oversight

Social Security Reform: Analysis of a Trust Fund Exhaustion Scenario Illustrates the Difficult Choices and the Need for Early Action

Published by the Government Accountability Office on 2003-07-29.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                             United States General Accounting Office

GAO                          Testimony
                             Before the Special Committee on Aging
                             U.S. Senate


For Release on Delivery
Expected at 10:00 a.m. EDT
Tuesday, July 29, 2003       SOCIAL SECURITY
                             REFORM
                             Analysis of a Trust Fund
                             Exhaustion Scenario
                             Illustrates the Difficult
                             Choices and the Need for
                             Early Action
                             Statement of David M. Walker
                             Comptroller General of the United States




GAO-03-1038T
                                                 July 29, 2003


                                                 SOCIAL SECURITY REFORM

                                                 Analysis of a Trust Fund Exhaustion
Highlights of GAO-03-1038T, a testimony          Scenario Illustrates the Difficult Choices
for the Special Committee on Aging,
United States Senate                             and the Need for Early Action



 Social Security is an important                 Although the Trustees’ 2003 intermediate estimates show that the combined
 social insurance program affecting              Social Security Trust Funds will be solvent until 2042, program spending will
 virtually every American family. It is
                                                 constitute a growing share of the budget and the economy much sooner.
 the foundation of the nation’s
 retirement income system and also               Within 5 years, the first baby boomers will become eligible for Social
 provides millions of Americans with             Security. By 2018, Social Security’s tax income is projected to be insufficient
 disability insurance and survivors’             to pay currently scheduled benefits. This shift from positive to negative cash
 benefits. Over the long term, as the            flow will place increased pressure on the federal budget to raise the
 baby boom generation retires, Social            resources necessary to meet the program’s ongoing costs. In the long term,
 Security’s financing shortfall                  Social Security, together with rapidly growing federal health programs, will
 presents a major program solvency               dominate our nation’s fiscal outlook. Absent reform, the nation will
 and sustainability challenge.                   ultimately have to choose between persistent, escalating federal deficits,
                                                 significant tax increases, and/or dramatic budget cuts of unprecedented
 The Chairman of the Senate Special              magnitude.
 Committee on Aging asked GAO to
 discuss Social Security’s long-term
                                                 The Trust Fund Exhaustion scenario we analyzed dramatically illustrates the
 financing challenges and the results
 of GAO’s analysis of an illustrative            need for action sooner rather than later. (See Social Security Reform:
 “Trust Fund Exhaustion” scenario.               Analysis of a Trust Fund Exhaustion Scenario. GAO-03-907. Washington,
 Under this scenario, benefits are               D.C.: July 29, 2003.) Under this scenario, after the combined trust funds had
 reduced proportionately for all                 been fully depleted, benefit payments would be adjusted each year to equal
 beneficiaries by the shortfall in               annual tax income. Under this scenario, after trust fund exhaustion those
 revenues occurring upon exhaustion              receiving benefits would experience large and sudden benefit reductions.
 of the combined Old-Age and                     Additional smaller reductions in the following years would result in benefits
 Survivors Insurance and Disability              equal to about two-thirds of currently scheduled levels by the end of the 75-
 Insurance Trust Funds. This                     year simulation period.
 scenario was developed for analytic
 purposes and is not a legal                     The Trust Fund Exhaustion scenario raises significant intergenerational
 determination of how benefits
 would be paid in the event of trust
                                                 equity issues. The timing of the benefit adjustments means the Trust Fund
 fund exhaustion. GAO’s analysis                 Exhaustion scenario places a much greater burden on younger generations.
 used the framework it has developed             Lifetime benefits would be reduced much more for younger generations. In
 to analyze the implications of reform           addition, under the Trust Fund Exhaustion scenario, benefits would be
 proposals. This framework consists              adjusted proportionately for all recipients, increasing the likelihood of
 of three criteria: (1) the extent to            hardship for lower income retirees and the disabled, especially those who
 which the proposal achieves                     rely on Social Security as their primary or sole source of retirement income.
 sustainable solvency and how it
 would affect the U.S. economy and               Fundamentally, the Trust Fund Exhaustion scenario illustrates trade-offs
 the federal budget, (2) the balance             between achieving sustainable solvency and maintaining benefit adequacy.
 struck between the twin goals of                The longer we wait to take action, the sharper these trade-offs will become.
 income adequacy and individual
                                                 Acting soon would allow changes to be phased in so the individuals who are
 equity, and (3) how readily changes
 could be implemented,                           most likely to be affected, namely younger and future workers, will have
 administered, and explained to the              time to adjust their retirement planning while helping to avoid related
 public.                                         “expectation gaps.” Finally, acting soon reduces the likelihood that the
                                                 Congress will have to choose between imposing severe benefit cuts and
 www.gao.gov/cgi-bin/getrpt?GAO-03-1038T.
                                                 unfairly burdening future generations with the program’s rising costs.
 To view the full product, including the scope
 and methodology, click on the link above.
 For more information, contact Barbara
 Bovbjerg at (202) 512–5491 or Susan Irving
 at (202) 512-9142.
Mr. Chairman and Members of the Committee:

