Chapter 11
Social Security: Where Are We? Where Are We Going?
What's in This Chapter and Why
After years of rapid growth but relative obscurity, Social Security has emerged as one of the most
important and controversial domestic programs of the federal government. Students need to know
something about Social Security and how it is likely to affect their future. This chapter provides an
orientation to the program and its principal effects.
The chapter is structured around the following questions: (1) How does social retirement
insurance compare with private retirement insurance? (2) What difference has Social Security
made in the economic well-being of the elderly? (3) How good an investment is Social Security
from an individual's perspective? (4) Has Social Security reduced saving, investment, and the rate
of economic growth? (5) Does Social Security face a long-run deficit? (6) How can we best utilize
the projected Social Security surplus?
Instructional Objectives
After completing this chapter, your students should know:
1. The principal features of Social Security and how they compare to the key features of private
retirement insurance.
2. How to calculate and interpret the gross replacement rate.
3. The meaning of the real rate of return on Social Security.
4. The effect of Social Security on the income and wealth of the elderly.
5. The factors affecting the ability of Social Security to influence private savings.
6. How the Social Security Trust Funds are likely to behave over the next 75 years, and why.
7. How to limit the size of the long run deficit of the Trust Fund.
Key Terms
Pay-as-you-go fund
Fully-funded fund
Indexing factor
Average indexed monthly earnings (AIME)
Primary insurance amount (PIA)
Early retirement penalty
Inflation indexing
Delayed retirement credit
Substitution effect of a wage decrease
Income effect of a wage decrease
Wealth substitution effect
Social Security wealth
Induced retirement effect
Risk reduction benefit
Inflation protection benefit
Fertility rate
Privatization
Suggestions for Teaching
Although Social Security is in the news frequently, it is difficult to get the college-age reader
excited about the issues being raised. You may have some luck in getting their attention by asking
143
144  Chapter 11/Social Security: Where Are We? Where Are We Going?
them to determine how much they are likely to be paying in Social Security payroll taxes on their
first job, both assuming and not assuming that the employer's share is shifted to them in the form of
lower wages. Then get them to speculate about how much they will "invest" in Social Security in
the course of their working lifetime. Following this, it is helpful to remind them how important
Social Security might be as a source of income to them after they retire. These exercises usually
convince students that they have an important stake in learning more about Social Security and
how it affects the economy.
The first topic addressed is how Social Security works. The focus here is on comparing social
and private retirement insurance, rather than on the details of Social Security. You may want to let
students know how the private retirement insurance plans to which you belong actually work. The
issue of who actually bears the burden for the tax is discussed.
The next topic is the adequacy of Social Security benefits. The measure used is the gross
replacement rate, which our calculations show varies inversely with pre-retirement income. Assure
your students that this is no accident; rather, that Congress designed the basic benefit formula to
provide relatively more generous benefits to lower-income workers.
Students have a keen interest in learning about the rate of return on the tax dollars they invest
in Social Security. We do a present value and rate of return calculation for a typical college
freshman born in 1982. If you have not assigned Chapter 9 already, you should refer students to
the first section of that chapter for an introduction to these types of calculations. Students will
resist the view that the low real rate of return on Social Security that they can expect may compare
favorably with private alternatives that could provide the same benefits as Social Security. Some
discussion of variation in private rates of return, the value of the protection that Social Security
provides against inflation, risk of default, and poverty in old age will probably be necessary to
convince them of the plausibility of the case.
The effect of Social Security on saving is a subject of great importance and considerable
controversy. Students are provided with a review of several conflicting effects of Social Security
on savings, and a sketch of the inconclusive empirical findings. No attempt has been made to settle
the issue because it is not settled in the professional literature.
The last two sections in this chapter address the questions that are currently receiving the most
attention in the media: Is Social Security headed for a long-run deficit? How can the size of the
deficit be limited. Our objective here is to explain choices and to avoid taking sides.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. The description of social security provided annually in the Social Security Bulletin.
