Date created: 12/4/07
Last modified:12/4/07
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John Quiggin

Growing pains of social security

Australian Financial Review

9 May 2005

Proposals to reform the US Social Security system have been the subject of vigorous political debate for more than 20 years, but never more so than today. Proposals for Social Security reform are central to the second-term agenda of the Bush Administration and their success or failure will do much to determine whether the Republican party maintains its current dominance of Congress and the Presidency. Many of the issues raised by the debate are relevant in considering the appropriate direction for superannuation policy in Australia.

The starting point for the problem is that the Social Security system, like most public pension systems, operates on a pay-as-you-go basis. That is, it collects taxes from current workers and pays out benefits to retired workers, but does not make an actuarial provision for future liabilities.

Unlike Australia, however, the US does not simply lump Social Security in with general revenue and expenditure. Instead, it operates a separate Social Security fund, which receives payroll tax revenue and invests it in government bonds, and pays out benefits to retired workers.

As in other countries, the pay-as-you-go system worked well during the 20th century, as taxes from a growing workforce with rising incomes were used to pay benefits to a relatively small group of retirees. But demographic changes including the end of the baby boom and increased life expectancy make the economics less favorable.

It is important to note, as observed in previous Economist Briefings, that these changes do not imply any significant change in the dependency ratio, that in is the proportion of the population of employable age. The increase in the proportion of the population aged over 65 is, roughly speaking, balanced by the decline in the proportion aged under 18. But there is still a financing problem, since children are mostly supported by their parents, while Social Security is financed by government.

An alarmist way of presenting the problem, common in the US debate, is that the Social Security fund will run out at some time in the future (2042 is a common estimate). Since the fund is simply an accounting device, a more accurate way of viewing the problem is that, on current projections, the existing payroll taxes will not fund the benefits promised by the government. Hence, either benefits must be cut, Social Security taxes must be increased, or the fund must be supplemented from general revenue.

The real problem is not the exhaustion of the fund, but the fact that the US budget appears to be set on a course of chronic deficit. In the short term, the primary cause of these deficits is the fiscal policy of the Bush Administration, based on large tax cuts with no corresponding restraint in total expenditure. In the long run, the steady increase in projected health expenditure, arising primarily from expensive innovations in health care and the rising relative cost of health services, is an even bigger problem.

Running in parallel with the debate over the funding shortfall is a separate debate over the question of how Social Security funds should be invested, and by whom. Currently, the law requires that the entire fund should be invested in US government bonds which have yielded an average real return of about 2 per cent. For the twentieth century as a whole, the real return on equity investments was much higher, around 8 per cent on average. Hence there is a natural interest in proposals to improve rates of return to Social Security funds through investment in equity.

Two main proposals have been put forward. The Clinton Administration considered proposals that would allow the Social Security fund to diversify its portfolio by investing in a diversified index fund. This proposal received little political support, largely because of opposition to the idea of public investment in private equity.

In testimony before the Senate Budget Committee in 1999, Federal Reserve Board chairman Alan Greenspan argued that allowing the government to hold private assets would risk "sub-optimal performance by our capital markets, diminished economic efficiency, and lower overall standards of living than would be achieved otherwise." Greenspan expressed concern that public ownership of private assets would introduce dangerous political interference in our capital markets.

The alternative proposal, supported by the Bush Administration is for some or all of the contributions made to the Social Security fund to be returned to individuals who could choose between a range of approved investments. This proposal has also encountered serious political difficulties, reflected in the changing names under which it has been marketed. Initially, called ‘privatisation’, it was changed to ‘choice’ in 2003 ‘private accounts’ in 2004 and ‘personal accounts’ in 2005. At each stage in this process, Administration supporters objected vigorously to any use of the previously-approved terms.

Although the question of investment policy is logically separate from that of inadequate funding, it’s apparent, at least on the face of things, that an improvement in investment returns could reduce the gap between the revenue from Social Security taxes and the benefits that have been promised. Not surprisingly, therefore, advocates of reform have linked the two issues.

The result has been to make an already complex debate even more confused. One problem is that of internal inconsistency. Those arguing that reform is urgent generally tend to use low estimates of future rates of economic growth, since more rapid growth reduces the severity of the underfunding problem. On the other hand, supporters of privatisation (generally the same people) assume that the return to equity investment will remain high.

Leading US economists Dean Baker, Brad Delong and Paul Krugman have argued that these assumptions are inconsistent. In standard economic models, the rate of growth of output and the equilibrium return to equity rise and fall together, so it makes no sense to suppose that growth will slow but that returns to equity will remain unchanged. The analysis seems compelling, but the debate is highly politicised, and the authors are prominent critics of the Bush Administration, so their arguments have been rejected out of hand by many Administration supporters.

Even more difficult problems arise in relation to the equity premium. The excess return to equity seems, on the basis of standard economic models, to be much higher than would be warranted by the relative moderate increase risk associated with holding equity rather than bonds. A vast literature has arisen in relation to this ‘equity premium puzzle’ over the past twenty years, but it is no closer to resolution now than it was when it was first raised.

There are three main viewpoints regarding the equity premium. The first is that, contrary to the standard economic models, the equity premium is an efficient market estimate of the cost of risk. In this case, changing the way Social Security funds are invested should make no difference, since the higher expected returns will be fully offset by increased risk. Workers should simply adjust their portfolios in response to restore the previous balance of risk and return.

A second viewpoint is that the equity premium arises from inefficiencies in the capital market and that government can avoid this inefficiencies by virtue of its power to tax. In this case, private accounts will make no difference, for the reasons already stated, but there is a potential net benefit from diversification of the Social Security fund.

Finally, there are some explanations, based on liquidity constraints, that suggest that workers, who could not otherwise hold as much equity as they would wish to, would benefit from either private accounts or diversification.

No resolution of these debates appears likely in the near future. At some point, the Social Security funding shortfall will have to be addressed, along with the structural budget deficit as a whole, but that point looks far away at present.

Quite a few of the issues raised in the US debate are relevant to Australia. In important respects, the system proposed by Bush resembles that in Australia, with a limited public pension supplementing private accounts invested with a fair degree of freedom of choice. The issues relating to risk, raised in the US debate, are relevant here.

Overseas experience, notably in Chile which was the pioneer in this area, suggests that systems of private accounts may perform well as long as the sharemarket is rising, but reveal serious problems in periods of stagnation or decline. Australia has yet to experience a sustained decline in share prices since the shift to accumulation-based superannuation schemes in the early 1990s.

The idea of investing government surpluses in a diversified portfolio, with the aim of preparing for adverse demographic shifts in the future has also been raised in the Australian debate, notably by Ric Simes, who has advocated an ‘Intergenerational Fund’. A similar scheme is already in operation in New Zealand. On the other hand, Australian governments, to a greater extent than those in New Zealand or the United States, already hold substantial equity in the form of government business enterprises.

The debate on social security reform is only just beginning. Given the magnitude of the problem, it is likely to be with us for some time to come.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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