$44 Trillion Discussion on Social Security

—–Original Message—–
From: Larry Hunter
Subject: RE: column

Bruce,

I’ll take your word on the numbers — I haven’t checked them myself — but assuming they are correct on what appears to be a present-value basis, why on earth is a debt equal to 6.5 percent of gross domestic product “something to be concerned about,” much less a crisis in the making?

As much as I would like that number to be true, I am, frankly, suspicious of it because if you project out the unfunded social security liability and assume that it must be debt financed [assuming a “current-law baseline”] the debt-to-gdp-ratio goes through the roof. [See my IPI piece of a year or so ago, “Who’s Afraid of the National Debt”.]

As I tried to emphasize at the White House meeting earlier this week, debt phobia and deficit neurosis are debilitating conditions afflicting both political parties, and unless we get over them, we will never reform our tax system and convert social security to a fully funded personal account retirement system.

Therefore, I believe we need to begin changing the national conversation to eliminate fear of deficits from the American psyche, which stands in the way of the kinds of reforms we must make, ironically, to prevent a real debt crisis from arising. Yes, getting over debt phobia means the Republicans will have to give up what they think is the last remaining political bulwark against run-away government spending. But, then, I always thought the “deficit threat” was way over sold as a check on spending; it simply prevented Republicans from reforming the tax code and left the GOP as the guardian of excessive tax rates in the name of “fiscal responsibility.”

You can take a look at “Who’s Afraid of the National Debt” at IPI’s web site (www.ipi.org). It was written before the recession in the context of the then projected surpluses but the analysis remains correct, and beyond years two or three out, the numbers are essentially the same. Spending, of course, remains a wild card in any out-year surplus/deficit projections, but the irony is that beyond the short-run “cyclical” deficits that wiped out the surpluses, any long-term change in the surplus outlook resulting from a higher “structural” spending baseline — to the extent that it may now exist — came about during times of projected surpluses, not deficits. So much for the canard that if you eliminate irrational public fear over deficits, spending will spin out of control. Anyway, if Republicans really want to use deficits as a political block against spending, they should immediately “use up” tolerable deficits for the next 75 years to fund the transition to personal retirement accounts and then wring their hands over every dollar of new federal spending, which would push the deficit beyond reasonable levels and threaten workers’ personal retirement accounts. I mean, if the effort is to scare people into behaving, give them a real bogey to fear.

Best,
Larry

—–Original Message—–
From: Donald L. Luskin
Subject: RE: column

Check me on this, but as I understand the meaning of these numbers, neither of you is thinking about this in the right way.

As I understand it, the $44 trillion is mostly the present value of unfunded Social Security and Medicare liabilities. In other words, it is the value of a “dedicated” bond portfolio that would have to be established today to match the duration of the anticipated liabilities and to pay them off with its future cash flows. It is precisely the same kind of calculation that a company like General Motors goes through regularly to determine the funded status of its pension plan.

Therefore, the size of the economy at some point in the future has nothing to do per se with the unfunded liability today (it’s not entirely irrelevant, I suppose ? but only in the sense that every future state of all the variables is, in some sense, relevant). The number today is what it is, in today’s context. If you want to compare the liability to the size of the economy in, say, 2050, then you’d have to ask what is the projected size of the liability in 2050.

“Thus this astronomical debt that so alarmed the editors of the Financial Times turns out to equal just 6.5 percent of the gross domestic product? something to be concerned about, but hardly a crisis in the making.”

Donald L. Luskin
Chief Investment Officer
Trend Macrolytics

—–Original Message—–
From: John C. Goodman
Sent: Thu 6/5/2003 6:02 PM
Subject: RE: column

Don is correct. We need the $44 trillion on hand right now. And failure to have it means the pay-as-you-go burden grows through time ? more rapidly than you might think.

For example, Social Security and Medicare combined are making no net claim on general revenues right now. But by 2040, the deficits in these two programs will require 47% of federal income tax revenues. By 2070, it will be 75%. And so forth.

For what it is worth, these projections tend to be linear. So after about 100 years, health care consumes the whole GDP. But there will be blood in the streets long before then.