2. Subrata N. Chakravarty and Katherine Wiseman, "Consuming Our Children," Forbes
November 14, 1988, pp. 222-232.
Outline
I. PRINCIPAL FEATURES OF SOCIAL SECURITY
A. Definitions and General Comments
1. The term Social Security is used in this text to refer to the old-age and survivors'
insurance program (OASI) administered by the Social Security Administration. In its
Instructor's Manual  145
broadest sense, Social Security refers to all social insurance programs established by
the Social Security Act.
2. OASI was financed in 2000 by a payroll tax equal to 10.6 percent on earnings up to
$80,400.
3. Employers "pay" one-half of the OASI tax and employees "pay" the other one-half
(Note: the actual incidence is examined in the section; Who Pays the Social Security
Tax).
B. Social Security Payments
1. Social Security is primarily financed on a pay-as-you-go basis, unlike private
insurance, which is fully funded.
a. In a pay-as-you-go insurance plan, the fund has a balance that can cover future
benefits and expenses for only a short period of time.
b. A fully funded insurance plan has a fund that can cover future benefits and
expenses for many years.
2. Social Security provides periodic benefit payments based on earnings averaged over
most of a worker’s lifetime.
a. Benefits are determined by “indexing” the earnings before age 60 to account for
changes in average national wages in the same period.
b. Social Security adds the 35 years of highest indexed earnings and divides this
amount by 420 (the number of months in 35 years) to determine the average
indexed monthly earnings (AIME) to which it applies a formula to arrive at the
basic benefit, or primary insurance amount (PIA).
c. PIA is the amount a person would receive at the normal or full retirement age,
which varies between 65 and 67.
3. PIA/AIME ratio falls as income rises since the Congressional intent was to deliberately
provide a safety net for elderly poor.
4. It is estimated that 45% of elderly would fall below poverty line in absence of Social
Security, however, in 1998, poverty rate for elderly (10.5%) was below the poverty
rate for the population as a whole (12.7%).
5. Social Security is indexed to Consumer Price Index (CPI)
6. Workers who delay retirement beyond age 65 receive, from Social Security, a delayed
retirement credit of 8% up to age 70.
7. Income from Social Security is treated more favorably in the federal tax code than is
income from private retirement insurance.
II. WHO PAYS THE SOCIAL SECURITY TAX?
A. A 10.6% tax is levied on taxable payroll. Employers collect half through a payroll
reduction and remit the full amount to the federal government.
B. How Much of the Tax Do Workers Pay?
1. The shape of the labor supply curve depends on two effects.
a. The substitution effect of a wage decrease says that when the hourly wage
decreases, the opportunity cost of leisure time decreases. Workers substitute more
leisure time for fewer hours worked.
1. Declining wages mean fewer hours worked
2. This can create a positively sloped labor supply curve.
146  Chapter 11/Social Security: Where Are We? Where Are We Going?
b. The income effect of a wage decrease says that since wages have fallen the worker
needs to work more in order to maintain his or her income.
1. Declining wages mean more hours worked.
2. This can create a negatively sloped labor supply curve.
c. If neither effect dominates, the labor supply curve is vertical.
2. In the case of a vertical supply of labor curve, where a change in wages has no impact
on hours worked, employers are able to shift the entire burden of the tax on to the
workers without causing a loss of hours worked.
3. In the case of a positively sloped supply of labor curve (where the substitution effect
dominates), the lower wage rate due to the tax will reduce hours worked. Employers
cannot shift the entire burden of the tax on to the workers. They share the burden.
4. Which interpretation is correct?
a. Congress probably assumed that employers and employees would share the burden
of the tax.
b. Evidence tends to favor a supply of labor curve that is vertical, or nearly so, which
implies that workers pay most of the tax.
III. SOCIAL SECURITY AND EARLY RETIREMENT
A. Labor Force Participation Rate
1. Labor force participation rate is the percentage of a certain population in the labor
force.
2. For men 65 and over, it has fallen from 41.4% to less than 15 %.
3. This trend is due to various factors including higher incomes, private pension plans,
changing lifestyles, and Social Security.
