The chief actuary of the Social Security Administration has declared that Social Security, which is the federal government’s largest spending program, most workers’ largest tax expense, and most retirees’ largest income source, is “not in close actuarial balance.”1 That declaration came not today but in 1990, more than three decades ago. In 1991, the program’s trustees first called for action to address Social Security’s long-term finances. By 1997, the trustees’ calls became more pressing:
It is important to address both the OASI [Old-Age and Survivors Insurance] and DI [Disability Insurance] problems soon to allow time for phasing in any necessary changes and for workers to adjust their retirement plans to take account of those changes.2
Since then, Congress and various presidential administrations have accomplished precisely nothing to make the Social Security program fiscally sustainable and more responsive to 21st-century Americans’ needs. Today, Social Security faces a long-term funding shortfall approaching $18 trillion, and the program’s combined trust funds are projected to run out in the early 2030s.3
- Social Security’s imminent insolvency poses grave social and economic threats, particularly for the most disadvantaged retirees.
- Reforming Social Security to prioritize protecting against poverty in old age would reduce long-term costs while improving economic security.
- Alongside Social Security reform, Congress should establish supplementary retirement accounts funded by employer, employee, and government contributions. In conjunction with Social Security benefits, these accounts would enable seniors to maintain their standard of living in old age. This two-tier model is similar to the retirement systems of Australia, New Zealand, and the United Kingdom.
The only active Social Security reform legislation under consideration is from congressional progressives, who argue that due to the failures of the US private retirement saving system, the only alternative to a future retirement crisis is to expand Social Security benefits for rich and poor alike, financed by higher taxes on rich and poor alike. By phasing out the current $147,000 ceiling on wages subject to Social Security taxes, the Social Security 2100 Act, cosponsored by nearly nine in 10 House Democrats, would raise the effective top marginal tax rate on earned income by 12 percentage points, giving the United States one of the highest top marginal tax rates in the developed world.4
Since the failure of President George W. Bush’s 2005 Social Security reform, Republicans and conservatives have been adrift on how to address the program’s looming insolvency. Many right-leaning officials have reverted to denial: wishing neither to increase Social Security taxes nor to reduce benefits, but not yet internalizing that those are the only two options available.
In this chapter, I discuss how Social Security is financed and how changing demographics increase the program’s costs and make it a poorer deal for current and future Americans. But I also discuss some good news: During a period when nothing has been done to fix Social Security, Americans’ own private retirement savings have skyrocketed, and retirement incomes have reached new highs. In combination, these two trends point to solutions that make Social Security more affordable and effective: reforms to truly guarantee against poverty in old age while gradually scaling down Social Security retirement benefits for middle and high earners, building a more limited but more robust safety net.
In conjunction, private retirement saving would be scaled up by making on-the-job retirement plans accessible to all workers and using incentives, nudges, and potentially a mandate to ensure that all US employees save some minimum amount for retirement. This approach, modeled on systems in countries such as Australia, New Zealand, and the United Kingdom, could pave the way for a more affordable Social Security program without sacrificing Americans’ retirement income security.
Understanding Social Security
Social Security provides a retirement income base on which most Americans must build with personal savings, employer-sponsored retirement plans, and earnings in retirement. The Social Security program was created in the 1930s under the Franklin D. Roosevelt administration. “We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life,” Roosevelt said, “but we have tried to frame a law which will give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age.”5
The Social Security program has several defining features that were introduced in 1935 and continue to this day. First, it is a contributory social insurance program, meaning that employees pay into Social Security from their wages. Roosevelt saw the worker contribution as generating earned benefits, not mere welfare to those who failed to provide for themselves. In 1935, the Social Security payroll tax was 2 percent of the first $3,000 in earnings, split evenly between employers and employees. In 2022, employees and employers pay a combined 12.4 percent of employee wages to Social Security, with the tax levied up to a maximum of $147,000 in annual earnings.
