A Curmudgeon's Notebook: Permanent Solvency for Social Security

This was originally posted on 2010 October 27 on a previous blog. The links are being checked and updated. Items not checked are identified as "changes in progress". Any links with "swagman" in the URL refer to the previous weblog and may be obsolete. Most are likely not available. Some of the invalid links are shown with ~~cross-out~~.

2010 October 27
Last update: 2011 Jan 02. Click on History for changes and updates.
Please refer to other posts on the subject of Social Security, particularly the post, Social Security Reform.
In dealing with national problems, one of the challenges is to ensure that all good ideas are reviewed. Business experience is that good ideas are everywhere, not just the ideas from the people who are in control or are professionals on the subject matter. Better solutions for each problem are likely in the in-boxes of the politicians and the designated experts. Social Security is probably no different.
    Most of the proposals for addressing the shortfall in Social Security OASI funding are "inside the box" such as raising Social Security OASI taxes, raising retirement age for full benefits, etc. All work within the system as currently defined and reflected in the formulas for calculating the various aspects of Social Security OASI revenues and benefits inherently retains the current assumptions and premises. The formulas which are based on current law may have unintended consequences that contribute to the shortfall in funding.
    I have approached Social Security OASI Solvency from a different perspective. I began with the question, "How can Social Security be made permanently solvent with the smallest possible change?" This leads to several key factors: (1) involve the largest possible number of participants, which means all; (2) make the change over the longest possible period of time, which means 75 years for the actuarial projection; (3) use the power of compounding to produce favorable results; and (4) make annual adjustments to ensure ongoing projected solvency over 75 years.
    The results are a unique and provide the smallest possible reduction in benefits to make Social Security permanently solvent. The reduction in benefits for a 20-year retirement span is 9% which is less than the adjustments in other proposals. I have sent this material to the chief actuary of the Social Security Administration (receipt acknowledged by SSA), National Commission on Fiscal Responsibility and Reform (Debt Commission), offices of some members of the Debt Commission, and others. Unfortunately, the proposal may be in the "black holes" of established organizations.
The continuation of this post describes the ideas in the proposal. The first paragraph contains a link to the working paper which develops and quantifies the ideas.
    Your thoughts are welcome. Please add them as comments. Thanks.
Don Nordeen
===========
Continue reading Permanent Solvency for Social Security.

Key Words: Social Security Administration, Social Security, OASI, public policy, entitlement, national debt, private accounts, trust fund

Read the Continuation of this Post and any Comments. Or Click Show All for the Above Introduction and the Continuation of this Post and any Comments.

Permanent Solvency for Social Security (continued)
This summary and its internet links discuss a proposal for Social Security to make OASI permanently solvent by making small adjustments to the benefits annually to ensure projected solvency over the long term (75 years). The working paper describing the proposal can be downloaded as a PDF file at Permanent Solvency for Social Security (Last update: 2010 Jan 02). It contains 18 graphics to help understand the trends and nuances in OASI. Any updates to the working paper will be available at this same internet link with the date noted.
The analysis and proposal in this working paper are unique in that they use the power of compounding to produce the desired result of bringing OASI benefits permanently in line with OASI income. The four key points are:

The OASI annual revenues on the long term are only about 75% of the OASI benefits according to the current law and formulas for calculation of benefits.
Mathematically, a reduction of 25% in overall benefits can be achieved with an annual adjustment of 0.4% in OASI benefits, which becomes an on overall reduction of 26% when compounded annually over 75 years.
The third point is a question: Is the current OASI Trust Fund balance sufficient to allow for the gradual reduction in OASI benefits? My analysis indicates that the answer is yes and that solvency with a Trust Fund Ratio of 100% can be maintained throughout the 75-year actuarial period.
Since no formula for benefits can ever be made to exactly balance OASI revenues, a refinement of the annual adjustment should be made annually to maintain a projected solvency of 100% Trust Fund Ratio.

An important overall result is that, for a retirement span of 20 years, the reduction in benefits would be on 8%, which should be compared to the 7% reduction in benefits associated with increasing the retirement age for full benefits by one year. An increase of 2 years in the retirement age for full benefits — a 14% reduction in benefits — has already be adopted in the law. The annual adjustment from the analysis in this paper is 0.474% for years 2011-2050, which results in a reduction of 9% over a 20-year retirement span.
My analysis has many of the same arguments as used in ~~PPI: A Progressive Fix for Social Security by Robert C. Pozen~~. In general, I endorse the arguments and conclusions by Mr. Posen, but I approach the solvency issue based on projected actuarial solvency over the long term. Since no formulas for benefits will ever exactly match the income into the Social Security OASI Trust Fund, annual adjustments, made annually, can ensure permanent projected solvency over the long term. The Nine Guiding Principles of Social Security (See Part 1, Chapter 1.) were used to guide the analysis.
I have selected two graphics from the working paper to illustrate the major findings. The first below shows the gradual change in OASI benefits over time as compared to the precipitous change that would occur if the Trust Fund becomes exhausted — currently projected to occur in 2040 (identified in the chart as "Solvency by Law").

Solvency of Social Security OASI for

Current Law and Solvency = 100%

    Note that both proposals converge to the same reduction in benefits over the long term which is based on the income and benefits being matched. This results in a reduction in benefits of about 25% as reported in the 2010 Trustees Report.

   For a retirement span of 20 years, the reduction in benefits would be about 9% based on this analysis, which is the same order of magnitude as the 7% reduction in benefits for each year increase in the retirement age for full benefits. Consequently, the level of reduction is well within the range being considered in other proposals.