B. Decreased labor force participation by men over age 65 was an early goal of the Social
Security program.
1. Older workers left the labor force and made room for younger workers who were
having trouble finding work during the Great Depression.
2. Today, early retirement is a problem.
a. It reduces labor supply and potential output.
b. It hastens the long-run Social Security deficit.
3. Early retirement penalties just make up for the extra years during which early retirees
will be drawing benefits. Total lifetime Social Security benefits are unchanged by the
penalty.
IV. SOCIAL SECURITY AND HOUSEHOLD SAVING
A. Social Security May Decrease Savings
1. If Social Security decreases savings, private investment, and hence GDP, will be
smaller.
2. Social Security may decrease savings because of the wealth substitution effect.
a. The wealth substitution effect induces workers to substitute Social Security wealth
for other types of wealth that could be financed by savings.
B. Social Security May Increase Savings
1. If Social Security increases savings, private investment, and hence GDP, will be larger.
Instructor's Manual  147
2. The induced retirement effect may induce people to save more.
a. The induced retirement effect refers to Social Security's tendency to encourage
people to retire at an earlier age.
b. Greater savings will be necessary to finance the longer retirement period.
3. The bequest effect may induce people to save more. The bequest effect refers to the
tendency of Social Security to induce working people to increase their saving so as to
increase the bequest they leave their children.
C. Evidence: Social Security and Its Effect on Savings
1. Martin Feldstein found that over the period 1930 - 1992, the wealth substitution effect
dominated.
2. Over this period, a $1.00 in Social Security wealth was associated with a decrease in
savings of $.028. This is equivalent to a $392 billion reduction in saving, and would
indicate that Social Security has a negative impact on the capital stock, and hence,
economic growth.
3. Other studies have produced results ranging from a positive effect to a negative effect
only one-sixth the size of Feldstein's.
V. INDIVIDUAL RATES OF RETURN
A. Rates of Return Based on Monetary Benefits and Costs
1. The real rate of return on Social Security for a typical person born in 1982 who enters
college in fall 2000, at age 18, graduates in 2004, and works until age 67 is only about
1.24%.
2. If the student/worker's best alternative is the 2% real rate of return earned historically
on long-term government bonds, the investment made in Social Security is not worth
it.
3. If the student/worker bears the burden of only the half of the Social Security payroll
tax that is deducted from the paycheck, the real rate of return would increase to 3.48%,
which is much better than 2%.
VI. IS THAT ALL THERE IS TO IT?
A. Rates of Return Adjusted for Nonmonetary Benefits
1. There are 3 principal nonmonetary benefits.
a. Protection against income risk
b. Protection against inflation risk.
c. Protection against post-retirement poverty.
2. In summary, the real rate of return from an investment in Social Security retirement
program is likely to be closer to 5% than 1% estimated above.
VII.
THE LONG-RUN DEFICIT
A. What Social Security Analysts Say
1. Alternative I is the most optimistic projection of Trust Fund surpluses.
2. Alternative III is the most pessimistic projection.
3. Alternative II is considered the “best projection.”
a. The OASI Trust Fund should have a growing surplus for another 20 years.
b. By 2017, annual expenditures will begin to outweigh annual receipts.
148  Chapter 11/Social Security: Where Are We? Where Are We Going?
c. By 2041, the Trust Fund will be exhausted.
B. Are The Analysts Right?
1. Two variables in the creation of the above alternatives are widely debated.
a. Fertility Rates
1. The “best projection” assumes a fertility rate of 1.9.
2. The likely impact of higher fertility rates on the Trust Fund deficit would be
small.
b. Rate of Increase in real gross domestic product (GDP)
1. Social Security analysts expect GDP growth rate of 1.8% for the next 75 years.
2. According to data in the 1999 report, a 3% annual growth rate of GDP would
eliminate the long-run imbalance in the Trust Fund. Policies to increase real
GDP growth should be on the list of options for fixing the long-run Social
Security deficit.