Second, while Social Security is contributory, it is also progressive. Benefits rise with wages in dollar terms. However, retirement benefits as a percentage of preretirement earnings—the so-called replacement rate provided by Social Security—are highest for low-earning workers and decline as earnings increase. The Congressional Budget Office calculates that for retirees who were born in the 1960s, Social Security benefits will replace 78 percent of the career-average inflation-adjusted earnings of individuals in the lowest fifth (quintile) of the lifetime earnings distribution, 49 percent for retirees in the middle quintile, and 31 percent for retirees in the highest earnings quintile.6 Financial planners often recommend a retirement income equal to 70 percent of preretirement earnings. Many low earners approach or even exceed that replacement rate through Social Security alone, while high earners must save substantial amounts on top of Social Security to get there.
Third, Social Security is funded on a pay-as-you-go basis, meaning that current taxes fund current benefits. Pay-as-you-go financing allowed the program to pay benefits soon after it was established, rather than waiting a full working generation before full benefits could be paid.
Over time, however, pay-as-you-go funding entails two significant downsides, which lie at the root of the financial problems that Social Security faces. First, a pay-as-you-go system pays huge windfalls to early generations of retirees, who receive full retirement benefits after contributing for only a few years. As late as the 1960s, retirees received over seven times more in Social Security benefits than they had paid in taxes over their working lifetimes.7 It’s no surprise that Social Security was extremely popular for many decades: Early program participants received a truly fantastic deal.
Yet this created a seesaw effect: Since Social Security is a pay-as-you-go program, the benefits paid out ultimately must equal the taxes paid in. If early generations of retirees received far more in benefits than they paid in taxes, later generations must pay more in taxes than they will receive in benefits. This explains why Social Security’s rate of return has fallen, such that many future retirees will get less from the system than they paid into it. In fact, every penny of Social Security’s nearly $18 trillion funding shortfall is a function of early generations of retirees receiving windfalls from the system. However Social Security’s funding gap is fixed, whether through tax increases or benefit reductions, it will never again be as good a deal for Americans as it was in its early decades of existence.
Pay-as-you-go funding creates an additional financing issue for Social Security. In a program that simply transfers money from workers to beneficiaries, the ratio of workers to beneficiaries is crucial. The math is not complex.
The average Social Security benefit is equal to about 40 percent of the average wage that workers receive in the economy. If there are 16 workers per beneficiary, as in 1950, we divide 40 percent by 16 to find that each worker must pay only about 2.5 percent of their wages into the program.8 If there are five workers per beneficiary, as in 1960, then the required payroll tax rate will rise to 8 percent of employee pay. And if there are only two workers per beneficiary, as there will be in coming decades, then the system’s cost will approach 20 percent of employee wages. (See Figure 1.)
Figure 1. Cost (as a Percentage of Wages) of Providing a Social Security Benefit Equal to 40 Percent of the Current Average Wage
This doesn’t necessarily mean the payroll tax rate must be set at 20 percent of pay; there are other ways to finance Social Security benefits, and of course benefits can be reduced. But even these simple illustrations show the powerful role of demographics in pushing Social Security’s costs upward.
In reality, Social Security has promised more in benefits than it will have the financial capacity to pay. Benefits must be adjusted downward or revenues adjusted upward.
The Blank-Slate Approach to Social Security Reform
Most Social Security reform proposals start with the current program’s tax and benefit formulas and then tweak these formulas based on a menu of common reform options to make the program financially sustainable in the long term. Different proposals place different weights on increasing taxes versus reducing benefits, but most reforms give little thought to Social Security as a program rather than a funding problem: They assume Social Security basically works well, except that it lacks sufficient funds.
The federal government treats almost no other program this way. Medicare and Medicaid are adjusted to produce better outcomes at lower costs. Welfare programs are reformed to improve social protections while reducing downsides, such as disincentives to work and marry. Education policy is continually reevaluated to improve outcomes. Yet Social Security is often treated as if its tax and benefit formulas were handed down on tablets from on high.
But there is another approach. Instead of thinking about where we would like the current system to evolve in coming years, we could ask what kind of retirement system we would like to give Americans who will retire, say, 50 years from now. These Americans have not paid a penny into Social Security, nor does the system owe them a penny.