John

John C. Goodman
President
National Center for Policy Analysis

—–Original Message—–
From: Larry Hunter
Subject: RE: column

John and Don,

Yes, of course the present value equivalent of the stream of unfunded liabilities (i.e., promised social security benefits) implies that IF the stream actually becomes a reality ex post (i.e., if the current system is left in place and the unfunded liability is allowed to grow under current law) and IF the government is on the hook to pay for it out of tax revenues generated by the payroll tax, THEN the government “requires” the present-value lump sum ex ante to cover the liability as it comes due in the future, or it will have to raise the payroll tax rate in the future to cover it. But folks, this is simply the arithmetic of the existing system, and it doesn’t apply if the system is CHANGED — which, I thought was the point of shifting to a fully funded private system in which individuals cover their own retirement “liability,” which in turn stops the government’s unfunded liability from growing and leaves only the problem of figuring out how to pay off the unfunded liability that was incurred before the change to the system took place, i.e., how to pay the cost of the transition problem.

The present value calculation that so scares people about the current system is nothing more than an hypothetical value that is premised on the assumption that the system continues generating unfunded liabilities under “current law” in perpetuity — which reduces to the rather uninteresting proposition that “if the system continues to go broke, it will most assuredly end up broke.” If, however, the system is CHANGED, that scary present value calculation goes right out the window because the expected stream of annual unfunded liabilities on which it is based will cease immediately upon the CHANGE in the system.

By shifting to private accounts, the government’s unfunded liability stops growing on the day the switchover occurs. The only unfunded liability that remains is the transition cost of paying benefits already incurred over a time frame dictated by the demographics of the population to whom the benefits are promised. That present value can be calculated and will look innocuous by comparison. Thus, the unfunded liability, which no longer is growing over time, can then be paid off gradually over time (i.e., as the benefit payments become due), by borrowing in the current period and repaying the debt in some future period with tax revenues. Moreover, because private accounts generate a higher rate of return (how much higher is an empirical question that will affect the length of time the transition problem lingers), people can count on a retirement income that is no less (and may be higher) than currently promised social security benefits by earmarking a share of their payroll taxes that is less than the current tax rate. So for example, the same or higher expected benefits could be generated by earmarking 5 or 6 percentage points for private accounts, leaving the remaining 6 or 7 percentage points of the payroll tax to cover the transition costs. (Note, these numbers are illustrative and a model would be required to figure out precisely what private-account earmarks, what residual payroll tax rates, what length of time and so forth would actually be involved.) The remaining un-earmarked portion of the payroll taxes can then be devoted in the future to repaying the debt that is incurred each year to pay benefits, i.e., to retire the (shrinking) unfunded liability.

Since that unfunded liability shrinks over time as people die off, it can eventually all be eliminated out of the revenues generated by the remaining un-earmarked payroll taxes without raising the rate; indeed, depending upon how long the society is willing to take to pay off the residual unfunded liability (i.e., to pay the transition costs), the un-earmarked tax rate could actually be lowered as the unfunded liability shrinks.

As to the relevance of the size of the economy in the future — no it does not affect the size of the transition problem per se (i.e., it doesn’t alter the arithmetic present value of the unfunded liability) however it sure as hell does affect the government’s ability to pay off the unfunded liability — the larger the economy the smaller the rate of taxation required to pay off the unfunded liability.

Larry Hunter

—–Original Message—–
From: Donald L. Luskin
Subject: RE: column

I agree with Larry, but I think we’re somewhat talking at cross purposes. I was simply trying to clarify the meaning of the $44 trillion as being the present value of an unfunded actuarial liability, and note that funding it would require establishing a “dedicated portfolio” of equal value today. The non-existence of that portfolio suggests that there’s an awful lot of money that’s going to have to come out of somewhere, someday.

Now Larry is right that this calculation is based on present-day realities. And the correct implication is that those realities must be changed. Larry’s insight suggests that advocates of SS and M reform should embrace these estimates as evidence of the need for reform. I am sure that Cato is doing just that, as they should.

Donald L. Luskin
Chief Investment Officer
Trend Macrolytics

From: John C. Goodman
Subject: RE: column

Larry,

If we evicted Social Security and Medicare tomorrow and agreed to pay for only those benefits already earned the present value of that obligation is $30 trillion, about 10 times the size of our national debt. Go to this link for the Saving/Rettenmaier study: http://www.ncpa.org/pub/st/st261/.

