Table of Contents

Introduction and the Current Social Security System 2

The Social Security Trust Fund 15

Social Security Reform Proposals 22

Transition Costs 37

Private Accounts: Pros and Cons 39

Subgroups Affected by Social Security 48

Chilean’s Pension Savings Account System 55

Pension Reform Around the Rest of the World 59

Social Security incorporates five categories of benefits: retirement, survivors, disability, dependents, and Medicare. The retirement, survivors’, and dependents’ benefits are paid out of the Old Age and Survivors Insurance (OASI) Trust Fund, while disability benefits are funded through the Disability Insurance (DI) Trust Fund. Combined, these two Trust Funds (OASI and DI) make up what is often called the Social Security Trust Fund.[1] These benefits come in the form of monthly cash payments; it is these four categories of benefits (retirement, survivors’, dependents’, and disability) that will be our focus throughout this book as we discuss the issues surrounding Social Security.

The PAYGO System and the Social Security Trust Fund

Social Security’s basic payment structure is often referred to as PAYGO: Pay As You Go. PAYGO simply means that the money you pay into Social Security in the form of taxes throughout your working life is not saved for you in some lockbox, waiting to be opened and released as soon as you retire. Instead, the taxes you pay into Social Security in any given year are used to pay the benefits of retirees during that year. When you retire, your benefits will come from the taxes paid by the workers at that time.

The set of formal accounting entries that keeps track of this system is called the Social Security Trust Fund. During years in which Social Security tax receipts exceed scheduled benefit payouts, the leftover money is reported as a surplus in the Trust Fund; during years in which tax receipts fall short of scheduled benefit payouts, assets in the Trust Fund can be used to make up the difference. (More on the Trust Fund can be found later chapters.)

A History of Revisions

Social Security is no stranger to growth, development, and reform. From the categories that merit benefit payments to the way benefits are determined, the Social Security system has evolved over time. In order to fully understand Social Security today, we must become familiar with its background.

The System’s Debut

Black Thursday, October 24, 1929. The stock marked crashed, and the Great Depression began to take shape, an ugly shape. Stocks fell, businesses failed, and unemployment soared. By 1932, one-quarter of American workers were unemployed. People were restless and looking for change, and for help. Democrats gained a majority in the House of Representatives and Franklin D. Roosevelt was elected president. It was during this time – a period in which millions lost their jobs, savings, and homes – that Social Security made its debut.

In a message to Congress on June 8, 1934, President Roosevelt announced his intention to provide a program for Social Security. On August 14, 1935, the Social Security Act was signed into law. It did nothing more than provide American workers with retirement benefits, payable in the form of a single lump-sum payment at age 65.

Social Security’s Records from the Candler Building in the late 1930s.

According to the master record, the official first Social Security Number ever assigned (055-09-0001) was assigned to a man named John D. Sweeney, Jr. of New Rochelle, New York. However, Grace Dorothy Owen of New Hampshire was the individual issued the lowest Social Security Number ever assigned (001-01-0001).

A Cleveland motorman named Ernest Ackerman retired one day after the Social Security program began and became the earliest reported applicant for a lump-sum refund. Five cents were withheld from his pay for Social Security in Mr. Ackerman’s one day of participation in the program. He received a lump-sum payment of 17 cents upon his retirement.

New Benefits and the End of Lump-Sum Payments

In 1939, amendments to the Social Security Act added two new categories of benefits: dependents benefits, which provide payments to the spouse and the minor children[2] of a retired worker, and survivors’ benefits, which provide payments to dependents left behind by the premature death of a worker. Shortly thereafter, in January of 1940, monthly payments of benefits beginning at age 65 replaced the provision of a single lump-sum check.

In 1956, amendments to the Social Security Act added the disability insurance program; after additional amendments in the next two years, the disability insurance program provided coverage to all qualifying disabled workers, regardless of age. Also in 1956, the age at which women were first eligible for retirement was lowered from 65 to 62. (The same policy was applied to men in 1961.)

A retired legal secretary in Vermont named Ida May Fuller was issued the first monthly retirement check. Miss Fuller died at the age of 100, receiving over $22,000 in benefits over her 35 years as a beneficiary.

The First Financial Trouble Strikes

Cost-of-Living Adjustments (COLAs) are annual increases in Social Security benefits that are designed to offset the effects of inflation. COLAs were originally legislated by Congress on an ad hoc basis. Thus, it was not uncommon for Congress to pass large increases in benefits at infrequent periods. The 1972 Social Security Amendments were designed to smooth out these sudden bursts of increased benefits by automatically adjusting payments for inflation each year, starting in 1975. Unfortunately, the formula used for these complicated calculations had a major error; this led to sharp increases in benefits and overspending by the program. (Given enough inflation, the miscalculation error would have eventually led people to earn more in Social Security benefits than they ever earned while working.[3])

By the mid-1970s, it became clear that Social Security faced serious long-term problems. The 1976 Social Security report projected a 75-year actuarial deficit of almost 8% of taxable payroll. In other words, the Social Security system required a payroll tax rate eight percentage points higher on average over the next 75 years beyond what was already planned to be taxed in order to match the promised benefits. In response, the 1977 Amendments corrected the indexing miscalculation that over-responded to inflation, effectively stopping the initial benefits from rising faster than wages, but still allowing the initial benefits to be wage-indexed (the benefits of each successive generation would keep pace with increases in the real wage over time). The 1977 Amendments also raised the tax rate and the cap on taxable earnings. Altogether, it was the largest peacetime tax increase in U.S. history, and it slashed the projected deficit from 8% of taxable payroll to 1.46%.[4] It wasn’t perfect, but it significantly improved the stability of the program.

