Is It Really a Pension? It’s a Problem

Is Social Security a pension plan?

No, but it was sold to the public in the 1930s as if it were one, and that matters.

Social Security Card
Tom Grill | Photographer's Choice RF | Getty Images
Social Security Card

Social Security is one of the issues that Congress will eventually have to address, but it was almost absent from the campaign that just ended. The conventional political wisdom is that serious changes to entitlement programs can be made only on a bipartisan basis, in which each party implicitly promises not to attack the other for the deal. For now, such a spirit seems unlikely, to say the least.

And yet it was interesting that the National Bureau of Economic Research chose the election week to release a new study on the impact of previous changes in the system on Social Security benefits. The paper concludes that a significant part of tax increases have not helped cure projected deficits because they are used to pay additional benefits — and that those added benefits go primarily to higher-income Americans.

If you look at Social Security as a pension plan, that result seems not only fair, but required. If you contribute more to a normal pension plan, you expect to get higher benefits. Why else would you contribute? And Social Security taxes are often called contributions.

But the reality is that Social Security is not a normal pension plan, even though it somewhat resembles one because the benefit level is related to the recipient’s income while he or she was working. It is what it was when it was created in the Great Depression: a plan to tax working Americans to pay for benefits given to retired and disabled workers, and to their families.

Over the years, the government has tried a couple of ways to increase revenue for the Social Security system as the retirement of the baby boom generation grew closer. One was to raise the payroll tax, which is now 12.4 percent of the first $106,800 earned by an employee. (The total tax is somewhat obscured because half of it is withheld from paychecks and the other half is paid directly by the employer.)

That tax rate is visible to everyone, and an increase hits hardest for people making less than the maximum that is taxed. For many lower-income wage earners, there is no federal income tax. But there is no escaping the Social Security payroll tax.

"Having sold Social Security as a retirement plan, I think it is important that the promise not be abandoned." -Dartmouth Professor, Alan Gustman

The other method has been to raise the maximum income subject to the tax. From 1937 to 1949, the limit was $3,000. That meant that workers earning more than that — and most earned less during the early years — did not pay taxes on income above that level. Nor was that income counted in determining benefits. As recently as 1965, the limit was $4,800.

Raising the limit brings in more money, of course, and gets that money from the higher-wage workers. But that comes at a cost to the system, because people who make more than the old cutoff also earn higher benefits.

The new paper, by Alan L. Gustman, an economics professor at Dartmouth; Thomas Steinmeier, an economics professor at Texas Tech; and Nahid Tabatabai, a researcher at Dartmouth, set out to estimate just how much those added benefits cost. That is harder than it seems, given the complexity of changes in Social Security law over the decades. But the authors had access to a lot of data from the Social Security Administration, which financed the study through the Michigan Retirement Research Center, and their estimates seem reasonable.

They compare three groups of Social Security recipients, the youngest being those born from 1948 through 1953, a group that is starting to retire now. That group is compared with a group 12 years older, born from 1936 through 1941, and to a group 24 years older, born from 1924 to 1929. They take into account inflation and increases in median income.

Comparing the youngest of these groups to those born 12 years earlier, they conclude that “for a person earning at the maximum level covered by Social Security, about a fifth of the additional taxes collected due to the increase in the earnings cap are used to pay for incremental benefits, reducing the incremental funds available for addressing the Social Security revenue shortfall by about a fifth.” Comparing the youngest group with the workers 24 years older, the increase in benefits is even greater.

Is this structure fair? It depends on how you look at it. In one view, all the extra taxes are paid by relatively high-income workers, but they get only about a fifth of the extra payments back. If you think of Social Security as a pension plan, that is the appropriate way to look at it, and you can conclude that those higher-income workers are being treated unfairly.

That results from the fact that Social Security is formulated to be somewhat progressive by replacing a large percentage of the first $8,000 in annual earnings and a much smaller proportion of additional earnings. A major purpose of Social Security was to reduce poverty among senior citizens, and it worked.

Earned benefit, or welfare?

But if you think of Social Security as a transfer payment system, in which taxes are transferred to the retired, it may not seem fair that the well-off get extra benefits at all. If government spending must be reduced in some areas to deal with the soaring level of national debt, would it make sense to cut spending that benefits those who need it least?

Such an issue was confronted by David Cameron, the new Conservative prime minister of Britain, when he imposed a new austerity budget. Heretofore, Britain has provided cash grants for all parents; now high-income workers will not get them. There was speculation that would provoke outrage from those who are losing the benefits, but that reaction seems to have been mild. There were complaints over the way the system handled two-income couples as opposed to couples in which one parent stays home, but generally the idea seems to have substantial support.

In this country, there is no way to cut off Social Security payments to the well-off, even if it does seem a little absurd for Warren Buffett to be getting a government check every month.

“Having sold Social Security as a retirement plan, I think it is important that the promise not be abandoned,” Mr. Gustman, the Dartmouth professor, told me in a telephone interview. “I would like to see the feature of an indexed annuity preserved.” But he also talks about adjusting benefits for changes in life expectancy — a somewhat subtle way of suggesting cuts in benefits.

You can get into an argument any time you discuss just how badly off Social Security is, although it clearly is not in fiscal straits as severe as those that will confront Medicare if its costs continue to rise.

Every year the Social Security system’s trustees release a new estimate, which politicians and advocates use to justify the views they already had. Those estimates are extremely sensitive to economic estimates for coming decades. If you assume there will be more economic growth, the situation looks better.

Given that, it is possible the best thing that could be done for Social Security now would be to adjust fiscal policy to stimulate the economy, even if, temporarily, that does produce higher budget deficits. It seems clear that the previous stimulus spending was neither large enough nor well enough fashioned to completely offset the drag on the economy caused by the financial crisis.

That crisis, however, also caused reported budget deficits to soar, and both Republicans and Democrats — but particularly Republicans — campaigned this year on promises to cut spending. Reaching an accommodation that would help the economy seems unlikely in the new Congress. The Federal Reserve’s new bond-buying plan may not be the best way to help the economy, but it may be the only one available given the fiscal stalemate.

Eventually, Congress will have to address whether to change Social Security. Politically, much of the support for the program stems from the perception that it is an earned benefit, not a welfare program. But in a time of fiscal austerity, Congress should at least consider whether it makes sense that an increase in taxes to finance the system automatically increases the benefits paid to those who need help the least.