VIII. WHAT CAN BE DONE ABOUT THE DEFICIT
A. Benefit Reductions
1. A reduction in benefits, starting now.
2. A reduction in benefits, starting after OASI Trust Fund assets are exhausted.
3. The use of a more accurate measure of inflation to index benefits.
4. A change in the method used to index the pre-retirement earnings of middle- and
upper-income retirees.
5. An increase in the normal retirement age.
B. Use a more accurate measure of inflation to index annual retirement benefits.
C. Change the method of indexing pre-retirement earnings of middle-and upper-income
retirees.
D. Increase the normal retirement age.
E. Revenue Increases
1. An increase in taxes, starting now.
2. An increase in taxes, starting after OASI Trust Fund assets are exhausted.
3. An increase in investment, financed by the Social Security surplus.
4. The privatization of Social Security
IX. THE TRADEOFF FOR INDIVIDUALS: LOWER DEFICITS MEAN LOWER RATES OF
RETURN
A. Calculations of the rate of return, above, reflect the unstated assumption that the long run
deficit problem will be solved without imposing additional taxes on, or reducing the
benefits of, our typical college graduate. This is unlikely to be the case.
B. Our typical graduate will be expected to pay his or her share of the costs associated with
the options just discussed. This will lower the rate of return.
Instructor's Manual  149
Answers to Review Questions
1. Explain how and why actual earnings are indexed to determine Social Security
retirement benefits.
Social Security provides periodic benefit payments to retirees based on earnings averaged over
most of a worker's lifetime. Benefit determination begins with the record of actual annual
earnings on which the Social Security payroll tax has been levied. Earnings realized before age
60 are then adjusted or "indexed" to account for changes in average national wages between the
year the earnings were realized and age 60. The indexing procedure uses the following
equation:
IEt = Et (ANW60/ANWt)
where IEt is the indexed value of earnings realized in year t, E represents past earnings, t is the
age at which the earnings were realized, ANW is the average national wage, and
ANW60/ANWt is the indexing factor - the ratio of the average national wage at age 60 to the
average national wage in the year when the earnings were realized.
After indexed earnings are determined, Social Security adds the 35 years of highest indexed
earnings and divides this amount by 420 (the number of months in 35 years) to determine the
average indexed monthly earnings (AIME). It then applies a formula to the AIME to arrive at
the basic benefit, or primary insurance amount (PIA). This is the amount a person would
receive at the normal or full retirement age. The normal retirement age depends on when a
person is born. It is 65 years for people born before 1938. It is 65 years and two months for
people born in 1938, 65 years and 4 months for people born in 1939, 65 years and 6 months for
people born in 1940, and it is scheduled to increase gradually each year until it reaches 67 for
people born in 1960 or later.
The formula for determining the basic benefit or PIA reflects the year a person was born. For
someone born in 1940 - a person who will be 62 in 2002 - the PIA formula is:
PIA = .9 (First $592 AIME) + .32 ($592 <AIME< $3567) + .15 (AIME over $3567).
2. Explain how Social Security provides more generous returns to the poor than to the rich,
using the concept of the PIA and AIME.
PIA formula places higher weight on the first bracket of AIME. Thus, the ratio of PIA to
AIME falls as AIME increases. The behavior of the PIA/AIME ratio indicates that the Social
Security PIA or benefit formula produces more generous benefits to lower- than to
higher-income retirees. This is not a mistake; it conforms to Congressional intent to
deliberately provide a safety net for the elderly poor.
3. "The Social Security payroll tax appears to be paid largely by workers, unlike Congress
intended.” Explain how this can be, using a diagram to illustrate your answer.
The extent to which the Social Security payroll tax is paid by workers will depend on the shape
of the labor supply curve. The labor supply curve describes how workers will respond when
their wage rate decreases (or increases). Many economists believe that the labor supply curve
is vertical, or nearly so. The interpretation of a vertical labor supply curve is that workers are
150  Chapter 11/Social Security: Where Are We? Where Are We Going?
unresponsive to changes in their wage rate. In other words, wage rates could increase or
decrease, but the number of hours worked would not change.