John C. Goodman
President
National Center for Policy Analysis

From: Larry Hunter
Subject: RE: column

John,

You say, “If we . . . agreed to pay for only those benefits already earned the present value of that obligation is $30 trillion, about 10 times the size of our national debt.” But, you must be careful about what you mean (or what you think you mean) when you say “already earned.” As I understand the number to which Saving & Rettenmaier referred, it consists of the present value of the total unfunded liability of the system as it exists right this minute, assuming it continues operating exactly the same way indefinitely into the future; which is why, I presume, the Social Security actuaries refer to that same number as the “maximum transition cost.”

But, this “maximum” transition cost would be the “real” transition cost only if we insist on paying out of the federal Treasury every penny of the currently unfunded liability on top of whatever workers earn in their new personal accounts. But that’s crazy since the whole point of the exercise is to change the system to save the government money without raising taxes or cutting benefits. Constructing a new system that generated the “maximum” transition cost would make no sense, and I know of no one who suggests any such thing.

The “real” transition cost would consist of whatever amount of money the government actually had to pay out to make up the difference between what workers are guaranteed and what they could generate out of their own new private accounts. And that amount depends upon a variety of things.

Personal accounts in the neighborhood of 5 or 6 percent would fully fund retirement for all new workers and require no government payments to meet the guarantee. Personal accounts would also fund the retirement for existing workers to varying degrees, depending upon how old they are at the date of switch-over.

With fully funded personal accounts, the size of the system’s unfunded liability, therefore declines immediate upon switch-over to the new system and the “real” transition cost will be substantially less than the “maximum transition cost.” How much less is an empirical question. However, this we know: the only unfunded liability remaining after switch-over will consist of that amount of money required to make good on a government guarantee of retirement income to people who, for whatever reason, will be unable to generate a sufficient retirement income between the point of switch-over and their retirement to yield the guaranteed retirement income. (I always urge that the guarantee equal exactly the amount to which workers otherwise would be entitled under the current system but note that does not imply that the “real” transition cost will be anywhere near the “maximum transition cost.”)

For young people not yet in the labor force and for current workers who have only been working a few years at the point of switch-over, the government will not have to pay anything to fund the guarantee. For middle aged workers, the government will have to pay something because they won’t be contributing to the new system long enough to fully fund their retirement. For workers near retirement, the government will have to pay most of the guarantee, although not all of it since even they will begin funding their own retirement at the moment of switch-over. And, of course, the government will have to continue paying the entire retirement income of those people who already are retired at switch-over.

Saving and Rettenmaier say that, “the present value of accrued Social Security obligations that year (2001) amounted to $12.9 trillion.” In my IPI piece I say that, “by 2075, the national debt would amount to almost 150 percent of GDP. In present value terms (in today’s dollars), that debt amounts to almost $13 trillion.” No disagreement there.

I go on to say, however, that “In present value terms, the transition borrowing cost of moving to private retirement accounts financed by 6 percentage points of the payroll tax would amount to only $1.6 trillion, about one-ninth of the debt burden confronting us if we simply attempt to patch up Social Security.” Rather than the national debt exploding to debt finance the “maximum transition cost” (i.e., to pay the unfunded liability of the current system), the national debt would remain fairly stable in the neighborhood of 30 percent of GDP for the next 25 years or so (as modest annual deficits averaging about 1.5 percent to 2 percent of GDP would be required to pay the annual transition costs), and eventually it would begin to decline as a share of GDP.

Again, the real issue is not so much the size of the personal accounts (that really is determined by whatever earmark is required to fully fund the system for new workers at whatever benchmark level of retirement income we decide upon) but rather how the transition is paid for. It is unambiguously clear that the only rational way to pay for the transition is to bond finance it.

Larry

From: Thomas A Giovanetti
Subject: RE: column

This doesn’t seem so complicated to me.

A tiny share of the current SS liability is MINE, due to me.

If I were to switch over to a decent private account, there is almost no chance that I will actually consume all of the SS liability that is due me. In fact, it is likely that I will consume none of it.

And I won’t be the only one.

This is, of course, is we convert the current SS liability into a government guarantee. The feds essentially become retirement insurers of last resort, and the liability is consumed only by an unfortunate few.

It seems to me that wide adoption of a well-crafted private account option shrinks the (theoretically) giant SS liability into one that is (actually) manageable.

Even if the accounts don’t perform as well as we think, they will still be something. If every private accountholder only consumes have of what is due them from the pot of SS liability, that is still a significant shrinkage.

I agree that these figures about SS’s liablity are rhetorically useful to us, but in crafting a private accounts plan, they should only be considered as a starting place.

Tom Giovanetti
President
Institute for Policy Innovation (IPI)

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