EconSouth (Fourth Quarter 2003)


Hard Choices Ahead
for Social Security

Stock market indexes in the United States are still well below record highs despite the current economic rebound. Corporate scandals and some companies’ apparent misallocation of capital during the late 1990s clearly took their toll on equity values. As a result, many employer-provided pension plans that rely on equity investment are severely underfunded. Some observers therefore conclude that when it comes to financing retirement, there is nothing riskier than investing in equity markets.

Photo of Karsten Jeske

But what may come as a surprise to many is that Social Security — the backbone of many elderly Americans’ income — also presents some serious risks to the quality of life in retirement, though the risks are less apparent. For example, increasing the retirement age to reform Social Security finances would have precisely the same effect as a bear stock market: People would have to work longer before they could retire.

No sure thing
The only thing close to certain about Social Security is that it will run into deficits in the future. After the baby boomers have left the labor force, fewer workers will be supporting more retirees, and thus Social Security benefits paid out will, in the absence of any reform, likely exceed contributions. At that point, Social Security surpluses currently used to cushion federal budget deficits through the Social Security trust fund will turn into Social Security deficits that will drive the federal budget even further into the red. In other words, even though the trust fund may not be depleted until 2040, Social Security deficits will put significant stress on the federal budget long before then. Consequently, before 2040 something has to give: Either benefits must be cut, payroll taxes increased or the structure of the system reorganized.

Uncertainty about how and when the government will address these concerns makes Social Security risky. A huge financial burden looms a couple of decades down the road, and it is impossible to tell who will have to bear it. If young voters are unwilling or unable to pay higher payroll taxes for a large retiree population, a political majority might demand cuts in benefits previously believed to be 100 percent guaranteed.

A perfect macroeconomic storm?
Apart from demographic and political risks, Social Security is also at the mercy of macroeconomic trends. The calculations for future Social Security contributions and benefits are based on estimates for growth rates of both productivity and the labor force. Since contributions are tied to payroll employment and earnings, a sustained adverse shock to the economy could trigger payroll tax hikes and larger federal deficits. Such hikes would cause an even larger drag on the economy, and larger fiscal deficits would leave the government less room to maneuver as it uses fiscal policy to stimulate the economy. During a recession, the government could face the unpleasant choice of either breaking its promises and cutting Social Security benefits or keeping its promises by raising payroll taxes, thus deepening the recession.

Learning our lesson
The lesson to learn is that there are risks in each method of providing retirement benefits. Social Security is not insulated from risk, as evidenced by the financial burden of the baby-boomer generation that could reduce the benefits of some future generation. Less obvious is the fact that the same forces that drive capital market returns — business cycle fluctuations and long-term growth rates — also determine the vitality of Social Security finances. Those who point to the risks of the stock market and future economic growth should be equally concerned about the future of Social Security.

By Karsten Jeske, a research economist and assistant policy adviser at the Federal Reserve Bank of Atlanta

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