Wage per Hour
(Dollars)
S1
W1
W2
A
B
D
C
F
D2
H1
D1
Hours W orked
Let us assume that the labor supply curve is, in fact, vertical. The demand for labor curve is
negatively sloped and indicates the value of the output produces by each hour of work. In the
absence of a tax, the demand curve would be represented by D1 in the graph below, and
equilibrium wage rate and hours worked are W1 and H1, respectively. Workers receive
earnings equal to the wage rate times the number of hours worked, or the area C+D+F.
Employers claim the area A+B, which is the value of output over and above wages that must be
paid to workers.
Imposition of the payroll tax reduces the amount employers are willing to pay by 0.106 of the
height of the demand curve. This effect is indicated by the demand curve D2. The height of D2
is everywhere 0.106 less than D1. The new equilibrium is H1 and W2. There is no change in
the number of hours worked, but wage rate falls by the same percentage as the payroll tax rate.
Labor earnings fall to area F only, and government collects tax revenues equal to area C+D.
Employers’ income remains the same as before the tax, A+B. Thus the full amount of the tax
is passed on to the worker.
In more common language, because the worker is unwilling or unable to reduce the number of
hours worked when the wage rage decreases, the employer is able to pass the tax on to the
worker in the form of a wage decrease. The employer will suffer no consequences because
hours worked will not fall, and thus output levels will not fall.
Congress probably intended that the tax would be shared equally by workers and employers.
This would likely be the case if the supply of labor curve was upward sloping (as most supply
curves are). In this situation, if an employer tried to pass the tax on to the worker in the form
of lower wages, the worker will work fewer hours and output will be reduced.
Instructor's Manual  151
4. In theory, Social Security may or may not induce people to retire early. Explain.
Theory alone cannot predict if Social Security will induce people to retire early. On one hand,
the prospect of Social Security benefits encourages early retirement. On the other hand, Social
Security discourages early retirement by imposing an early retirement penalty and by providing
delayed retirement credits. Since theory alone cannot provide the answer, it is left to empirical
evidence to provide the answer, and evidence indicates that Social Security does indeed induce
people to retire earlier. Apparently, prospective benefits appear to outweigh the effects of the
early retirement penalty and the delayed retirement credit.
5. In theory, Social Security may or may not induce people to save less. Explain.
Theory cannot answer the question of whether Social Security causes people to save less. On
one hand, Social Security will reduce savings if workers assume that Social Security will
provide them with enough retirement income that they can spend a larger share of their preretirement earnings. If this happens, economists say that Social Security has a wealthsubstitution effect. In other words, workers will substitute Social Security wealth for other
types of wealth, such as private pensions.
On the other hand, if Social Security does induce people to retire early, then they may be
motivated to save more in order to finance this early retirement. The net effect of Social
Security on savings depends on the size of these two effects. Once again, empirical evidence
provides the best indication of the actual impact.
Martin Feldstein is an economist that is very well known for studying this particular question.
He is a firm believer that Social Security does cause people to save less and that this has a
drastic impact on real GDP.
6. If Social Security does induce people to save less, it only reduces savings by less than
three cents for each dollar of Social Security wealth. Surely this is a negligible effect. Do
you agree or disagree? Explain.
According to Martin Feldstein’s latest study, each dollar of Social Security wealth corresponds
to a decrease in household savings of $0.028 (less than three cents). While this sounds like a
relatively small impact, it turns out that this amount could have reduced household savings by
$392 billion. This means that investment and the nation’s capital stock were $392 billion less
than they would be in the absence of Social Security. Given Feldstein’s findings, Social
Security may have reduced potential output in 1999 alone by as much as $130 billion.
7. Given benefits and costs that can be measured in dollars, Social Security pays only 1 to 2
percent real rate of return for the typical college graduate. Is it really this low?
