better returns under a funded pension system. In a funded system their contributions might earn 4% a year if invested in a prudent mix of stocks and bonds. Recent spectacular returns in the stock market have made alternatives to Social Security look even more attractive to many workers. If we could wave a magic wand and replace the existing pay-as-you-go system with a fully funded pension system, young workers just entering the workforce would almost certainly receive a better rate of return on their contributions. But the magic wand would also have to create trillions of dollars of reserves to back up existing pension promises, and that requires magic beyond the capacity even of Congress.

Transition to a funded system. Congress could allow younger workers to withdraw from the pay-as-you-go system and contribute to a fully funded pension system instead. But the country would still have to find a way to pay for the past pension promises of the current retirement system. The Social Security system has accumulated about $10 trillion in liabilities in the form of outstanding benefit promises. If the Treasury stopped collecting taxes for Social Security tomorrow, it would need a bit less than $10 trillion to pay for the benefit promises already made to insured workers and their dependents. The Trust Funds contain only about $750 billion in reserves, less than 10% of the amount needed to pay for promised benefits.

If the country wants to phase out part or all of the present retirement system, it will have to come up with a way to pay for $10 trillion in benefit promises. Alternatively, Congress could default on the promises, forcing retirees and workers near retirement to find some other way to support themselves in old age. Democratically elected legislators are unlikely to take this step, at least if they intend to continue holding elective office. This means the government must come up with the funds to pay for nearly all the benefit promises Social Security has already made.

Assume for a moment that Congress establishes an alternative, funded retirement system for workers under age 40 so they can obtain a higher return on their contributions. These workers will still be expected to pay for part of the $10 trillion in outstanding benefit promises that the Social Security system has already accumulated. (It is hard to see how the benefit promises can be financed without substantial contributions from people under 40.) If younger workers are excluded from receiving benefits under the old Social Security system, their real rate of return on their contributions to the old system will be -100% (that is, minus one hundred percent). To calculate young workers’ average rate of return on their contributions to the new and old retirement systems, we must calculate the weighted average return on their contributions to the two systems. It does not take a genius to recognize that when -100% is averaged with another number, the resulting average is not terribly high.

This discussion suggests that any transition to a fully funded pension system faces a big financial hurdle. The existing pay-as-you-go system has accumulated huge unfunded liabilities to workers who are already retired or who will retire in the next couple of decades. To establish a fully funded pension system for young workers, Congress must find resources to pay for existing Social Security obligations while still leaving young workers enough money to deposit in the new retirement system. If we focus narrowly on the return that young workers can obtain on their contributions to the new funded system, their expected return looks very attractive, at least compared with returns under the present Social Security system. But if we look more broadly at the return young workers will obtain on their combined contributions to the new and old systems, the return may be no better than the one offered by the existing system. For some workers, the return is likely to be worse. When the $10 trillion in outstanding benefit promises are paid off, young people just entering the work force will be spared the obligation of helping pay for those liabilities. However, it will be several decades before the bulk of those liabilities are paid off.

Individual accounts compared with a collective account

The discussion so far has focused on the rates of return obtainable in a pay-as-you-go and a fully funded pension system and the return obtainable during the transition between the two kinds of system. I have not mentioned individual retirement accounts or discussed the pros and cons of public and private management of the retirement system. These issues do not have a decisive effect on the potential rate of return of a retirement system. If we want to boost the rate of return on pension contributions in the long run, we should move toward more advance funding. In the short run, the transition to funded pensions will hurt the returns received by at least some contributors, because some people must make larger contributions or accept smaller pensions if the system is to accumulate additional reserves. The crucial step toward achieving higher returns in the long run is the move toward greater advance funding—that is, toward higher saving.