Thank you for inviting me here to talk about our nation’s Social Security
program. Social Security not only represents the foundation of our
retirement income system; it also provides millions of Americans with
disability insurance and survivors’ benefits. As a result, Social Security
provides benefits that are critical to the current and future well-being of
tens of millions of Americans. As I have said in congressional testimonies
over the past several years,1 this important program faces both solvency
and sustainability challenges in the longer term that require our attention
today.

Last January, I testified before this Committee on the need for early action
to reform Social Security.2 That testimony presented GAO’s analysis of the
reform models developed by the President’s Commission to Strengthen
Social Security. Since that time, the Social Security Trustees have issued
their 2003 report, which showed that the program’s financial condition
remains virtually unchanged since last year. Under the Trustees’ 2003
intermediate estimates, the actuarial balance of the combined trust funds3
over the 75-year period deteriorated from last year’s estimate of –1.87
percent of taxable payroll to this year’s estimate of –1.92 percent of
taxable payroll. The present value of this actuarial deficit is $3.8 trillion
over the 75-year period. Absent legislative action, within 15 years
projected Social Security outlays will begin to exceed projected tax
receipts, and by 2042 the combined Old-Age and Survivors Insurance and
Disability Insurance (OASDI) trust funds are projected to be exhausted.
These new estimates once more underscore the program’s unsustainability
as Social Security continues to await reform.

Today we are issuing a report you requested using the same criteria and
framework we used in our report on the Commission reform models to


1
 U.S. General Accounting Office, Social Security: Criteria for Evaluating Social Security
Reform Proposals, GAO/T-HEHS-99-94 (Washington, D.C.: Mar. 25, 1999); Social Security:
The President’s Proposal, GAO/T-HEHS/AIMD-00-43 (Washington, D.C.: Nov. 9, 1999);
Budget Issues: Long-Term Fiscal Challenges, GAO-02-467T (Washington, D.C.: Feb. 27,
2002); Social Security: Long-Term Financing Shortfall Drives Need for Reform
GAO-02-845T (Washington, D.C.: June 19, 2002).
2
 U.S. General Accounting Office, Social Security: Analysis of Issues and Selected Reform
Proposals, GAO-3-376T (Washington, D.C.: Jan. 15, 2003).
3
 In this testimony, the term “trust funds” refers to the combined Old-Age and Survivors
Insurance and Disability Insurance (OASDI) Trust Funds.



Page 1                                              GAO-03-1038T Social Security Reform
    analyze the potential effects over the long term if no program reform takes
    place. 4 For this analysis, we applied our criteria to a scenario in which the
    Trust Fund reaches exhaustion, after which only benefits equal to cash
    available from program income are paid. The scenario illustrates some
    potential outcomes of a lack of action to address the serious imbalance
    between Social Security’s projected revenues and the costs of paying
    currently scheduled benefits.

    Before I summarize the findings from this analysis, let me first highlight a
    number of important points in connection with the Social Security
    challenge.