This viewpoint allows policymakers to ask much broader questions. What protections should Social Security offer to future retirees? What should we demand that working Americans pay in return for those protections? How many retirement benefits should be mandated, encouraged, and simply left to individuals’ preferences?
Different people will describe that ideal Social Security program differently. Yet those who honestly perform this thought experiment are unlikely to answer, “Exactly like the current Social Security program,” because the world has changed dramatically in the 85 years since Social Security was designed. When Social Security was originally contemplated, widespread individual-level participation in capital markets for retirement saving was difficult to foresee. Practically no mutual funds were available, and those that existed were costly. No internet helped manage administration and investment choices. Americans were not merely financially illiterate but in many cases had difficulty even reading.9 Social Security was constructed as it was largely because there was little other option.
In the 21st century, however, many Americans would likely agree with the following framework: The government should protect against penury in old age, and it should do that job well. Gaps in the existing safety net should be filled. But to generate income on top of that government-provided protection, Americans should adopt greater responsibility to save for retirement on their own. After all, if every American saved assiduously for retirement, Social Security’s role could understandably be more limited.
Government policy should at the least facilitate household retirement saving; it might go further to automatically enroll workers in retirement plans, or it could take the final step and mandate personal retirement saving, as it effectively does today via Social Security. But dividing the labor between government-sponsored poverty protection and household-managed personal retirement saving allows each sector to operate at its best.
It is worth illustrating how this framework might play out by examining the retirement systems of similar countries, including Australia, Canada, New Zealand, and the United Kingdom. This exercise demonstrates how much might be accomplished by modeling policy after countries that share the United States’ tradition of social protections for the poor coupled with robust private financial markets.
Australia combines a means-tested minimum retirement pension, provided by the government and funded through general tax revenues, with a requirement that all full-time private-sector employees participate in an employer-provided retirement plan with a minimum contribution level. Australia’s Age Pension provides a retired couple with no assets or other income sources a benefit equal to about USD 1,900 per month. However, that government-provided minimum benefit decreases by 50 cents with each dollar the couple earns over about USD 450 per month. Benefits also decrease based on retirees’ assets, including their home value.
This means test acts as an implicit tax on personal saving for retirement, but Australia seeks to overcome that disincentive to save by requiring all full-time workers to participate in a retirement plan. Each employee is enrolled in a retirement plan funded by an amount equal to 9.5 percent of employee wages, contributed to by their employer. The contribution rate is scheduled to increase to 12 percent by 2025. About half of Australian retirees receive the full means-tested benefit, about one-quarter receive a reduced benefit, and about one-quarter lose their benefit via the means test.10 The 2020 cost of the means-tested benefit in Australia was 2.5 percent of gross domestic product (GDP). Over time, as savings grow in employer-sponsored retirement plans, government outlays on the means-tested benefit are projected to decline to about 2.3 percent of GDP in 2060, despite a decline in Australia’s ratio of workers to beneficiaries.11 Over that same period, US government expenditures on Social Security are projected to increase from 5.3 percent to 6.05 percent of GDP.12
New Zealand offers a universal, non-means-tested, flat-dollar benefit to nearly all retirees, regardless of past earnings or years in the labor force. For a retired couple, the New Zealand Superannuation benefit is equal to about USD 1,800 per month. That flat-dollar benefit is not reduced based on other retirement savings, though it is subject to taxes. The lack of a means test makes New Zealand’s Superannuation benefit more expensive than a means-tested program such as Australia’s Age Pension, but it also reduces the need to mandate personal retirement saving on top of what the government provides. New Zealand’s supplemental KiwiSaver accounts, introduced in 2007, feature automatic enrollment and a government and employer match but no requirement to save.
The United Kingdom’s reformed State Pension offers benefits based on years in the labor market, not average lifetime earnings, in contrast to US Social Security. A couple who have both spent at least 35 years in the labor force would each receive the full new State Pension benefit of about USD 1,800 per month. The State Pension is not means-tested, though it is subject to income taxes.