In strictly monetary terms, the rate of return to Social Security really is as low as 1.5% for a
typical college graduate. That sounds pretty low when most of us know that we could invest
the funds contributed to Social Security in other private securities and earn much higher
returns. What this ignores is the substantial nonmonetary benefits provided by Social Security.
There are three primary nonmonetary benefits of Social Security. First, it provides protection
against income risk. Individual investors are normally willing to sacrifice income to obtain
lower risk. How much they are willing to sacrifice depends on how much they value lower
risk. Social Security is almost free of income risk associated with market fluctuations
152  Chapter 11/Social Security: Where Are We? Where Are We Going?
Second, Social Security benefits are indexed for inflation. Again, investors are usually willing
to sacrifice income to obtain protection from inflation risk. Finally, Social Security provides a
safety net against low retirement income. Once again, investors would probably sacrifice
income to obtain that kind of protection.
In conclusion, because of these three nonmonetary benefits of Social Security, the real rate of
return to Social Security is really greater than 1-2%. Unfortunately, economists are not yet
able to tell us how much greater.
8. “All economists agree that Social Security is going to completely run out of money by
about 2036.” What parts of this statement are true and what parts are false? Explain.
First of all, you would be hard pressed to find a topic upon which all economists (or anyone
else for that matter) completely agreed. With respect to the Social Security deficit, there are at
least three Alternative projections. Alternative I is extremely optimistic, and Alternative III is
extremely pessimistic. Alternative II supposedly provides the “best estimate.”
According to Alternative II, the OASI Trust Fund will continue to run a surplus for about 20
more years. After that, annual expenditures will begin to outweigh annual receipts. By 2036,
the Trust Fund will be exhausted, and Social Security will be able to pay only part (roughly
2/3) of promised benefits.
Economists do not necessarily agree with the Social Security analysts in their “best estimate”
projections. Most often, economists raise questions about the assumed rate of growth of real
gross domestic product. The analysts project a major slow down in the growth rate of GDP by
2000 (down to 2%) and again by 2075 (down to 1.2%). Some economists believe that the
annual growth rate of GDP will not be this small, and, in fact, will be fast enough to totally
eliminate the long-run imbalance in the Trust Fund. The authors do not subscribe to this view,
but do believe that policies to increase real GDP growth should be on the list of options for
fixing the long-run Social Security deficit.
9. It is often said that the long-run deficit in Social Security can be eliminated at relatively low
cost if the problem is addressed right away, but that the cost will be quite high if we wait to
address the problem. Provide an example or two from the chapter that illustrate the point.
Eliminating the long-run deficit in Social Security might be accomplished if benefits were
reduced. Some advocate reducing benefits now. Others suggest waiting until 2036 (or
whenever the Trust Fund is exhausted). According to the 1999 annual report, the deficit could
be avoided if benefits were reduced by an amount equal to 1.7 percent of taxable payroll each
year, starting in 2000 and continuing until 2075. The cost per retiree would be small, only
about $163 per retiree, per year. In 2075, the required benefit reduction would actually
decrease to just 0.7% of benefits. Not only would the cost per retiree be small, but the costs
would shared by all generations of beneficiaries. If action is delayed until 2036, the annual
reduction in benefits would have to be 28.6% (compared to 1.7%) in 2036 and increased to
33.5% in 2075.
Another approach to eliminating the deficit would be to increase taxes. Again we could start
now or in 2036. If we start now, the tax increase would be relative small per retiree and would
be shared by all generations. If we wait until 2036, the cost per retiree would be quite large
and would be paid for younger generations only.
Instructor's Manual  153
10. “The long run deficit in Social Security could be eliminated by a series of small changes
that spread the cost out over the population and over time.” What, if any, such
combinations were implied in the discussion in this chapter? Explain.
Several combinations to spread small changes out over the population were discussed in this
chapter. Two were described in response to question 9. The deficit could be eliminated by
small tax increases for all generations beginning right now. Also, the deficit could be
eliminated by small benefit reductions shared by all generations beginning right now.
