Will the Social Security System Be There for the Baby Boomers?

By Ali Connolly

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In 1935 the Social Security Act was passed, instituting the United States retirement program. Although throughout the years there have been numerous amendments to the program the basic concepts are still in place. During an individuals working years they pay a payroll tax that is placed into a separate trust fund, which is then used to pay benefits to retirees. In 1965 Medicare was added to the benefits included under the Social Security system. Social insurance includes numerous government programs, but for this paper it refers to Old-Age, Survivor, and Disability Insurance (OASDI) along with Medicare. Recently economists, politicians and much of the population have become concerned with the future of social insurance because of increased dependability on the system due to the aging of the population. This paper will look at the projections of the current Social Security systems and investigate the problems and solutions of funding Social Security in the future.

The reason so much concern surrounds the Social Security system is the coming retirement of the baby boom generation. Large demographic changes will occur in the age structure of the U.S. population as the baby boomers (born between 1945 and 1965) move from their working years to retirement. In 1990 12.7% of the population was age 65 or older, this figure is expected to increase to more than 21% over the next 20 years. Along with the large size of the baby boomer cohort average life expectancy at 65 years of age has increased for both men and women, by 25 and 40 percent respectively. Despite these increases the average age of retirement has not increased, in fact most Americans are retiring earlier. "By the year 2030 the retirement period of an average worker will be nearly half as long as his or her work life" (Bosworth, 96). When the first of the baby boomers begin to retire in 2010 a sudden increase in benefit payments will create serious funding problems for social insurance.

The 1995 annual Medicare and Social Security report projects that Medicare will run out of funds in 2002 and Social Security will be unable to pay cash benefits beyond 2030. In the meantime the baby boomers will contribute to a build up of benefit payments as they continue to work, but this reserve will be rapidly depleted upon their retirement putting an increasing burden on the current generation to support the elderly.

The Medicare problem is much more severe than social security because the program pays for medical expenses of which the costs have constantly increased. The lack of knowledge about medical advancements and future pricing makes Medicare cost projections very difficult. Medical costs have been rapidly increasing at a faster pace than income. Certain medical treatments have become too expensive and have created the problem of deciding what treatments are worth the cost. Another reason for increased cost in Medicare was the inclusion of disabled in 1973. Further increases in enrollment in Medicare can be attributed to increased life spans, and elderly living longer after receiving treatment through Medicare. Medicare studies show that expenditure per person increases with age, with male 85-year-old recipients costing twice as much as 65-year-old male recipients. Lastly, since the baby boomers had fewer children then their parents they are less likely to receive in home care from family members causing increases in nursing home costs and in turn Medicare costs. Therefore, as the population continues to age Medicare costs will continue to rapidly grow.

The Social Security problem is not as severe as the Medicare problem, but still warrants a great deal of attention. Fortunately, Social Security pays benefits according to a predetermined formula and therefore by calculating the number of retirees accurate predictions can be made about future spending schedules. Social Security is divided into two parts: who will receive benefits and how much, and collecting revenues to pay the benefits. Revenues to pay benefits come from a payroll tax along with a small portion of income taxation and lastly the interest earned on the trust fund. It is important to realize that an additional dollar paid out in benefits means that a worker had to pay an additional dollar in taxes. The dependence on payroll tax makes revenues very sensitive to the number of taxpayers to the number of beneficiaries. With the retirement of baby boomers the dependency rate is projected to rise by 80 percent from 1994 to 2070.

Every year projections are made to determine whether Social Security will be in actuarial balance 75 years from the present. Currently the Social Security system is not in balance. In order to achieve balance the payroll tax would need to be raised and continue to rise well into the future. To cover the baby boomers retirement the payroll tax would need to be 16.5 percent by 2030 and continue to rise to 18 percent by 2070. The payroll tax percentage in 1995 was 12.4 percent. Due to the drastic demographic changes brought about by the baby boomer’s retirement it is apparent that "Social Security and Medicare cannot survive as now configured under current law" (Schieber, 119). The relevant topic is what modifications must be made in order to fund the retirement of the baby boomers without placing large burdens on succeeding generations.

Proposals for changing Social Security have mainly focused on two separate methods: "reducing future benefits or expanding the tax base" (Bosworth, 95). More recent suggestions propose increasing savings to cover additional costs, shifting from a pay-as-you-go system to a funded program, and changing the management of the OASDI trust fund to allow for investment in the private sector.

The first suggestion proposes reducing the benefits of retirees to counterbalance the increase in cost that will be experienced when the baby boom generation retires. The magnitude of benefit cuts necessary to balance Social Security would depend on when the cuts were made. If in 2002 benefits were cut for all enrolled in Social Security then a 20.5 percent cut would be sufficient. If benefit cuts weren’t made until 2022 then a 33.5 percent cut would be required. In the 1983 amendment to the Social Security Act they scheduled an increase in the normal retirement age from 65 to 67 years of age, which is one means to decrease benefits. Even though collection can still begin at 62 years of age, this is a way of cutting benefits because smaller amounts are received during the early years. Other benefit cut proposals include further increasing the normal retirement age, increasing the entitlement age of 62 or changing the way in which benefits are calculated. Presently the best 35 years of a worker’s indexed earnings are used to determine the amount of benefits they receive. To reduce benefits this period could be increased. However, in comparison to other developed countries the U.S. level of benefits is quite small. An across-the-board cut in benefits may lead to other problems, such as higher poverty rates. Currently, a worker that earned half the average wage receives benefits below the poverty line. One solution would be to decrease benefits of more wealthy workers, while leaving benefits to the poor untouched. Researchers believe this would not be a viable solution because the Social Security system is already so redistributional that it would discourage workers from saving during their working years because savings would be counteracted by reductions in Social Security benefits. Although in the past, including the amendments made in 1983, benefit reduction has been an easy solution to financing the future of Social Security it is a short-term solution which will lead to more problems in the future.