Additionally, in 2012, the United Kingdom introduced the National Employment Savings Trust, which automatically enrolls all employees who earn a minimum of about USD 10,000 per year in a defined contribution retirement account if they are not already offered a retirement plan at work. Participation is voluntary, but if the employee continues in the plan, their employer must contribute at least 3 percent of their pay, and the employee must contribute at least 5 percent of their salary. Most employees, however, receive a government credit that reduces their cost to about 4 percent of their salary.
Canada’s government retirement system has two tiers. Canada’s Old Age Security (OAS) benefit is a buffer to prevent poverty and is means-tested based on additional retirement income. The OAS benefit is paid on a flat-dollar basis and prorated based on years of residency in the country. The benefit and means-testing formulas are complex, but a retired couple with no other income sources would receive about USD 910 per month in OAS benefits. However, the OAS benefit can decrease if a retiree has other income sources, including from the Canada Pension Plan (CPP).
The CPP provides benefits on top of the OAS, but unlike US Social Security, the CPP benefit formula is not progressive. Each retiree receives a benefit equal to 33 percent of their average preretirement earnings, whereas Social Security can replace up to 90 percent of preretirement earnings for very low-earning individuals. The relatively low level of earnings that are subject to CPP taxes limits CPP benefits’ dollar value.
In the US, Social Security payroll taxes are levied on earnings up to $147,000 in 2022, while in Canada, taxes are levied and benefits calculated based only on earnings up through about $65,000 per year. Thus, the average new Canadian retiree in 2021 received a CPP benefit of about $562 per month versus over $1,600 in US Social Security benefits for an average new retiree that year. On top of the OAS and CPP, Canadians may participate in employer-sponsored retirement plans similar to those offered in the US.13
The point of this review is that however politically sacrosanct US policymakers might consider Social Security’s tax and benefit formulas to be, there are other ways to attain retirement income security that are compatible with the United States’ basic political and economic traditions. Australia, Canada, New Zealand, and the United Kingdom each have fully functioning economies and democracies and provide well for their retirees while structuring their retirement systems differently from the US Social Security program.
How Social Security Reform Might Look
I construct a Social Security reform plan built on the general philosophies of retirement programs in the four countries discussed above. The reform plan most closely resembles Australia’s retirement savings model while allowing policymakers to make several significant choices regarding the plan’s ultimate structure.
In this reformed Social Security program, retirees would be guaranteed a government-provided benefit equal to 28 percent of the national average wage for single retirees and 41 percent of the average wage for couples, as is done in Australia. For 2022, given that the Social Security Administration projects the average wage will be $61,600, this would produce a benefit of $27,720 for single retirees and $33,880 for couples.14 In each case, these benefits are slightly over twice the federal poverty threshold.15
Using 2022 parameters, in which approximately 55 percent of retiree households are married, 45 percent are single, and there are 2.7 workers for each beneficiary, these benefits would cost approximately 8.8 percent of employee wages. On top of this cost would be expenditures for Social Security’s disability and survivor’s insurance benefits. Moreover, the 2022 cost terms would rise to about 11.4 percent of employee wages as the changing demographics gradually reduce the worker-to-beneficiary ratio to two-to-one.16
Policymakers must face two important questions. First, would this base benefit be means-tested? In Australia, the government-provided benefit is subject to a means test that eliminates benefits for roughly the richest quarter of the retiree population, reduces them for another quarter, and leaves them unchanged for approximately half of retirees. A similar means test in the United States would reduce the cost of the minimum benefit by approximately 38 percent, reducing the long-term cost from 11.1 percent of wages to about 7.1 percent.17
However, a means test acts as an effective tax on retirement savings. For that reason, Australia mandates that all employers offer a retirement plan and that all employees must participate, with contributions funded by employers alone at an amount equal to 12 percent of employee wages, up to a maximum annual wage of about USD 178,000. Together, mandatory personal retirement savings and a means-tested government benefit reduce the cost of Australia’s government retirement system.