•   Focusing on trust fund solvency alone is not sufficient. We need to
    put the program on a path toward sustainable solvency. Trust fund
    solvency is an important concept, but focusing on trust fund solvency
    alone can lead to a false sense of security about the overall condition of
    the Social Security program. The size of the trust fund does not tell us
    whether the program is sustainable—that is, whether the government will
    have the capacity to pay future claims or what else will have to be
    squeezed to pay those claims. Aiming for sustainable solvency would
    increase the chance that future policymakers would not have to face these
    difficult questions on a recurring basis. Estimates of what it would take to
    achieve 75-year trust fund solvency understate the extent of the problem
    because the program’s financial imbalance gets worse in the 76th and
    subsequent years.5

•   Social Security reform is part of a broader fiscal and economic
    challenge. If you look ahead in the federal budget, the combined Social
    Security or OASDI program together with the rapidly growing health
    programs (Medicare and Medicaid) will dominate the federal government’s
    future fiscal outlook. Under GAO’s long-term simulations it continues to
    be the case that these programs increasingly constrain federal budgetary
    flexibility over the next few decades. Absent reform, the nation will
    ultimately have to choose between persistent, escalating federal deficits,
    significant tax increases, and/or dramatic budget cuts.



    4
     As in our report on the Commission reform models, we used the 2001 Trustees’
    intermediate assumptions in analyzing the Trust Fund Exhaustion scenario.
    5
     In addition to assessing a proposal’s likely effect on Social Security’s actuarial balance, a
    standard of sustainable solvency involves looking at (1) the balance between program
    income and cost beyond the 75th year and (2) the share of the budget and economy
    consumed by Social Security spending.



    Page 2                                                GAO-03-1038T Social Security Reform
•   Solving Social Security’s long-term financing problem is more
    important and complex than simply making the numbers add up.
    Social Security is an important and successful social program that affects
    virtually every American family. It currently pays benefits to more than 46
    million people, including retired workers, disabled workers, the spouses
    and children of retired and disabled workers, and the survivors of
    deceased workers. The number of individuals receiving benefits is
    expected to grow to over 68 million by 2020. The program has been highly
    effective at reducing the incidence of poverty among the elderly, and the
    disability and survivor benefits have been critical to the financial well-
    being of millions of others.

•   Acting sooner rather than later would help to ease the difficulty of
    change. As I noted previously, the challenge of facing the imminent and
    daunting budget pressure from Medicare, Medicaid, and OASDI increases
    over time. Social Security will begin to constrain the budget long before
    the trust funds are exhausted in 2042. The program’s annual cash flow is
    projected to be negative beginning in 2018. Social Security’s annual cash
    deficit will place increasing pressure on the rest of the budget to raise the
    resources necessary to meet the program’s costs. Waiting until Social
    Security faces an immediate solvency crisis will limit the scope of feasible
    solutions and could reduce the options to only those choices that are the
    most difficult. It could also contribute to further delay the really tough
    decisions on health programs (e.g., Medicare, Medicaid). Acting soon
    would allow changes to be phased in so the individuals who are most
    likely to be affected, namely younger and future workers, will have time to
    adjust their retirement planning while helping to avoid related
    “expectation gaps.” It would also help to assure that the “miracle of
    compounding” works for us rather than against us. Finally, acting soon
    reduces the likelihood that the Congress will have to choose between
    imposing severe benefit cuts and unfairly burdening future generations
    with the program’s rising costs.

    The Trust Fund Exhaustion scenario analyzed in our report6 dramatically
    illustrates the need for action sooner rather than later. Under this
    scenario, once the combined trust funds had been fully depleted, benefit
    payments would be adjusted each year to equal annual tax income. 7 After



    6
     U.S. General Accounting Office, Social Security Reform: Analysis of a Trust Fund
    Exhaustion Scenario, GAO-03-907 (Washington, D.C.: July 29, 2003).
    7
     The Trust Fund Exhaustion scenario is intended as an analytic tool, not a legal
    determination.



    Page 3                                              GAO-03-1038T Social Security Reform
trust fund exhaustion, those receiving benefits would experience a large
and sudden benefit reduction of about 27 percent (to 73 percent of
currently scheduled levels) in 2039.8 By the end of the 75-year period,
smaller reductions in successive years after trust fund exhaustion would
mean that benefits would be about two-thirds of what they would have
been under current benefit formulas (or 67 percent of currently scheduled
levels).