The Second Financial Trouble Strikes

The simultaneous problems of rising prices and slower economic growth (called stagflation) in the U.S. economy immediately following the 1977 Amendments certainly did not help the situation. By the early 1980s, the Social Security program confronted a short-term financial crisis: estimates projected that the Trust Fund could be exhausted as early as August of 1983. In 1981, President Reagan and Congress appointed a bipartisan National Commission on Social Security Reform[5] to examine the problem and search for a solution. In 1983, the Commission suggested changes that were intended to eliminate the 75-year projected actuarial deficit[6] as well as the short-term funding problems. These changes, passed into law in the 1983 Amendments, included the first-ever coverage of federal employees and mandatory coverage for city and state employees (municipal governments could no longer opt out of the system), resulting in the most recent substantial expansion of coverage under Social Security. The 1983 Amendments also increased the payroll tax rate, made up to one-half of the value of Social Security benefits subject to income tax, and created a plan to raise the normal retirement age from 65 to 67 over a 22-year period starting for those born in 1938. Furthermore, the 1983 Amendments increased the reserves in the Social Security Trust Fund in an attempt to partially pre-fund the future retirement of the Baby Boomers.

Are the Financial Troubles Over?

In 2005, President Bush put Social Security reform at the top of his domestic agenda and the debate about whether or not further changes to the current system must be made has resumed. As you may have noticed, it appears that in each subsequent decade the United States has bitten off more and more for Social Security to chew – and, hopefully, swallow – with only a small pullback in the past two decades. This brings us to what we now have: our current system.

Our Current Social Security System

How the Wage-Tax Works

Old-Age Survivors and Disability Insurance (OASDI) is a key component of the Social Security program. OASDI is the part of the Social Security system that does not include the Medicare’s Hospital Insurance program (HI). The OASDI portion of the Social Security system and the HI portion of Medicare are financed through the Federal Insurance Contributions Act (FICA) tax. This is a payroll tax that is levied equally on employees and employers; however, as mentioned in the introduction, we are only concerned with discussing the issues involving the Social Security (OASDI) portion, and not the Medicare portion.

For 2005, the Social Security (OASDI) portion is financed by a 6.2% tax on a worker’s wages up to $90,000 per year, and a matching 6.2% tax paid by the worker’s employer. As a current worker, you might be tempted to think “but I only have to pay a 6.2% tax and that’s what matters to me”; however, most economists argue that the 6.2% tax paid by the employer leads the employer to offer lower wages, the result being that Social Security effectively amounts to a tax of 12.4% on employees.

An additional two points regarding this tax must be clarified. First, self-employed workers face the full 12.4% tax rate on their first $90,000 earned annually because they are treated as both the employer and the employee.[7] Second, the maximum earnings cap (currently $90,000) is raised annually to reflect increases in average wages.

So Why the Payroll Cap?

The Social Security tax is often called regressive because the OASDI tax is the same for a person earning $90,000 as for a person earning $90 million. For this reason, some individuals advocate raising the tax cap or even eliminating the tax cap entirely; however, before this idea gets taken too far, a few notes must be made.

First, the payroll cap exists in order to limit the amount of Social Security benefits that a prosperous retiree can receive. While it’s true that Bill Gates and Donald Trump will pay the same amount into the system as somebody earning only $90,000, they also will get benefits based just on those $90,000. This keeps Social Security from paying huge amounts in benefits to individuals who are already well off.

Supporters of an increase in the payroll tax cap say that such an increase would make the Social Security system less regressive and would at least postpone the financial difficulties projected for the system.

Opponents to a change in the payroll tax cap argue that even entirely eliminating the payroll tax cap would merely delay Social Security’s oncoming deficits by about six years. They also argue that raising the payroll tax cap would hurt middle-class families, stifle small business owners and the self-employed, weaken economic growth, and reduce job opportunities.

Determination of Benefits

We now move to the other side of the program: the determination of retirement benefits. In order to qualify for any retirement benefits at all, you have to have at least ten years of covered employment after the age of 22.[8], [9]

If you qualify, when you retire, your annual earnings are adjusted in accordance with average wages (“wage indexing”). The Social Security administration then uses your 35 years of highest indexed earnings to calculate your Average Indexed Monthly Earnings (AIME). If you didn’t work for at least 35 years, the remaining years it takes to make up 35 years of earnings will simply be entered as zeroes. If you worked for more than 35 years, the years other than your top 35 are ignored for benefit purposes. For example, if you were to work for 45 years, the taxes you pay during your 10 working years with the lowest indexed earnings (your “dropout years”) will not affect your retirement benefits at all.

Finally, your AIME is used to compute what is called the Primary Insurance Amount (PIA). The PIA is the amount that a single working person would initially receive if he or she retired at the Normal Retirement Age (NRA).[10] Future benefits are increased once per year by a factor reflecting price inflation (“price indexing”).

It is important to note that benefits are less than this calculated PIA for people who retire before the normal retirement age, and are greater than this calculated PIA for people who retire after the normal retirement age. The extent of these changes depends on how early or late you retire. The reasoning behind these benefit changes is that how early or late you retire affects how long you will likely be receiving benefits. The intent is to keep Social Security neutral, to provide neither incentives nor disincentives for retiring before or after the normal retirement age.

Marriage and Social Security

Social Security also provides spousal benefits, including but not limited to survivorship benefits. Once you reach the normal retirement age (currently 65 years and 6 months), you are entitled to receive 50% of your retired spouse’s inflation-adjusted primary insurance amount (PIA) instead of whatever your own benefits would be based on your wage history. If your spouse dies, you have the option of receiving 100% of your deceased spouse’s benefit instead of whatever your own benefit would be based on your wage history.[11]