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4. Modernize and Reform Social Security

For 65 years, Social Security has provided retirement security for tens of millions of Americans. Four generations of Americans have relied on the Government to keep the promises it made to them during their working years. As demographics change and costs increase, the challenge we face is ensuring that the Social Security system is strengthened for tomorrow's retirees.

The Need for Reform

Social Security's spending path is unsustainable in the long run, driven largely by demographic trends.

First, longer life spans mean more benefit payments. In 1940, during the early years of the program, life expectancy at age 65 was an additional 12 years for men and 13 years for women. By 2075, the remaining life expectancy at age 65 is projected to be 20 years for men and 23 years for women. As a result, people are spending a growing proportion of their lives in retirement. While longer life spans are clearly desirable, they also mean additional years of benefit payments, and a dramatic long-term increase in Government obligations.

In addition, a long-term decline in fertility rates means there will be fewer workers available to support each retiree once the baby boom generation starts to retire. As a result of declining birth rates and increasing life expectancy, the ratio of workers to Social Security beneficiaries is expected to shrink from 5.1 in 1960 to 3.4 today to 2.1 in 2030. These demographic trends will strain our ability to make benefit payments at current payroll tax rates.

The Social Security system faces a long-term unfunded liability of $8.7 trillion. In addition, the structure of Social Security leads to substantial generational inequities in average rate of return. (See Chart 4–1.)

4–1. Social Security Rates of Return Falling with Each Generation

Old Solutions and a New Approach

Without new thinking on Social Security reform, two old choices will soon present themselves. We can further reduce future retirees' returns from Social Security through benefit cuts or through tax increases. Or we can do nothing—inaction would simply mean leaving this problem for our children and grandchildren instead of addressing it for them now.

There is a better way to address both the long-term financial crisis and the generational inequities. Allowing individuals to keep some of their payroll taxes in personal retirement accounts to provide for their own retirement security can reduce the need for a rapidly growing Government outlay by creating opportunities for younger workers to enjoy the fruits of higher rates of return in private equity markets.

Principles for Reform

Modernization must not change existing benefits for current retirees or near-retirees, and it must preserve the disability and survivors' components. The promises made to current retirees must be kept.

The Social Security surplus must be preserved only for Social Security. For 30 years, Social Security surpluses have been used to mask spending increases in programs unrelated to Social Security. Surpluses in the Social Security Trust Funds will total $2.6 trillion over the next 10 years. These surpluses will be saved for Social Security reform and will be used to reduce debt held by the public until Social Security reform is enacted.

Social Security payroll taxes must not be increased, as they have been 20 times since the program began in 1937.

The Government itself must not invest Social Security funds in the private economy.

Successful Social Security reform, which addresses both the long-term unfunded liability and the generational inequities, must be built upon a core of individually controlled, voluntary personal retirement accounts that will augment the Social Security safety net.

The Benefits of Personal Retirement Accounts

Personal retirement accounts, which would be voluntary, would enable individuals to build financial wealth and security in a way that the current Social Security system does not. Personal accounts invested in safe private financial markets will earn higher rates of return than the traditional system and help workers enhance their personal savings and their freedom to retire. Ownership of a real financial asset without the political risk of future changes would mean more security for working Americans to build their own retirement assets, and to pass those assets on to their children.

A balanced portfolio of stocks and bonds can, in the long run, yield almost a 5.5 percent real rate of return. Even a portfolio of inflation-adjusted Government bonds yields a 3.0 percent real rate of return. Both are significantly better investments than those implicit in the current Social Security system, which, for many younger workers, could ultimately result in a negative rate of return.

This higher rate of return, through individually controlled investments in private debt and equity markets, is the key to the success of personal accounts. A two to four percentage point differential, compounded over time, means greater retirement security than under current law.

The long-term fiscal challenge facing the Social Security system, and the generational inequities inherent in that system, drive the need for reform. Reform is significantly easier to implement if done far in advance, so that individuals and families have time to adjust their retirement plans, and so that changes can be phased in slowly over time. Reform based on personal accounts presents a tremendous new opportunity to enable individuals to build financial wealth and security, while reducing the twin problems of fiscal imbalance and generational inequity.

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