The Trust Fund Exhaustion scenario raises significant intergenerational
equity issues. The timing of the benefit adjustments means the Trust Fund
Exhaustion scenario places a much greater burden on younger
generations. For example, those born in 1955 would receive currently
scheduled benefits until they reached age 83, while those born in 1985
would always receive benefits in retirement lower than currently
scheduled benefits. This means that lifetime benefits would be reduced
more for younger generations. In addition, under the Trust Fund
Exhaustion scenario, benefits would be adjusted proportionately for all
recipients, increasing the likelihood of hardship for lower income retirees
and the disabled, especially those who rely on Social Security as their
primary or sole source of retirement income.

As we all know, fixing Social Security is about more than finances. It is
also about maintaining an adequate safety net for American workers
against loss of income from retirement, disability, or death. Social Security
provides a foundation of retirement income for millions of Americans and
has prevented many former workers and their families from living their
retirement years in poverty. Proposals to restore the long-term financial
stability and viability of the Social Security system must also be
considered in terms of how potential changes affect different types of
beneficiaries. The Trust Fund Exhaustion scenario illustrates trade-offs
between the criterion of achieving sustainable solvency and the criterion
of maintaining benefit adequacy and equity. The longer we wait to take
action, the sharper these trade-offs will become. We need to put the


8
  In our analysis of the Trust Fund Exhaustion scenario, as in our January report on the
Commission models, we used the Trustees’ 2001 intermediate assumptions, under which
the combined OASDI trust funds are projected to reach exhaustion in 2038. Under the 2001
intermediate assumptions, in 2038 the benefit reduction would be about 7 percent because
trust fund assets would be available for part of the year to pay benefits. In 2039, the first
full year after trust fund exhaustion, benefits would fall sharply, to about 27 percent (or 73
percent of currently scheduled levels). Under the Trustees’ 2003 intermediate assumptions,
the projected exhaustion date for the combined trust funds is 2042, and the overall drop is
approximately the same.



Page 4                                               GAO-03-1038T Social Security Reform
                           program on a path toward sustainable solvency as soon as possible to
                           assure that future policymakers would not have to face these difficult
                           questions on a recurring basis.

                           I hope my testimony will help clarify some of the key issues in the debate
                           about how to restructure this critically important program.


                           Today the Social Security program faces a long-range and fundamental
Social Security’s          financing problem driven largely by known demographic trends. The lack
Long-Term Financing        of an immediate solvency crisis affects the nature of the challenge, but it
                           does not eliminate the need for action. Acting soon reduces the likelihood
Problem Is Truly           that the Congress will have to choose between imposing severe benefit
Urgent                     cuts and unfairly burdening future generations with the program’s rising
                           costs. Acting soon would allow changes to be phased in so the individuals
                           who are most likely to be affected, namely younger and future workers,
                           will have time to adjust their retirement planning. Since there is a great
                           deal of confusion about Social Security’s current financing arrangements
                           and the nature of its long-term financing problem, I would like to spend
                           some time describing the nature, timing, and extent of the financing
                           problem.


Demographic Trends Drive   As you all know, Social Security has always been largely a pay-as-you-go
Social Security’s Long-    system. This means that current workers’ taxes pay current retirees’
Term Financing Problem     benefits. As a result, the relative numbers of workers and beneficiaries has
                           a major impact on the program’s financial condition. This ratio, however,
                           is changing. In 1950, before the Social Security system was mature, the
                           ratio was 16.5:1. In the 1960s, the ratio averaged 4.2:1. Today it is 3.3:1 and
                           it is expected to drop to around 2.2:1 by 2030. The retirement of the baby
                           boom generation is not the only demographic challenge facing the system.
                           People are retiring early and living longer. A falling fertility rate is the
                           other principal factor underlying the growth in the elderly’s share of the
                           population. In the 1960s, the fertility rate was an average of 3 children per
                           woman. Today it is a little over 2, and by 2030 it is expected to fall to 1.95
                           —a rate that is below replacement. Taken together, these trends threaten
                           the financial solvency and sustainability of this important program. (See
                           fig. 1.)




