Why does the United States and every other developed nation have a system of social-insurance pensions? The simple answer is that social insurance is intended to ensure basic income to those no longer able to work. These include the elderly, the disabled, orphans, and widows and widowers with small children. “Ensure” means that incomes must be available reliably; “basic” means that government's obligation is limited. That is why social-insurance pensions typically replace a larger fraction of earnings of those at the bottom of the wage ladder than those at the top. Social Security benefits also rise as average earnings increase. As Bernard Wasow of The Century Foundation points out, in 1935, when the Social Security Act was passed, “basic” may not have included indoor plumbing and running water in much of the country.
There are alternatives to social insurance. One approach would leave entirely to individuals the task of saving for retirement and of buying insurance against death or disability. But left to ourselves, many of us would save too little and most of us would start saving too late. How many 30-year-olds are prepared to save 20 percent of their income every year of their lives, the portion necessary to buy a pension equal to their pre-retirement income? Most would procrastinate. But if they waited until age 45 to begin saving, they would have to save a whopping 35 percent of their income. Disability and life-insurance premiums would be extra. So would saving for their children's college education, and for new cars, houses, or a vacation. Even with the tax breaks currently on offer, not many of us would rise to this challenge and voluntarily save enough to maintain our living standards during retirement.
A second approach would be to depend exclusively on welfare payments to the indigent. This, however, would destroy social insurance as a program that protects the middle class as well as the poor. It would also create perverse incentives. Why bother to save if the sacrifices of deferring consumption generate no more than one could get on welfare?
Compared with other developed nations, the U.S. system is parsimonious. It provides smaller benefits compared with earnings, and at a later age. U.S. designers of Social Security never expected most people to sustain pre-retirement living standards on Social Security alone. They recognized that most people would need additional income from private pensions or personal savings if they were to avoid sizeable drops in living standards when earnings stopped.
The current system reflects that philosophy. Workers with average earnings who claimed retirement benefits at age 65 received an average of approximately $19,000 a year in 2001. For retirees with average earnings, this benefit replaced about 41 percent of earnings. (Nearly 72 percent received less because they claim benefits at an earlier age.) After the automatic deduction of premiums for part B (hospitalization) of Medicare, the remaining benefit equals only about 38 percent of earnings. Because of benefit reductions enacted in 1983 that take effect over the next few years, and because Medicare premiums are rising faster than Social Security benefits, “take-home” replacement rates are projected to fall still more -- to an average of about 33 percent of earnings for retirees in 2030.
In recognition of the need for sources of income to supplement Social Security, successive Congresses have offered tax incentives for employees to offer pensions and for individuals to save on their own, via IRAs, Keogh plans, and 401(k) accounts. These incentives have worked -- sort of. About half of all workers have pension coverage. Many have small additional savings, but few have sizable assets, and America's household savings rate is one of the world's lowest. Social Security still supplies more than half the income for more than three-fifths of all people over 65. It is the exclusive source of income for about one in five.
Against this background, President Bush would encourage workers to shift payroll taxes from Social Security into personal accounts. But all such individual accounts would be subject to financial market risk that is inconsistent with the basic objective of social insurance -- to ensure basic income. The worst risks would occur if people were free to pick and choose among assets. Some would get rich. Some would go broke. Forced diversification helps, but not enough. As broad a stock index as the S&P 500 lost nearly 50 percent of its value in an 18-month period during 2001–02.
Individual ownership means individual risk. Such risks are fine and proper as cold, hard incentives to direct the allocation of capital in a market economy. But the function of social insurance is to make sure that no one who has worked hard for a lifetime ends up destitute. Individual accounts cannot provide that guarantee. Social Security has done it for 65 years. It can continue doing so indefinitely, but not if proposals to strip it of revenue become law.
Henry Aaron is a senior fellow at the Brookings Institution.