In addition, Michael Boskin of Stanford found that a small correction to the Consumer Price
Index (the index used to adjust Social Security benefits for inflation) would have a substantial
effect on the deficit if it was compounded over a long period of time. A correction of 1% could
reduce the deficit by 60%.
Also, if the normal retirement age were increased uniformly by 2 months each year from 2000
to 2030 and indexed thereafter to increases in life expectancy, the deficit would fall by 45%.
This would actually produce changes in both benefits and revenues.
11. One way to reduce the long-run Social Security deficit is to increase the rate of growth in
real GDP. Explain why, and explain how the appropriate use of the projected Social
Security surplus over the next decade or so will lead to this result.
According to some calculations, a 1.2% increase in the annual growth rate of real GDP would
eliminate the long-run Social Security deficit. Higher real GDP simply means that there is
more income in the economy to be taxed and thus OASI receipts would be larger.
The surplus in the Trust Fund that is supposed to exist for the next 20 years could be used in a
way that would actually increase investment and thus potential real GDP. Currently, the
surplus is invested in U.S. Treasury securities, providing income to the Treasury. This money
replaces money that would otherwise have to be borrowed by the Treasury to finance deficit
spending. This indirectly increases the supply of loanable funds available to private entities.
Use of the funds by the private sector could result in a larger real GDP, larger taxable payroll,
and larger Social Security tax collections.
There is a catch to this. The induced spending described above must be used to increase the
nation’s capacity to produce. If it does, the above is the result. If it does not induce spending
that impacts the nation’s capacity to produce, the Social Security surplus will not indirectly
reduce the long-run Social Security deficit. To ensure that the Social Security surplus
indirectly reduces the long-run Social Security deficit, the induced spending should be
concentrated in areas like education, training, and infrastructure.
12. Explain why privatization, alone, cannot eliminate the long-run Social Security deficit?
Portions of the surplus could be used to buy private securities. This is called privatization of
Social Security. However, even if all of the projected surplus was invested in private
securities, the Social Security deficit would shrink but would not be eliminated. The projected
deficit is simply too large.
The required revenue could be raised if a modest tax increase was put in place and the surplus
was privatized. This has several problems, however. First, the plan does not increase benefits
154  Chapter 11/Social Security: Where Are We? Where Are We Going?
paid to retirees, but does increase taxes. The result is an even lower rate of return. A second
problem is that private securities are subject to risk and this raises the specter that a prolonged
market downturn will jeopardize the Social Security Trust Fund. Finally, the government
could become a major shareholder in many private companies and might use their influence to
impact private sector decisions.
13. What do you think is most likely to really be the real rate of return on Social Security?
Explain, referring in your answer to the estimates presented in this chapter.
Calculation of the real rate of return of Social Security for a typical college graduate is only
1.24% if the Social Security is paid entirely by the student/worker. If the student/worker's best
alternative is the 2 percent real rate of return earned historically on long-term government
bonds, the investment made in Social Security is not worth it. However, the verdict is better if
the student/worker bears the burden of only the half of the Social Security payroll tax that is
deducted from the paycheck. In this case, the real rate of return is 3.48%, which is significantly
better than the 2% alternative.
Real rates of return on private securities are typically higher than the rates calculated for Social
Security, but income from private securities is subject to considerable variation or risk.
Individual investors are willing to assume additional risk if they receive a rate of return that
includes a risk premium. The size of the required risk premium varies by type of investment,
but premiums in the neighborhood of 3-4% are often mentioned. If Social Security is free of
income risk, a risk reduction benefit of this magnitude should be added to the real rate of return
on Social Security.
Investors should be willing to pay more for a security that provides protection against inflation.
Given the few investments that are indexed for inflation, there is little market evidence of the
value of this protection. That which is available suggests an inflation protection benefit in the
neighborhood of 1 percentage point should be added to the real rate of return on Social
Security for the inflation protection it provides. The bottom line is that the real rate of return
from an investment in the Social Security retirement program is likely to be closer to 5% than
it is to the 1% estimated above.