(May 2002) Social Security and Medicare reform proposals were important topics of debate in the 2000 presidential campaigns, and they are likely to be prominent on the congressional agenda for some time to come. In December 2001, a bipartisan commission appointed by President George W. Bush produced three separate sets of recommendations for Social Security alone, focusing mainly on providing or encouraging individual retirement accounts. A complete set of solutions to the fiscal problems caused by population aging across the board will take a great deal more work.

This guide does not offer detailed proposals, but it does offer suggestions for evaluating the detailed proposals that emerge from the political process.

Population Aging Is Not Just a Social Security Problem

Social Security is expected to grow mainly because of the increase in the number of older people. Medicare is expected to grow both because of the increase in the older population and because of the continued increase of health care expenditures per person (although the extent of the increase is difficult to predict). Projections of Medicaid’s growth are based on the proportion of the older population expected to need care and on the proportion who will rely on family members or care in the community, although those numbers are hard to predict. At present, Medicare expenditures are just over half as large as Social Security expenditures. By 2030, when most baby boomers will be retired, the two programs will be about the same size, even under the Congressional Budget Office’s assumption of slower growth in health care costs.

Sometimes it pays to keep problems separate, but since decisions made about any of the three programs (Social Security, Medicare, and Medicaid) can have major consequences for older people, reforming all three at once could permit more compromise and coordination. As population aging speeds up, reforming the social insurance system becomes more urgent.

Restoring the Balances in Trust Funds Is Not the Only Goal

Each year, the Social Security trustees present their findings in terms of the estimated actuarial balance for a period 75 years into the future. For the funds to be in exact balance, the discounted value of all the expected payments into the fund during the next 75 years would have to equal the discounted value of all expected benefits to be paid out of the funds. The 2001 trustees’ report projected that the benefits would exceed the taxes paid in by 1.86 percent of total payroll. But even if the funds were in balance, the system would need further reform. Surplus years are expected early in the 75-year period, but the system would be in deficit in all the later years. To build up the trust funds enough to make them sustainable for the rest of the century and beyond would require a payroll tax increase of between 3 percent and 6 percent, not 1.86 percent.

The Social Security and Medicare trust funds have been running surpluses in recent years, as members of the large baby boom generation are in peak earning years and most beneficiaries are members of the much smaller Depression and World War II generations. The surpluses are, by law, invested in interest-bearing obligations of the government, and the interest counts as revenue in future years. In essence, the assets of the trust funds are promises from the government to pay for future benefits in future years. Proposals to put the surplus in a “lockbox” are adding another promise to the ones already made in the entitlement law and the bond obligation. Promises are credible if there is reason to believe that future Congresses and presidents will feel bound by them. Past attempts to cap discretionary spending at the federal level suggest that no single Congress can do much to take fiscal policy out of the hands of its successors. It is not clear why future retirees should feel more secure if a lockbox provision were added, or less secure if it were not.

Some reform plans would allow part or all of an individual’s contributions to be invested in private assets, such as equity stocks or money market funds. Such privatization would entail a break from the pay-as-you-go tradition. If there were complete privatization, an individual’s benefits would depend on the amount of her or his contributions and the investment performance of the assets chosen. Each generation, in principle, would take care of its own retirement, rather than relying on succeeding generations of workers. Partial privatization would entail some residual guarantee of a minimum benefit payment to each retiree, whatever the performance of his or her investments.

Privatization would mean that future retirees would draw their incomes from dividends and interest paid by companies and financial institutions. This method of payment might be more palatable to future workers, since it would look more like something owned by future retirees than something promised to them in the past by the government. Nevertheless, the basic demographic problem remains: In the future, a larger proportion of the population will not be working to produce goods and services but will still have a claim on those goods and services.

Reforms’ effects on the economy will depend on their impact on savings and investment, thus affecting the size of the economy from which both retirees and workers will derive income, and what they do to redistribute income. If privatization or matching savings plans increase the proportion of national income that is saved and invested, they may increase the growth rate and thus make future retirement and health care programs more affordable. But if they simply divert funds people would have saved anyway into different channels, the overall effect on the real economy would likely be small.

Reform Proposals Should Consider the “Transition Generation”

One of the biggest challenges faced by reformers, particularly those proposing partial or complete privatization, is figuring out how to manage the transition so that one generation does not end up being caught in the middle, paying for current retirees as well as financing its own future retirement.

People born between 1875 and 1915 received a large gift from future generations through Social Security, because when it was implemented it began paying out benefits to retirees who had not been paying into the system for very many of their working years. This bonus to the early generations amounted to a 4 percent or 5 percent increase in their lifetime wealth. The transfer was financed by a small loss imposed on people born after 1935, rising to several percent of lifetime wealth for those born today, and increasing as the population ages. If Social Security were privatized, many people born after 1935 would face a significant loss of lifetime wealth, but those who are now early in their working careers or not yet working would spend most of their careers in the new system and would see a much smaller loss. If each cohort of voters acted only in their own self-interest, those currently over age 50 would probably be neutral about privatizing Social Security, most of the working-age population would be opposed, and the very young would be in favor.

Although there is controversy about exactly how high the bill for the transition would be, most economists agree that there would be some costs, which should be compared to the promised benefits.

Consider Both Fairness and Actuarial Balance

Discussions of entitlement reform are complicated because there are several possible approaches to reform, involving various combinations of increases in revenues or decreases in benefits. Social Security benefits could be decreased if a lower estimate of the cost of living were used to index benefits, if the ages of eligibility for full or partial retirement benefits were increased further, or if a means test were set for all or part of the benefits. Medicare expenditures could be lowered or targeted by paying less to providers for some services, by reducing the number of services paid for, or by raising premiums or copayments for some or all beneficiaries. Revenues could be increased by raising the payroll tax rate, by raising the upper limit on salaries taxed for Social Security, or through some other device. Political feasibility, equity, and efficiency may require a complex mix of these basic approaches.

Adding coverage of prescription drugs to the Medicare program or matching private savings for retirement may be among the most popular ways to allocate the country’s growing wealth. But voters and elected officials should know that the number of beneficiaries is about to grow rapidly and that there is no clear idea where the growth will end. And the nation should know about costs and benefits of alternate uses of funds, including programs for older people, programs for younger people, and programs that are age-neutral.

Ronald Lee is professor of demography and economics at the University of California at Berkeley, where he also directs the Center for the Economics and Demography of Aging. John Haaga is director of the Population Reference Bureau’s domestic programs group.

Excerpted from PRB’s Reports on America, “Government Spending in an Older America” (PDF: 455KB).