Without changes, the Social Security payroll tax will stop raising enough money to meet the system’s pension payment obligations in 2018, just 13 years from now. This funding shortfall can be corrected with only modest adjustments, if action is taken now. Indexing retirement benefits on the consumer price index rather than the average wage increases would eliminate most of the shortfall and modestly and gradually increasing the retirement age a few years would reduce the rest. Other adjustments are also being discussed. The change in the benefit index would reduce the planned increase in benefits and leave the real value of current benefits unchanged. Choose which ever way of saying it that sounds best to you. Both are correct.
The issue of privatizing or otherwise reforming the nature of the system is another matter all together. Evaluating such reforms calls for a clear understanding of the purposes we wish Social Security to achieve. Before we can intelligently debate whether SS should be a fully funded insurance program (whether with a defined benefit or a defined contribution) or continue as a pay-as-you-go entitlement, we need to debate the role we want it to play in our overall system of retirement income.
Traditionally most Americans’ retirement incomes come from employer based pensions and individual savings (home ownership, whole life insurance, and other investments). Schools taught the need for proper preparations. On August 14, 1935, when the country was still struggling to overcome the Great Depression, President Franklin D Roosevelt added a mandatory government pension when he signed the Social Security Act. In addition to old age pensions, the Act established unemployment compensation, and aid to children and to the ill.
Roosevelt intended for the old age pension provided by Social Security to be a mandatory, defined benefit pension financed by the contributions of the pensioner and his employers over his working life. The system provided a guaranteed minimum pension for those who worked and paid into it. However, the relationship between what a person paid in and ultimately received was never close. Those at or near retirement when the system started were allowed benefits that were financed by young workers who would not draw their own benefits for many years. Pay-as –you-go financing is the cause of the upcoming financing problem as baby boomers swell the ranks of the retired. “As a result, the ratio of workers paying Social Security taxes to people collecting benefits will fall from 3.3 to 1 today to 2.1 to 1 by 2031.”[1] It was over 8 in 1955. The tax burden on those currently working is raising fast.
In its current form, Social Security’s old age pension is a complicated structure that is neither a sound insurance or pension scheme nor a well-designed and targeted safety net. The payroll taxes that finance it “account for more than 25% of all federal revenue; its payments represent more than 20% of all federal spending. For almost two-thirds of American’s pensioners, Social Security payments make up over half their income.”[2] As a social safety net, it does not target benefits or redistribute income in a clear and defensible way. As a compulsory, government administered pension, it is not financially sound and is considered by many to be an inappropriate and unnecessary government intrusion into private life.
How the system should be reformed, if at all (rather than merely fixing its demographic based financing problems), depends on how as a nation we answer the following questions: “Is Social Security a planning vehicle that an individual uses for his or her own retirement, or is it a pooling of resources so that all of society can meet the needs of its older members? Is it about each person saving for himself, or is it a matter of young helping old and rich helping poor?”[3] Should Social Security be part of the social safety net that Ronald Reagan spoke of for a society in which individuals and families are basically responsible for their own lives, or should it be an instrument of collective social responsibility for public welfare? The attitudes behind different answers to these questions reflect the great divide that has always separated (in varying degrees) Republicans and Democrats. But there may be a proper place for each view.
World Bank research found “that financial security for the old—and economic growth—would be better served if governments develop three instruments, or ”pillars,” of old age security: a publicly managed pillar with mandatory participation and the primary goal of reducing poverty among the old; a privately managed, mandatory saving system; and voluntary savings. The first covers redistribution, the second and third cover savings, and all three coinsure against the many risks of old age. By separating the redistributive function from the saving function, the amount of spending in the public pillar—and the tax rate needed to support it—can be kept relatively small. Spreading the insurance function across all three pillars offers greater income security to the old than reliance on any single system.”[4]
“A central recommendation of the [World Bank] report is that countries should separate the saving function from the redistributive function and place them under different financing and managerial arrangements in two different mandatory pillars—one publicly managed and tax-financed, the other privately managed and fully funded—supplemented by a voluntary pillar for those who want more.
