Testimony of Christian Weller

Senate Special Committee on Aging

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Good morning. Thank you very much, Chairman Craig, Ranking Member Breaux, and members of the committee for inviting me to speak on the issue of individual accounts and Social Security.

I would like to make the following points:

  • Social Security is a necessary and increasingly important component to improve retirement income adequacy,
  • Any expected shortfalls under Social Security can be addressed without radically changing the system, and
  • Privatization as an alternative is too risky and too costly.

The Elusive Quest for More Retirement Income Adequacy

Usually, 80 percent of pre-retirement income is considered adequate for a decent standard of living. A substantial minority of households – about one third – falls short of this standard. The shortfalls are especially large for minorities, single women, workers with less education, and low wage workers. To make ends meet in retirement these households will have to curtail their consumption, often severely, and rely on public assistance.

Retirement income adequacy has also worsened for the typical household. Underlying this trend are three factors. First, Pension coverage has remained low and declined in recent years. Further, retirement wealth has become increasingly unequally distributed. Finally, with the proliferation of defined contribution plans, such as 401(k)s, risks have shifted onto workers.

Social Security’s Growing Relative Importance

Against this backdrop, Social Security gains in relative importance. Its coverage is almost universal, its benefits favor low lifetime earners, and it has guaranteed lifetime, inflation adjusted benefits. The share of households nearing retirement in 1998 that could expect some benefits from Social Security was 97.7 percent. Further, Social Security offered higher relative benefits to lower-lifetime earners. This is especially important to women, minorities and workers with little education. And guaranteed, inflation-adjusted lifetime benefits are particularly valuable for older retirees as they begin exhausting their savings.

Part of Social Security’s importance also results from its other benefits. One third of its expenditures pays for disability and survivorship benefits. These benefits are also at stake when Social Security benefits are reduced to pay for privatization.

But Social Security’s benefits are bare bones. The average replacement ratio is about half of that in Germany or Italy. And the average monthly benefit was about $850 in 2002. Yet, Social Security benefits were 80 percent of income for households in the bottom 40 percent of the income distribution in 2000.

Social Security’s Long-term Financial Outlook

Yet, Social Security’s trustees predict a financial shortfall in the long run. It is anticipated that by 2042, Social Security will have exhausted its trust funds and that tax revenues will cover more than two thirds of promised benefits. An immediate and permanent increase of the payroll tax by 1.89 percent would allow Social Security to pay all of its promised benefits for the next 75 years.

Social Security expenditures are expected to stabilize at around 6.5 percent of GDP. But payroll tax rates will grow as the tax base shrinks at the same time. Thus, Social Security’s expected shortfalls can be addressed within the parameters of the system.

Privatization Too Risky and Too Costly

Privatization as an alternative is too risky and too costly. And it would require large transfers from general revenues and large benefit cuts to pay for benefits that workers have already earned.

With privatization, insurance is replaced with savings accounts. That is, risks are privatized. These risks include the risk of misjudging the market and investing in losing assets. Another risk is the possibility of financial markets staying below their long-term average performance for long periods of time. Moreover, workers face the risk that they will exhaust their savings during their retirement. And finally, workers face the risk that they are unemployed or have low earnings, when asset prices are low, so that they cannot take full advantage of dollar cost averaging.

Along with the risks, the costs rise, too. For one, administrative costs rise, particularly for low income workers in small plans. These costs top 1 percent of assets annually.

Other costs arise from the loss of security. For instance, workers could purchase lifetime annuities to minimize longevity risks and they could purchase investment guarantees to reduce market risks. The costs of lifetime annuities average about 5 percent of savings, with higher costs for smaller accounts. And the costs of guaranteed minimum benefits amount to 16.1 percent of annual contributions during a 40-year period with a balanced portfolio.

And some workers are more likely than others to experience unemployment and low wages during an economic downturn. Thus, they cannot take full advantage of dollar cost averaging. In research I am conducting with Professor Wenger from the University of Georgia, we find that this adds costs similar to those associated with annuitization for women and minorities.

All of these costs will not be offset by substantially higher rates of return. In particular, Social Security’s expected long-term shortfalls are based on low-growth assumptions. But stock market returns follow economic growth over the long-term. Hence, if the trustees are correct in their assumptions, the real rates of return on the stock market should also fall below historical averages.

Privatization also increases the costs to the government. Privatization means that Social Security has less income to pay for promised benefits. To fill this gap, Social Security would either have to receive large transfers from general revenue, raise payroll taxes, or cut benefits. For instance, enacting Model 2 of the President’s Commission to Strengthen Social Security would entail a shortfall of $2.2 trillion in 2001 net present value terms.

And these large demands on general revenue are unlikely to be offset by faster growth. For one, national savings are unlikely to rise as a result of privatization as the literature shows. And more equity investments are unlikely to generate more productive investments since the stock market has been a drain on, not an addition to corporate resources for the past ten years.

Benefits would have to be cut as well. Today’s GAO report estimates that benefits would be 21 percent lower for a worker born in 1985 under the Commission’s Model 2.

In light of the obstacles to improving retirement income security, the relative importance of Social Security has grown. Social Security’s finances are secure for the foreseeable future and the anticipated shortfall can be addressed within the system. Instead, privatization would reduce retirement income adequacy through greater risks, more costs, higher taxes, and lower benefits for working families. Many of these risks and costs would be higher for low-income workers than for higher-income earners.

Thank you very much for your attention.

Christian E. Weller is a senior economist at the Center for American Progress.

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