Should Social Security Be Group Insurance, or Individual?

The Time Is Coming Eventually, the United States will confront the problem of Social Security funding.

Americans may be pardoned for distrusting criticism of the Social Security Administration’s health. They have been warned for decades by Wall Street investment salesmen that Social Security won’t be around when they retire. (When I joined Morningstar in 1988, that was already a familiar refrain.) Yet every year since the early 1980s, Social Security’s inflows have exceeded its costs. The Social Security trust fund has never been larger.

Eventually, though, the wolf will arrive. It cannot be prevented, as the system is currently structured. In 2019, Social Security’s expenditures will exceed its income, causing the system to tap into its trust fund. The event will not be temporary. As the nation’s retiree-to-worker ratio continues to rise, the trust fund will continue to fall. The SSA currently estimates that the fund will be exhausted in 2035.

More Revenue There are two ways to ensure Social Security's long-term health, one being to pay more into the system, and the other being to receive less. (Supply-siders advocate paying less to receive more, and free marketers would invest Social Security's receipts into equities, but they likely will be shut out of the debate.)

There aren't many options for boosting revenue. Social Security could be maintained by supplementing the program's receipts with other federal revenue. In practice, that seems unlikely. If you were in the workforce, would you accept sending an ever-increasing share of your paycheck to retirees, in addition to funding Social Security through the standard payroll deduction? Me neither.

The other option is raising the payroll tax. I imagine that will occur, with, for the sake of compromise, the cost split equally between the employee and employer. But there is a limit to how steep the increase can be.

Fewer Outflows There are more ways to cut benefits--and they will be needed. If current projections hold, the demographic prospects are frightful. In a voluminous global study, population scientists estimated that by 2100, the U.S. worker-retiree ratio will decline from its current ratio of 4.5 to 1, to 1.9 to 1. True, the century's end remains far away, but such trends change direction only slowly. The authors considered it "unlikely" that their forecasts would greatly miss the mark.

One plan for reducing benefits is to give everyone the same haircut. Directly lowering Social Security payments would raise a ruckus. Freezing benefits by eliminating cost-of-living adjustments could work, though. Such an approach would not only improve Social Security’s finances, but would also align with most retirees’ spending patterns, which--aside from healthcare costs--are highest in the early retirement years, and then decline over time.

(Mathematically, receiving a 2% pay cut when inflation is 1% is equivalent to receiving no raise when inflation is 3%. Most people not being mathematicians, they bitterly resent the former, and reluctantly accept the latter. Economists call this condition "nominal rigidity.")

Another solution is to raise the eligibility date. This has the advantage of sounding entirely reasonable. People today live longer, so why should they not work longer? It has the disadvantage of being difficult to implement. Many who are approaching the 70-year market are either not healthy enough for full-time work, or (more likely yet) not desired by employers. Their work prospects are dim.

The combination of a tax hike, benefit freeze, and (perhaps) increase in the age of eligibility would shore up the SSA temporarily, but not permanently. A long-term fix appears to require an answer to this column’s headline: Should Social Security serve as group insurance, or individual? The question is overdue for a response.

Disaster Insurance? Perhaps Social Security is group insurance. That is certainly how the program is structured. An employee's payroll taxes--and those paid by her employer--are not placed in an individual account, as with a 401(k) plan. In fact, they do not even go into a commingled account. Those monies enter the general SSA pool and are either promptly paid, or dropped into the administration's rainy-day trust fund. That looks and feels like a collective endeavor.

Which is indeed the goal, respond group insurance’s supporters. Social Security is not just an individual’s safety net. The program also protects society against the turmoil that occurs when people are hopelessly, desperately poor. By this reading, Social Security’s finances can be salvaged by robbing the rich to give to the poor. To put the matter more gently, one can means-test the benefits.

During his 2016 presidential campaign, Chris Christie proposed means-testing for those making more than $80,000 per year, and eliminating Social Security payments entirely for workers earning over $200,000. That of course is but one of many potential formulas, but it illustrates the basic framework. Think of Social Security as a form of fire insurance. No catastrophe, no benefits. And base the evaluation on income, rather than on assets (which may more easily be hidden).

Or Baseline Savings? The alternative to group insurance, advocated by Baylor professor William Reichenstein, is that Social Security become more of an individual plan. (His article "Social Security Reforms" sparked this column.) As Reichenstein points out, today's Social Security structure incorporates large transfer payments; the rich already subsidize the poor, in some cases substantially. Reducing those transfer payments would help to stabilize the SSA's finances.

For example, he calculates that unmarried workers who make $35,000 annually for 35 years can expect to receive $1.86 in Social Security benefits for every tax dollar that they pay into the system. In contrast, unmarried workers who earn $133,000, and work for 40 years, receive just $0.78 on the tax dollar. The disparity does not seem equitable to Reichenstein, and it is not good for Social Security’s fiscal health, either.

To support his thesis, Reichenstein cites President Franklin D. Roosevelt. Stated FDR to Congress, “The Act does not offer anyone an easy life--nor was it ever intended so to do.” On the contrary; the program aims to “Furnish that minimum necessity to keep a foothold.” That would seem to suggest that efforts to push the retired poor into the middle class, by giving them Social Security benefits that far exceed their contributions, are misguided.

Start Talking! On the other hand, the president said those words 80 years ago, and was notorious for telling audiences what they wished to hear, as opposed to what he really thought. The debate about whether Social Security should function as group or individual insurance is far from settled. Indeed, it has barely begun. What does seem evident, though, is that the discussion about Social Security's purpose be made explicit, rather than implicitly conducted through benefits' formulae.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.