                           Page 5                                       GAO-03-1038T Social Security Reform
Figure 1: Social Security Workers per Beneficiary




Note: Projections based on the intermediate assumptions of the 2003 Trustees’ Report.


The combination of these trends means that labor force growth will begin
to slow after 2010 and by 2025 is expected to be less than a third of what it
is today. (See fig. 2.) Relatively fewer workers will be available to produce
the goods and services that all will consume. Without a major increase in
productivity, low labor force growth will lead to slower growth in the
economy and to slower growth of federal revenues. This in turn will only
accentuate the overall pressure on the federal budget.




Page 6                                                  GAO-03-1038T Social Security Reform
                           Figure 2: Labor Force Growth Is Expected to be Negligible by 2050




                           Note: GAO analysis based on the intermediate assumptions of The 2003 Annual Report of the Board
                           of Trustees of the Federal Old-Age and Survivors Insurance and the Federal Disability Insurance
                           Trust Funds. Percentage change is calculated as a centered 5-year moving average.


                           This slowing labor force growth is not always recognized as part of the
                           Social Security debate. Social Security’s retirement eligibility dates are
                           often the subject of discussion and debate and can have a direct effect on
                           both labor force growth and the condition of the Social Security
                           retirement program. However, it is also appropriate to consider whether
                           and how changes in pension and/or other government policies could
                           encourage longer workforce participation. To the extent that people
                           choose to work longer as they live longer, the increase in the share of life
                           spent in retirement would be slowed. This could improve the finances of
                           Social Security and mitigate the expected slowdown in labor force growth.


Social Security’s Cash     Today, the Social Security Trust Funds take in more in taxes than they
Flow Is Expected To Turn   spend. Largely because of the known demographic trends I have
Negative in 2018           described, this situation will change. Although the Trustees’ 2003
                           intermediate estimates project that the combined Social Security Trust
                           Funds will be solvent until 2042,9 program spending will constitute a
                           rapidly growing share of the budget and the economy well before that



                           9
                               Separately, the DI fund is projected to be exhausted in 2028 and the OASI fund in 2044.



                           Page 7                                                 GAO-03-1038T Social Security Reform
date. In 2008, the first baby boomers will become eligible for Social
Security benefits, and the future costs of serving them are already
becoming a factor in the Congressional Budget Office’s (CBO) 10-year
projections. Under the Trustees’ 2003 intermediate estimates, Social
Security’s cash surplus—the difference between program tax income and
the costs of paying scheduled benefits—will begin a permanent decline in
2009. To finance the same level of federal spending as in the previous year,
additional revenues and/or increased borrowing will be needed.

By 2018, Social Security’s tax income is projected to be insufficient to pay
currently scheduled benefits. At that time, Social Security will join
Medicare’s Hospital Insurance Trust Fund (whose outlays are projected to
begin to exceed revenues in 2013) as a net claimant on the rest of the
federal budget. The combined OASDI Trust Funds will begin drawing on
the Treasury to cover the cash shortfall, first relying on interest income
and eventually drawing down accumulated trust fund assets. The Treasury
will need to obtain cash for those redeemed securities either through
increased taxes, and/or spending cuts, and/or more borrowing from the
public than would have been the case had Social Security’s cash flow
remained positive.10 Neither the decline in the cash surpluses nor the cash
deficit will affect the payment of benefits. The shift from positive to
negative cash flow, however, will place increased pressure on the federal
budget to raise the resources necessary to meet the program’s ongoing
costs.




10
  If the unified budget is in surplus at this point, then financing the excess benefits will
require less debt redemption rather than increased borrowing.



Page 8                                                 GAO-03-1038T Social Security Reform
                       Figure 3: Social Security’s (OASDI) Trust Funds Face Cash Deficits as Baby
                       Boomers Retire




                       Ultimately, the critical question is not how much a trust fund has in assets,
                       but whether the government as a whole can afford the benefits in the
                       future and at what cost to other claims on scarce resources. As I have said
                       before, the future sustainability of programs is the key issue policymakers
                       should address—i.e., the capacity of the economy and budget to afford the
                       commitment. Fund solvency can help, but only if promoting solvency
                       improves the future sustainability of the program.