Individual accounts. Many critics of Social Security want to scale back the present defined-benefit plan and replace it partially or fully with a privately managed system of individual defined-contribution pension accounts. Such accounts could be run independently of traditional Social Security or as an additional element in the existing system. Advocates of individual accounts claim three big advantages from establishing individual accounts:

  • It can lift the rate of return workers earn on their retirement contributions
  • It can boost national saving and future economic growth
  • It has practical political advantages in comparison with reforms in existing public programs that rely on higher payroll taxes or a bigger accumulation of public pension reserves

As we have seen, individual saving accounts can boost workers’ rate of return by allowing their retirement contributions to be invested in private assets, such as equities, which yield a better return than traditional Social Security. But exactly the same rate of return can be obtained if the existing Social Security system is changed to allow reserves to be invested in high-return private assets. Put simply, the rate-of-return advantage claimed for individual accounts could be duplicated by the present system if it accumulated the same level of reserves and if its investment options were expanded.

By shifting the retirement system away from pay-as-you-go financing and toward advance funding, a system of individual accounts could boost national saving. Such a move will require a consumption sacrifice, either through a cut in benefits or a hike in combined contributions to the old and new retirement plans. Individual account plans that do not impose a near-term consumption sacrifice will not achieve a higher saving rate. Higher national saving can also be achieved by reforming the present Social Security system. The crucial change in policy is the move toward more advance funding, not the move to individual accounts. Thus, the claimed economic advantages of individual retirement accounts—higher returns and higher national saving—can be obtained either in a new individual account system or with a modification of the existing Social Security system.

In an individual account system workers would be free to decide how their contributions are invested, at least within broad limits. Contributions could be collected by a single public or semi-public agency and then invested in one or more of a limited number of investment funds. A worker might be given the option of investing in, say, five different funds—a money market fund, a stock market index fund, a real estate investment trust, a corporate bond fund, and a U.S. Treasury bond fund. By pooling the investments of all covered workers in a small number of funds and centralizing the collection of contributions and funds management, this approach minimizes administrative costs but it limits workers’ investment choices. Another strategy is to allow mutual fund companies, private banks, insurance companies, and other investment companies to compete with one another to attract workers’ contributions in hundreds or even thousands of qualified investment funds. This strategy would permit workers unparalleled freedom to invest as they choose, but the administrative, enforcement, and selling costs of such a system would be almost certainly be high, reducing the rate of return workers earn on their investments.

Risks in an individual account system

Individual account plans differ from traditional Social Security in an important way. The worker’s ultimate retirement benefit depends solely on the size of the worker’s contributions and the success of the worker’s investment plan. Workers who make larger contributions receive bigger pensions; workers whose investments earn better returns get larger pensions than workers who invest poorly.

Individual account plans differ from traditional Social Security in an important way. The worker’s ultimate retirement benefit depends solely on the size of the worker’s contributions and the success of the worker’s investment plan. Workers who make larger contributions receive bigger pensions; workers whose investments earn better returns get larger pensions than workers who invest poorly.

Because the connection between individual contributions, investment returns, and pension benefits is very straightforward in a defined-contribution individual account program, the system offers less scope for redistribution in favor of low-wage workers. Pensions financed out of individual investment accounts are based solely on deposits into the accounts (which are strictly proportional to workers’ earnings) and on the investment performance of the accounts. Redistribution in favor of low-wage or other kinds of workers must take place outside these accounts. In contrast, the Social Security pension formula explicitly favors low-wage workers and one-earner married couples in order to minimize poverty among elderly and disabled people who have worked for a full career. To duplicate Social Security’s success in keeping down poverty among the elderly and disabled, an individual account system must supplement the pensions from the individual accounts with a minimum, tax-financed pension or with public assistance payments.

The deficit risk. Some proponents of individual accounts would fund the new accounts by diverting a small part of the present payroll tax into private retirement accounts. In FY 1998, Social Security tax revenues exceeded OASDI benefit payments by $51 billion, or about 1½% of taxable earnings. Thus, 1½% of the 12.4% payroll tax could be invested in individual retirement accounts while still leaving enough taxes to pay for current pension payments. This source of financing for the new accounts will not last forever. Even if workers under age 40 were completely excluded from collecting Social Security pensions, benefit payments will exceed Social Security taxes by around 2015. In addition, workers must contribute much more than 1½% of their wages if they hope to accumulate enough private savings to enjoy a comfortable retirement. Thus, the strategy of diverting a small part of Social Security taxes can only work if current benefits are scaled back (yielding a surplus in Social Security long after 2015) and if private pension accounts provide only a modest supplement to Social Security pensions.

