Why Social Security Must Be Reformed

Social Security represents our national commitment that every American who has contributed to the country’s economy over their lifetime will have some income to support them in their retirement. It is not, however, as many Americans believe, a retirement savings account like, say, 401(k) accounts. The money that we pay into Social Security does not go to create a savings account for us; it goes to pay the benefits that are paid to our parents and grandparents.

That is because Social Security began paying benefits just three years after it was founded. Obviously, those initial recipients had not paid enough into the system to pay for their benefits. That “borrowing” from the future generations has been carried forward throughout the history of the program.

This type of retirement system is frequently referred to as a “generational transfer.” That is, we are transferring income from younger generations to the retired generation. This is not unlike the traditional model that existed in tribal and rural societies for millennia, where younger generations provided for those who had grown too old or infirm to contribute. When Social Security was created in 1937, the U.S. nationalized and monetized this traditional model.

The viability of a retirement system based on the generational transfer model depends on the ratio of those contributing to the system to those receiving benefits. For a generational transfer system to work well, there must be many more individuals contributing into the system than those receiving benefits. Conversely, the lower that ratio becomes, the more difficult it will be to sustain the system, because the burden on those contributing becomes too great. This is one of the reasons that we see higher birth rates in societies which traditionally relied on generational support for the elderly.

Demographers have developed a tool called the population pyramid to visualize how the relative size of generations compare. There is a valuable website, www.populationpyramid.net, which shows the population pyramid for every country in the world. It has historical data going back to 1950 and projections through the end of the 21st century. Here are their calculations of the pyramids for the U.S. in 1950 and 2100.

These diagrams vividly show the challenge of the long-term viability of Social Security. This is a case where the old adage that “demographics is destiny” could not be truer. In 1950, just ten years after Social Security began paying benefits, 58% of Americans were 20-64 and only 8% were over 65. As a result, there were just over seven Americans of working age for every potential retiree. Since 1950, the percentage of the population in the working age bracket is about the same (57%), but the percentage over 65 has more than doubled to nearly 19%. That lowers the ratio from 7:1 in 1950 to 3.1:1 today.

And the situation is only going to get worse. By 2050, the ratio falls to 2.3:1 and by the end of the century to 1.7:1. So, the burden on the working generations to support the retired generation will gradually become unsustainable.

We are already seeing this phenomenon play out. This is the reason that the private sector almost entirely abandoned “defined benefit” plans – which were largely based on the generational transfer model – 20-30 years ago. It is also the reason that, notwithstanding a steady increase in payroll taxes since the founding of Social Security, it is currently projected that the system will not be able to pay benefits at the current level beyond 2037.

Fortunately, this is a problem with a simple answer. In the future, Americans will have to work longer and save more. But sometimes the simple answer is hard to accomplish politically. More on that soon.

This article was originally published by RealClearPolitics and made available via RealClearWire.