Decline in Budgetary   From the perspective of the federal budget and the economy, the
Flexibility Absent     challenge posed by the growth in Social Security spending becomes even
Entitlement Reform     more significant in combination with the more rapid expected growth in
                       Medicare and Medicaid spending. This growth in spending on federal
                       entitlements for retirees will become increasingly unsustainable over the
                       longer term, compounding an ongoing decline in budgetary flexibility.
                       Over the past few decades, spending on mandatory programs has
                       consumed an ever-increasing share of the federal budget. In 1963, prior to
                       the creation of the Medicare and Medicaid programs, spending for
                       mandatory programs plus net interest accounted for about 32 percent of


                       Page 9                                        GAO-03-1038T Social Security Reform
                                        total federal spending. By 2003, this share had almost doubled to
                                        approximately 61 percent of the budget. (See fig. 4.)

Figure 4: Federal Spending for Mandatory and Discretionary Programs, Fiscal Years 1963, 1983, and 2003




                                        *Estimate for 2003 includes $41 billion in discretionary spending and about $1 billion in mandatory
                                        spending for the Iraq war supplemental. Includes $11 billion in mandatory spending for the Jobs and
                                        Growth Tax Relief Reconciliation Act of 2003.


                                        In much of the last decade, reductions in defense spending helped
                                        accommodate the growth in these entitlement programs. Even before the
                                        events of September 11, 2001, however, this ceased to be a viable option.
                                        Indeed, spending on defense and homeland security will grow as we seek
                                        to combat new threats to our nation’s security.

                                        GAO prepares long-term budget simulations that seek to illustrate the
                                        likely fiscal consequences of the coming demographic tidal wave and
                                        rising health care costs. These simulations continue to show that to move
                                        into the future with no changes in federal retirement and health programs
                                        is to envision a very different role for the federal government. Assuming,
                                        for example, that the tax reductions enacted in 2001 do not sunset and
                                        discretionary spending keeps pace with the economy, by midcentury




                                        Page 10                                                  GAO-03-1038T Social Security Reform
federal revenues may only be adequate to pay Social Security and interest
on the federal debt.11 To obtain balance, massive spending cuts, tax
increases, or some combination of the two would be necessary. (See fig.
5.) Neither slowing the growth of discretionary spending nor allowing the
tax reductions to sunset eliminates the imbalance.

Figure 5: Composition of Spending as a Share of Gross Domestic Product (GDP)
Assuming Discretionary Spending Grows with GDP, the 2001 Tax Cuts Do Not
Sunset, and Payment of Currently Scheduled Social Security Benefits




Note: Assumes currently scheduled Social Security benefits are paid in full throughout the simulation
period. Social Security and Medicare projections are based on the Trustees’ 2003 intermediate
assumptions.


Although this figure assumes payment of currently scheduled Social
Security benefits, the long-term fiscal imbalance would not be eliminated
even if Social Security benefits were to be limited to currently projected


11
  This simulation assumes that all currently scheduled benefits would be paid in full
throughout the 75-year projection period. The simulation does not reflect the effects of any
legislation enacted after March 2003, e.g., the tax reductions in the Jobs and Growth Tax
Relief Reconciliation Act of 2003.



Page 11                                                   GAO-03-1038T Social Security Reform
trust fund revenues. This is because Medicare (and Medicaid)—spending
for which is driven by both demographics and rising health care costs—
present an even greater problem.

This testimony is not about the complexities of Medicare, but it is
important to note that Medicare presents a much greater, more complex,
and more urgent fiscal challenge than does Social Security. Medicare
growth rates reflect not only a burgeoning beneficiary population, but also
the escalation of health care costs at rates well exceeding general rates of
inflation. Increases in the number and quality of health care services have
been fueled by the explosive growth of medical technology. Moreover, the
actual costs of health care consumption are not transparent. Third-party
payers generally insulate consumers from the cost of health care
decisions. These factors and others contribute to making Medicare a much
greater and more complex fiscal challenge than even Social Security. GAO
is developing a health care framework to help focus additional attention
on this important area and to help educate key policymakers and the
public on the current system and related challenges.