More ambitious individual account plans would require borrowing or new federal taxes to pay for existing Social Security liabilities. These plans would divert half or more of the present Social Security payroll tax into private retirement accounts. The Social Security benefits promised to young workers (for example, those under age 40) would be slashed. A high rate of contributions into the new private accounts would be needed to ensure that enough money is accumulated to pay for reasonable pensions. However, the diversion of payroll taxes would starve the Social Security system of revenue, forcing the program to run huge deficits. To cover these deficits Congress would be forced to raise taxes or borrow funds. The need for extra taxes or borrowing would shrink as pensioners collecting Social Security are eventually replaced by pensioners who receive benefits from the new private accounts, but this process would not be complete for several decades. In the interim, the federal government would need to impose extra taxes (temporarily replacing most of the lost Social Security taxes) or run large deficits in order to cover the shortfall in the remaining Social Security program.

Investment risk. The most commonly mentioned advantage of individual accounts is that they would permit workers to earn a much better rate of return than they are likely to achieve on their contributions to traditional Social Security. I have heard it claimed, for example, that workers will earn less than 0% real returns on their contributions to Social Security, while they could earn 8% to 10% on their contributions to an individual retirement account if it is invested in the U.S. stock market.

This comparison is incorrect and seriously misleading. First, the claimed return on Social Security contributions is too low. Some contributors will earn negative returns on their Social Security contributions, but on average future returns are expected to be between 1% and 1½%, even if taxes are increased and benefits reduced to restore long-term solvency.

Second, workers will not have an opportunity to earn the stock market rate of return on all of their retirement contributions, even if Congress establishes an individual account system in the near future. As noted above, workers’ overall rate of return on their contributions to the retirement system will be an average of the return obtained on their contributions to individual accounts and the return earned on their contributions to whatever remains of the traditional Social Security system. For most current workers, this overall rate of return will be much closer to the current return on Social Security contributions than it is to 8%.

Advocates of individual retirement accounts often overlook the investment risk inherent in these kinds of accounts. All financial market investments are subject to risk. Their returns, measured in constant, inflation-adjusted dollars, are not guaranteed. Over long periods of time, investments in the U.S. stock market have outperformed all other types of domestic U.S. financial investments, including Treasury bills, long-term Treasury bonds, and highly rated corporate bonds. But stock market returns are highly variable from one year to the next. In fact, they are substantially more variable over short periods of time than are the returns on safer assets, like U.S. Treasury bills.

Some people mistakenly believe the annual ups and downs in stock market returns average out over time, assuring even the unluckiest investor of a high return if he or she invests steadily over a twenty-year period. A moment’s reflection shows that this cannot be true. From January 1973 to January 1975 the Standard and Poor’s composite stock market index fell 50% after adjusting for changes in the U.S. price level. The value of stock certificates purchased in 1972 and earlier years lost half their value in 24 months. For a worker who planned on retiring in 1975, the drop in stock market prices between 1973 and 1975 would have required a drastic reduction in consumption plans if the worker’s sole source of retirement income depended on stock market investments. Historical fluctuations in stock market returns are displayed in Chart 1, which shows the twenty-year trailing rate of return on the Standard and Poor’s composite stock index for successive twenty-year periods starting in 1871 and ending in 1997. The historical real stock market return has averaged about 6.4%, but the twenty-year trailing return fell below 1% as recently as 1981 and reached 12% in the 1960s.

I have made calculations of the pensions that workers could expect under an individual account plan using information about annual stock market performance, interest rates, and inflation dating back to 1871. I start with the assumption that workers enter the workforce at age 22 and work for 40 years until reaching their 62nd birthdays. I also assume they contribute 2% of their wages each year to their individual retirement accounts. Workers’ earnings typically rise throughout their careers until they reach their late 40s or early 50s, and then wages begin to fall. I assume that the age profile of earnings in a given year matches the age profile of earnings for American men in 1995 (as reported by the Census Bureau using tabulations from the March 1996 Current Population Survey). In addition, I assume that average earnings in the economy as a whole grow 1% a year.

