The Future of Social Security: Shifting Away from Pay-As-You-Go

created by Raheem Williams |

This is the final installment in a series of articles addressing the future of Social Security.

In my previous articles, I laid out the arguments and counterarguments for raising taxes and/or reducing benefits to fix Social Security. However, none of those proposals addressed the challenges associated with how the program is funded.

The United States uses a pay-as-you-go model that allocates earnings from current workers to current retirees. Due to demographic changes, this system is failing as benefits become chronically underfunded. Rather than trying to fix Social Security, some economists propose shifting to an entirely new retirement model.

Countries around the world use different retirement systems with a variety of nuances and results. In the final post of my series on the future of Social Security, I will outline three alternatives to pay-as-you-go and describe the difficulties in transitioning.

Norway

The Government Pension Fund of Norway is an oft-cited example of a fully-funded national pension system. Back in 1966, Norway utilized a pay-as-you-go model called the National Insurance Scheme Fund (NIS Fund). This system operated similar to Social Security by taxing the earnings of current workers to pay for retirees. However, Norway invested surplus tax revenues in the open market to build up reserves for future shortfalls.

The Norwegians also established the Government Pension Fund of Norway in 1990 to further strengthen the existing retirement system and ensure that future generations would benefit from the current development of natural resources. Today, the fund is worth more than $1.04 trillion (nearly $200,000 per citizen).

Singapore

Singapore offers additional guidance when examining market-based alternatives. In 1955, while under British colonial rule, the city-state established the Central Provident Fund (CPF). Instead of taxing natural resources, Singapore mandates the use of individual retirement accounts. These accounts are funded by worker and employer contributions.

Unlike our system in the U.S., which is primarily a transfer between current workers and retirees, contributions to the CPF are set aside in individual investment accounts. These accounts are regulated by the government and offer citizens the flexibility to control some aspects of the investment strategy and to fund home purchases.

Change Hurts

Advocates for market-based retirement systems frequently point to the success of Norway and Singapore in implementing quasi-public funding models. They point out that Social Security offers Americans a dismal rate of return compared to the expected market rate of return. However, there is still much debate surrounding how to facilitate a transition.

Some economists propose a two-pillar approach in which a minimum standard of benefits is guaranteed to current retirees by continuing some version of pay-as-you-go. Meanwhile, a portion of payroll taxes from current workers begins to be dedicated to mandated individual retirement accounts.

It is unclear how this approach would affect current payroll taxes and beneficiaries. For these types of plans, the devil is in the details. Because the Social Security Trust Fund is no longer running large surpluses, it would be nearly impossible to shift away from pay-as-you-go without reducing the benefits of current and future retirees or increases taxes on current workers to cover the cost of their future retirement.

While it is easy to spot potential political and financial pitfalls of the two-pillar approach, until specific legislation is put forth, it remains mostly a theoretical construct.

Chile

One country that successfully navigated the transition from unfunded pension liabilities to a quasi-public system is Chile. Chile implemented a variation of the two-pillar approach in the 1980s by allowing workers to choose between privately-invested funds and the old pay-as-you-go system. A majority of workers chose to participate in the private system.

Research shows the shift from a centralized public system to a private, competitive market led to a loss of efficiency in administrative costs, but this loss was negated by higher returns. While Chile’s system is imperfect and presents some serious equity concerns, it provides a blueprint for nations looking to transition away from pay-as-you-go.

Conclusion

In the end, there are many different policy approaches available to reform Social Security. This series serves as an introduction to some of the most popular policy proposals, including raising taxes, reducing benefits, and shifting away from a pay-as-you-go system. It is clear that each of these options comes with inherent challenges and, regardless of the solution employed, it is unlikely that a universally accepted outcome will be produced. That is why the future of Social Security is a complex issue that deserves our attention.

Try It Yourself

Try your hand at fixing our nation’s Social Security problems with this tool from the Committee for a Responsible Federal Budget. The tool allows you to mix and match different policy changes to plug the projected Social Security shortfall. Click HERE to test your ideas. 

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