A second option is to increase the Social Security revenue through an increase in the payroll tax. The slowing of the growth of the working age population will result in a higher dependency rate. Therefore a tax increase would be one method to return the Social Security system to balance. The problem with this solution is that it would require a one percent increase every ten years to maintain similar benefits for future generations. Bonsworth points to further decreases in fertility along with longer life spans which will continue to increase cost well beyond the baby boomer’s retirement years.

These first two approaches, decreasing benefits and increasing the tax base, deal with the idea of a fixed size pie. In other words, we have a limited amount of resources and we need to decide how best to allocate our resources between the younger and older generations. Another option, increasing savings, addresses the issue of increasing the size of the entire pie. By investing the Social Security fund through government bond purchases more money will flow through the economy. This money can be used by private investors to invest in more risky assets with a higher return than government bonds. This will increase the savings rate, which will in turn lead to more physical capital. The increase in capital means a more productive work force and therefore higher real wages. This rise in GDP increases the size of the economic pie so that the living standard of younger generations will not decline due to the increased dependency ratio. In order for the increase in savings to translate to an increase in GDP the government must run a Social Security surplus. This approach stresses the importance of the growth of real wages and productivity in order to eliminate increased burden on current generations. One drawback of this solution is the necessity for a surplus to be set aside in order to increase the national savings rate. In actuality, a Social Security surplus may not lead to increased savings for several reasons. Social Security is not regarded as a separate entity and is regularly placed into the government budget along with everything else. Often the surplus in Social Security is used to fund other programs. These loopholes could be fixed if there was a "change in the status of the Social Security system to that of an independent agency and remove its revenues and expenditure from the budget documents" (Bosworth 106). This is much more likely to occur through a funded program as opposed to a pay-as-you-go program.

Internationally almost all Social Security programs are operated as pay-as-you-go programs which means "each generation pays for the retirement costs of the currently retired, in return for a commitment for the same treatment from future generations" (Bosworth, 97). A fully funded system would benefit from investment in private pension funds, which yield 4 to 5 percent in return as opposed to the current 2 percent return on the Social Security fund. Although attractive, a fully funded system is unlikely because the transition would require the current generation to pay twice. Workers would pay for the retirement of the currently retired through the pay-as-you-go system and would then have to pay for their own retirement. One possible alternative would be a partially funded system in which the government controlled the tax rate to ensure that Social Security remained in actuary balance and the surplus was used to increase national savings. This would produce sufficient funds to offset the additional costs to future generations through increases in before-tax-income.

The last proposed modification of the Social Security system would involve changing the management of the trust fund. The new system would either invest part of the fund in the private sector as opposed to Treasury bonds, or allow individual workers to make their own investment decisions. Stocks and corporate bonds yield a higher rate of return than treasury bonds, although more risk is involved. Researchers predict that despite the higher risk, investing in the private sector would increase Social Security revenue. A more drastic approach would allow for workers to be responsible for their own investments. One problem with this proposal is that part of the payroll tax revenue would be given to individuals decreasing the overall size of the trust fund from which benefits are paid out. Diamond concludes, "small, mandated, individual accounts would be expensive and would be poor providers of retirement income".

The retirement of the baby boom generation will place increased stress on the Social Security and Medicare systems. Fortunately, many possible solutions have been proposed to solve the problem of future funding. Although researchers are not in agreement about the most effective solutions, few would argue that structural changes need to take place in the near future in order to allow for changes to occur and allow workers to better plan their own retirement. The current Social Security system will not withstand the demographic changes caused by the baby boomers, yet it is not so severe that viable solutions won’t be effective. The prolongation of the Social Security system requires that action be pursued today before it is too late.

Bosworth, Barry P. "Fund Accumulation: How Much? How Managed?" Social Security What Role for the Future?, edited by Peter A. Diamond, David C. Lindeman and Howard Young, National Academy of Social Insurance, Washington, D.C., 1996, Chapter 2, pp.89-113.

Diamond, Peter A. "The Future of Social Security" Social Security What Role for the Future?, edited by Peter A. Diamond, David C. Lindeman and Howard Young, National Academy of Social Insurance, Washington, D.C., 1996, Chapter 7, pp.225-233.

Scheiber, Sylvester J. "Can Our Social Insurance Systems Survive the Demographic Shifts of the Twenty-First Century?" Demography and Retirement: the Twenty-first Century edited by Anna M. Rappaport and Sylvester J. Schreiber, Praeger, Westport, Conn., 1993, pp. 111-173.