While it would be interesting to see how workers’ pensions would vary if we altered the percentage of contributions invested in different assets, in my calculations I assume that all contributions are invested in stocks represented in the Standard and Poor’s composite stock index. Quarterly dividends from a worker’s stock holdings are immediately invested in stocks, too. Optimistically, I assume that workers incur no expenses buying, selling, trading, or holding stocks. (The average mutual fund that holds a broadly diversified stock portfolio annually charges shareholders a little more than 1% of assets under management. Even the most efficient funds impose charges equivalent to 0.2% of assets under management.) When workers reach their 62nd birthdays they use their stock accumulations to purchase a single-life annuity for males. (Joint survivor annuities for a worker and spouse would be about one-fifth lower.) To determine the annuity company’s charge for the annuity, I use the Social Security Actuary’s projected life table for males reaching age 65 in 1995. To earn a secure return on its investments, the annuity company is assumed to invest in long-term U.S. government bonds. I assume that the annuity company sells a “fair” annuity: It does not earn a profit, incur administrative or selling costs, or impose extra charges to protect itself against the risk of adverse selection in its customer pool. (These assumptions are all unrealistic. Annuity companies typically charge an amount that is between 10% and 15% of the selling price of annuities to cover these items.) My assumptions therefore yield an overly optimistic estimate of the pension that each worker would receive.

The attached chart shows the replacement rate for workers retiring at the end of successive years from 1910 through 1997. The hypothetical experiences of 88 workers are reflected in this table. The worker who entered the workforce in 1871 and retired at the end of 1910, for example, would have accumulated enough savings in his individual retirement account to buy an annuity that replaced 19% of his peak lifetime earnings (that is, his average annual earnings between ages 54 and 58). The worker who entered the workforce in 1958 and retired at the end of 1997 could purchase an annuity that replaced 35% of his peak earnings. The highest replacement rate (40%) was obtained by the worker who entered the workforce in 1926 and retired at the end of 1965. The lowest (7%) was obtained by the worker who entered work in 1881 and retired in 1920. Nine-tenths of the replacement rates shown in the chart fall in the range between 10% and 37%. The average replacement rate was 20.7%. (For workers retiring after 1945 the replacement rate averaged 25.3%.)

The principal lesson to be drawn from these calculations is that defined-contribution retirement accounts offer an uncertain basis for planning one’s retirement. Workers fortunate enough to retire when financial markets are strong obtain big pensions; workers with the misfortune to retire when markets are weak can be left with little to retire on. The biggest pension shown in the chart is more than 5 times larger than the smallest one. Even in the period since the start of the Kennedy Administration, the experiences of retiring workers would have differed widely. The biggest pension was 2.4 times the size of the smallest one. In the six years from 1968 to 1974 the replacement rate fell 22 percentage points, plunging from 39% to 17%. In the three years from 1994 to 1997 it jumped 14 percentage points, rising from 21% to 35%. Social Security pensions have been far more predictable and have varied within a much narrower range. For that reason, traditional Social Security provides a much more solid basis for retirement planning and a much more reliable foundation for a publicly mandated basic pension.

The uncertainty of individual account pensions is understated in the chart, because it does not take account of the effects of inflation in years after a worker retires. In benign periods, such as the 1950s or the past few years, U.S. inflation has been low and stable. In other periods, such as the 1940s, the 1970s, and the early 1980s, inflation has been high and erratic. Since 1950, Social Security has spared pensioners from the adverse effects of big jumps in inflation, because benefit payments have been formally or informally indexed to prices. If workers were forced to buy annuities from private firms, this kind of inflation protection would be much harder to obtain. Workers could see big drops in the purchasing power of their annuities when prices rose rapidly.

Individual retirement risk. The calculations shown in the table refer to the experiences of workers who consistently invest 2% of their wages in an indexed portfolio of U.S. equities. This investment strategy has on average yielded the highest pension of the alternative investment strategies open to most U.S. workers. If instead the worker had invested a fixed percentage of contributions to corporate or U.S. Treasury bonds, the ultimate pension would have been lower, because the rate of return associated with the alternative strategy is lower than it is when all contributions are invested in equities. Of course, many workers, especially low-wage workers, are too risk averse to invest all their contributions in equities. They would instead invest some or all of their contributions in bonds or even short-term Treasury bills. Workers who selected a lower-return strategy would receive lower pensions than shown in the chart. Some workers might even earn negative returns if they withdrew their investments from stocks or long-term bonds at inopportune times.