An alternative approach would not means-test the reformed Social Security benefit, which would increase its cost but reduce the need to mandate personal retirement saving. New Zealand’s flat-dollar retirement benefit is not means-tested. While employees are automatically enrolled in workplace retirement plans, they are free to withdraw if they choose. Thus, whether to means-test the reformed Social Security benefit involves a trade-off between financial costs to the taxpayer and individuals’ personal autonomy to prepare (or not prepare) for retirement as they choose.
Policymakers must also choose how to finance the government-provided benefit. A tax on wages currently funds Social Security. Although there is no explicit link between taxes paid and the benefits to which a person becomes entitled, payroll tax financing was designed to make Social Security more closely resemble a private retirement savings plan. But if policymakers shifted Social Security’s focus toward preventing old-age poverty, they might also consider altering how benefits are financed.
In Australia, Canada, and New Zealand, general tax revenues fund government retirement benefits focused on poverty prevention. In the US, individual income taxes generate most general tax revenues. The United Kingdom, by contrast, continues to fund its flat benefit with an explicit tax on earnings, similar to Social Security’s payroll tax. Congress would more likely choose to fund a poverty-oriented Social Security benefit with general tax revenues if that benefit were means-tested, while it would probably retain a payroll tax if no means test were applied to benefits.
A means-tested benefit coupled with general revenue financing would be far more progressive than the current program, leaving low earners better off on both the tax and benefit sides of the program. But this would also shift more costs to higher-earning households. Since Social Security is underfunded, payroll tax and general revenue financing could conceivably be combined to help fill the funding gap. For instance, general revenues might initially be employed to ensure that no retirees received less than promised under the new benefit formula, even if they had worked most of their lives under the current benefit formula. Over time, as the maximum benefit payable by Social Security is phased down, the costs of the minimum benefit borne by general revenues might be increased and the payroll tax rate reduced when Social Security’s financial health allows.
I here outline a specific policy proposal for budgetary analysis purposes. Implementing this proposal would make Social Security solvent and fix shortfalls that the current pay-as-you-go structure created. Emulating Australia’s retirement system, the federal government would provide all seniors with a benefit equal to 28 percent of the national average wage for single retirees and 41 percent of the average wage for couples. Each employee must be offered and enrolled in a workplace retirement plan, which could be either an employer-sponsored plan or a government-sponsored defined contribution plan similar to the Thrift Savings Plan offered to federal government employees. As in Australia, contributions would be set at 12 percent of employee wages. Unlike in Australia, however, employers, employees, and the federal government would split the contributions.
Employers and employees would each contribute an amount equal to 5 percent of employee wages. The federal government would contribute an amount equal to 2 percent of employee wages, up to the national average wage. This federal contribution would be funded by reductions in the tax preference for private retirement savings, with a focus on reducing the net preference for the highest-income fifth of taxpayers. Universal retirement-plan coverage and participation would reduce the need for the federal tax preference. Moreover, higher-income households have demonstrated little difficulty in saving for retirement on their own.
All these provisions would be phased in, including introducing the minimum benefit, scaling down the maximum benefit that Social Security pays, introducing mandatory retirement-plan coverage and participation, and scaling up the contribution rate, perhaps by starting at 1 percent of employee wages and increasing each year until the 5 percent ultimate contribution rate is reached. Other provisions would also need to be filled out, such as whether and to what degree retirement-plan balances must be converted to annuities rather than being available as lump sums.
The United States needs innovative thinking on a range of public policy issues, including Social Security and retirement savings. Unfortunately, anyone advocating a more focused Social Security program and increased private retirement savings will likely be accused of wishing to “privatize” the program. But Australia, Canada, New Zealand, and the United Kingdom clearly demonstrate ways to address retirement security that reduce budgetary costs and increase private retirement savings while agreeing with our political and economic traditions.
Reforming Social Security to focus on low-earning Americans could eradicate old-age poverty while making the program financially sustainable. The nation should reform its private retirement savings system to close coverage gaps and automatically enroll employees in retirement plans. Compared to other public policy challenges facing the United States, such as health care and education, Social Security and retirement savings are eminently solvable—but only if policymakers willingly step up with creative solutions to politically difficult issues.