   The second graphic below shows the solvency of Social Security OASI for the long term for the proposal.

Level of Change in Social Security OASI Benefits
for Current Law and Solvency = 100%

    For the current law, the Trust Fund Ratio (assets at the beginning of the year divided by projected benefits (costs) for the year) becomes zero in 2040, the time at which benefits must be reduced to match income.

   For my proposal, the annual adjustments in benefits were selected to ensure a projected Trust Fund Ratio = 100% on the long term. Targeting a Trust Fund Ratio, such as 100%, for the long term is actuarially sound.

   The abrupt change in benefits is avoided because the current Trust Fund balance is used to ease the transition to balancing OASI income and benefits (costs).

   The effect of the annual adjustments in OASI benefits effectively converts OASI from being both a defined contribution and a defined benefit insurance to a defined contribution only with benefits adjusted to match available funds. Because the adjustments can be made gradually and over the long term, estimated benefits for retirement planning are still provided.

   The formulas for calculation of Social Security OASI benefits appear to create ever-increasing benefits for later dates of birth. Mr. Pozen appears to have made the same observation. Such increases in benefits are counter-productive to the objective of maintaining balance between OASI income and benefits. Elimination of this structural increase in benefits might be sufficient to maintain solvency over the long term. Careful study is required.

The conclusions listed in the working paper are:

Since the longer-range requirements cannot be accurately predicted, a self-correcting method is needed to ensure permanent solvency of the Social Security Trust Fund.
A simple and fair self-correcting adjustment to ensure projected long-term solvency is an annual adjustment factor updated annually applied to all benefits.
Small annual adjustments, that have been accepted as appropriate and are in the current law, in Social Security OASI benefits can be made to bring OASI Income and Benefits in balance over the long term.
The structural increase in benefits built into the current law (benefit formula) appears to be counter-productive to maintaining solvency. This appears to advantage those with later dates of birth — possibly at the expense of current retirees.
Structural benefit increases based on the Social Security OASI law should be avoided to prevent a counter-productive — in effect, hidden — effect undermining the national policy to ensure that OASI remains solvent and available to all participants.
With annual adjustments in benefits, updated annually, the solvency target can be based on actuarially-sound principles without having a large effect on benefits.
With annual adjustments in benefits, the current retirement age for full benefits can be maintained. Participants can always elect to delay retirement which would result in higher annual benefits.
The large increases in Maximum Taxable Earnings may be counter-productive to maintaining balance between OASI income and benefits since benefits increase with increases in maximum taxable earnings. Limiting increases in Maximum Taxable Earnings to the cost of living plus productivity improvements would seem to be good public policy.
Since the income tax collected on OASI income is returned to the OASI Trust Fund, after-tax income should be the basis for evaluating the effects of any proposal on OASI benefits.
Some detail adjustments in the incomes subject to Social Security tax and benefits may be appropriate to ensure sharing of benefits and burdens among current and future recipients. Those, however, are beyond the scope of this paper.
The cost of living formula in OASI calculations should be studied and refined to ensure that it reflects the cost-of-living changes meaningful for retirees. More consistent year-to-year adjustments would be helpful. See Social Security Cost-of-Living Adjustments and the Consumer Price Index.

The most important aspect may be:

An observation made concerning several aspects of the factors discussed in this working paper is that there may be a structural benefit increase (annual cost increase) with later dates of birth. It may be on the order of magnitude of 1% per year. It is not surprising that the complex formulas used to define the benefits might include some unintended consequences. The magnitude of the structural increase in costs may well exceed the downward annual adjustments necessary to achieve projected solvency over the long term. Are these structural increases intended or unintended? Understanding the reasons for this observation is very important, but is beyond the scope of this working paper.

I would be pleased to answer any questions concerning the proposal. I believe the proposal is unique in its use the power of compounding to produce a favorable outcome. Thank you for your consideration.

Sincerely,

Donald L. Nordeen
Gaylord, Michigan
(989) 939-8240

History: Changes are usually identified in the text with the date which facilitates searching by date. Edits are usually noted by add and ~~delete~~ changes.

2010 Oct 27 — Initial Post
2010 Nov 04 — Added content to the introduction.
2010 Nov 12 — Update link for Nine Principles. The prior link was removed from the internet.
2010 Nov 16 — Added paragraph on a comprehensive History of SSA 1993-2000. Internet links to the chapters and other references are included. Also added new Eighth Major Conclusion and renumbered the subsequent conclusions. Internet links checked and updated as required.
2010 Nov 22 — Added OASI tax rate chart (new Figure 13) and renumbered the subsequent figures.
2010 Nov 23 — Added memo re difference between increasing the retirement age for full benefits increasing the early (minimum) retirement age at which benefits are paid. Also added in multiple places a statement concerning erosion of confidence by younger participants that OASI as it exists today will be available to them when they retire. Revised paragraph to state that after-tax income is the net benefit to the participant and the net cost to OASI.
2010 Nov 30 — Added content and revised the basis for The Nine Guiding Principles of Social Security.
2010 Dec 28 — Added reference to Robert Samuelsonâ€™s article.
2011 Jan 02 — Minor editing for clarity.

Links: Permanent Solvency for Social Security at [http://curntbk.blogspot.com/2010/10/permanent-solvency-for-social-security.html]

A Curmudgeon's Notebook

October 27, 2010

Permanent Solvency for Social Security

No comments:

Post a Comment