“The public pillar would have the limited object of alleviating old age poverty and coinsuring against a multitude of risks. Backed by the government’s power of taxation, this pillar has the unique ability to pay benefits to people growing old shortly after the plan is introduced, to redistribute income toward the poor, and to coinsure against long spells of low investment returns, recession, inflation, and private market failures.”[5]
For the United States, the World Bank’s advice suggests a much smaller public pillar (the existing Social Security system), targeted on the poor (means tested) whether they had worked and contributed to retirement income or not. It would be financed from the government’s general revenues, not from wages if there were any. This social safety net would be supplemented by the second, mandatory savings pillar, which should sharply limit the need to resort to the first pillar. This mandatory, defined contribution, second pillar would be satisfied by qualifying (and regulated as now) company pension funds, 401K plans, or social security tax contributions to private mutual funds. Reasonable, but not excessive, restrictions and safeguards would be required. Recent experiences with pensioner losses with defined benefit pensions when their employer goes bankrupt indicate that further reforms of the private pension system are still needed as well.
The system would insure that those who could, i.e. those with jobs, would save enough for minimally acceptable levels of retirement income, but would still protect those who had not adequately protected themselves, whether from inability, short sightedness, or bad luck. Allowing workers to manage more of their retirement savings has several advantages. More would be invested in stocks and private bonds, which historically have yielded more on average than government bonds. Such savings would be part of the pensioner’s estate and any unused part would be passed on to his/her heirs. Both the reduction in wage taxes and the real savings of private pensions would tend to increase the supply of labor and national savings and investment, and thus economic growth. Fully funded benefits from saving would be free of the demographic problems now besetting our pay as you go system. Benefits from the second tier would be closely related to contributions, which would tend to increase saving (and economic growth) and to be seen as fair. Workers would become capitalists and thus potentially more sensitive to the health of the economy. Those who could not contribute enough, or experience poor returns on their investments would be protected by the first, public pillar.
President George W. Bush’s current proposals for Social Security combine both financial fixes for the existing system and substantive reform of the system by introducing “personal accounts.” His recent proposals may be seen as transitional steps to the above system. However, like the existing system, current proposals constitute a mixed and rather incoherent collection of ideas. The final result will be more satisfactory to everyone if the details now being debated contribute to a coherent overall three pillar plan for the provision of retirement income and medical care.
[1] “Fast Facts and Figures About Social Security, 2004,” U.S. Social Security Administration. http://www.ssa.gov/policy/docs/chartbooks/fast_facts/2004/ff2004.html#financing
[2] “How to mend Social Security,” The Economist, February 12 2005 p 10.
[3] Steven Mufson, “FDR’s Deal, In Bush’s Terms,” The Washington Post, February 20, 2005, page B3
[4] “Averting the age old crisis for the old,” World Bank Policy Research Bulletin, August – October 2004, Volume 5, Number 4. http://www.worldbank.org/html/dec/Publications/Bulletins/PRBvol5no4.html
[5] Ibid.
Warren's space 
Warren,
Even indexing SS benefits by the CPI will result in real benefits increasing. The CPI would be correct only if all prices increase at the same rate. Since they don’t consumers engage in substitution. Indices that correct for the substitution effect have been developed by Erwin Diewert and others at least 20 years ago and the discussion papers are sitting somewhere in the archives of BLS.
Of course your larger point is that SS is Stupid; it’s not a good Safety net, it decreases private Savings, and it is not Sustainable. It was created for political reasons. Whenever an administration increases the program, it is able to giveaway free money to court seniors, and juniors don’t mind so much since they imagine getting large benefits themselves. The fundamental economic reason for SS, but not pay-as-you-go SS, is that, under cradle-to-grave welfare, people are incentivized to under-save and throw themselves onto the mercy of the state if things go badly (or they live longer than expected). But that motive is well served by a fully-funded system of mandatory savings, with means-tested supplementary contributions funded by general revenues. Some devilish details would need to be worked out: Would allowable 401k investments exclude “excessively risky” portfolios? Would the means test be on income, wealth, or income averaged over a period of years? How big would the qualified savings portfolio have to be before the contribution requirement is waived?