The risk that workers might choose a particularly bad investment strategy does not arise under the present Social Security system. That system provides a minimally adequate pension for nearly all workers who make contributions over a full career, regardless of the individual worker’s investment expertise. In my view, that is appropriate in a mandatory public pension. The mandatory pension should provide a secure and adequate retirement income regardless of a worker’s investment expertise. If voters or taxpayers are concerned about the low rate of return earned under the present Social Security system, then the investment strategy of the Social Security Trust Funds should be changed to permit the funds to be invested in higher yielding assets. All of us should recognize, however, that this new investment strategy will expose the Trust Funds to greater short-run risk.


The debate about reforming Social Security should not rest on exaggerated claims about the potential gains workers can obtain from a shift to privately managed individual retirement accounts. The debate should start with a sensible discussion of the role played by Social Security in protecting the living standards of the old and disabled. For people who are (or expect to be) very well off, the role of Social Security may not seem terribly important. For the great majority of old and disabled Americans, however, the program provides a large percentage of retirement income. Low-income American families containing a person over 64 derive more than three-quarters of their cash income from Social Security. Even among most nonpoor elderly families, more than half of income is derived from Social Security. A large percentage of nonpoor families would be poor were it not for Social Security pensions.

The debate about reforming Social Security should not rest on exaggerated claims about the potential gains workers can obtain from a shift to privately managed individual retirement accounts. The debate should start with a sensible discussion of the role played by Social Security in protecting the living standards of the old and disabled. For people who are (or expect to be) very well off, the role of Social Security may not seem terribly important. For the great majority of old and disabled Americans, however, the program provides a large percentage of retirement income. Low-income American families containing a person over 64 derive more than three-quarters of their cash income from Social Security. Even among most nonpoor elderly families, more than half of income is derived from Social Security. A large percentage of nonpoor families would be poor were it not for Social Security pensions.

Social Security also provides workers with a crucial protection against the financial market risks of their other retirement savings. It is worth remembering that when the system was established in 1935, many industrial and trade union pension plans had collapsed as a result of the 1929 stock market crash and the Great Depression, leaving workers with no dependable source of income in old age. The private savings of many households was wiped out as well. Given these circumstances, it is hardly surprising that most voters thought a public pension plan, backed by the taxing power of the federal government, was preferable to sole reliance on individual retirement plans. Financial market fluctuations continue to make private retirement incomes uncertain. As a result, the argument for a continued role for traditional Social Security is strong, even for workers who earn middle-class wages throughout their careers.

The only practical way to reduce the burden on future workers of paying for retirement benefits is to raise future national income. This can be accomplished within the context of retirement policy by increasing national saving, either in the private sector or in the public sector. Many proposals to “fix” the Social Security financing problem by introducing individual retirement accounts boost private sector saving but simultaneously increase the federal deficit by an equivalent amount, leaving national saving unchanged. Some advocates of private pensions have suggested that part of the current Social Security payroll tax be diverted to private pension accounts, thus boosting private saving. Unless federal spending is cut sharply at the same time, this strategy will simply increase the federal deficit or shrink the federal surplus, reducing government saving.

The best way to improve the welfare of both young workers and future retirees is to boost national saving so that there will be more future income to divide between future workers and retirees. Some individual retirement account plans can accomplish that goal, but most would not—and many would actually reduce aggregate saving. I cannot see how elimination or sharp curtailment of Social Security pensions could ever improve the prospects of today’s younger workers. Their welfare and confidence in the system could be improved if pensions and contribution rates were promptly adjusted to keep Social Security’s promises in line with its future revenues. The returns on pension fund contributions of future workers can ultimately be improved by moving the retirement system away from pay-as-you-go financing and toward greater advance funding. But that move does not require that we move away from traditional Social Security. It requires that we take steps to increase the reserves backing up the program’s benefit promises.