Indeed, long-term budget flexibility is about more than Social Security and
Medicare. While these programs dominate the long-term outlook, they are
not the only federal programs or activities that bind the future. The federal
government undertakes a wide range of programs, responsibilities, and
activities that obligate it to future spending or create an expectation for
spending. A recent GAO report describes the range and measurement of
such fiscal exposures—from explicit liabilities such as environmental
cleanup requirements to the more implicit obligations presented by life-
cycle costs of capital acquisition or disaster assistance.12 Making
government fit the challenges of the future will require not only dealing
with the drivers—entitlements for the elderly—but also looking at the
range of federal activities. A fundamental review of what the federal
government does and how it does it will be needed.

At the same time it is important to look beyond the federal budget to the
economy as a whole. Figure 6 shows the total future draw on the economy
represented by Social Security, Medicare, and Medicaid. Under the 2003
Trustees’ intermediate estimates and CBO’s long-term Medicaid estimates,
spending for these entitlement programs combined will grow to 14 percent



12
 U.S. General Accounting Office, Fiscal Exposures: Improving the Budgetary Focus on
Long-Term Costs and Uncertainties, GAO-03-213 (Washington, D.C.: Jan. 24, 2003).



Page 12                                          GAO-03-1038T Social Security Reform
of GDP in 2030 from today’s 8.4 percent. Taken together, Social Security,
Medicare, and Medicaid represent an unsustainable burden on future
generations.

Figure 6: Social Security, Medicare, and Medicaid Spending as a Percent of GDP




Note: Projections based on the intermediate assumptions of the 2003 Trustees’ Reports, CBO’s
March 2003 short-term Medicaid estimates, and CBO’s June 2002 long-term Medicaid projections
under midrange assumptions.


When Social Security redeems assets to pay benefits, the program will
constitute a claim on real resources in the future. As a result, taking action
now to increase the future pool of resources is important. To echo Federal
Reserve Chairman Greenspan, the crucial issue of saving in our economy
relates to our ability to build an adequate capital stock to produce enough
goods and services in the future to accommodate both retirees and
workers in the future.13 The most direct way the federal government can
raise national saving is by increasing government saving, i.e., as the
economy returns to a higher growth path, a much more balanced and
disciplined fiscal policy that recognizes our long-term challenges can help
provide a strong foundation for future economic growth and can enhance
future budgetary flexibility. In the short term, we need to realize that we


13
  Testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate,
July 24, 2001.



Page 13                                               GAO-03-1038T Social Security Reform
are already facing a huge fiscal hole (gap). The first thing that we should
do is stop digging.

Taking action now on Social Security would not only promote increased
budgetary flexibility in the future and stronger economic growth but
would also make less dramatic action necessary than if we wait. Some of
the benefits of early action—and the costs of delay—can be seen in figure
7. This compares what it would take to achieve actuarial balance at
different points in time by either raising payroll taxes or reducing
benefits.14 If we did nothing until 2042—the year the Trust Funds are
estimated to be exhausted—achieving actuarial balance would require
changes in benefits of 31 percent or changes in taxes of 46 percent. As
figure 7 shows, earlier action shrinks the size of the adjustment.

Figure 7: Size of Action Needed to Achieve Social Security Solvency




Note: Based on the intermediate assumptions of the 2003 Trustees’ Report. The benefit adjustments
in this graph represent a one-time, permanent change to all existing and future benefits beginning in
the first year indicated.




14
   Solvency could also be achieved through a combination of tax and benefit actions. This
would reduce the magnitude of the required change in taxes or benefits compared to
making changes exclusively to taxes or benefits as shown in figure 7.



Page 14                                                   GAO-03-1038T Social Security Reform
                        Thus both sustainability concerns and solvency considerations drive us to
                        act sooner rather than later. Trust Fund exhaustion may be almost 40
                        years away, but the squeeze on the federal budget will begin as the baby
                        boom generation starts to retire. Actions taken today can ease both these
                        pressures and the pain of future actions. Acting sooner rather than later
                        also provides a more reasonable planning horizon for future retirees.


                        As important as financial stability may be for Social Security, it cannot be
Evaluating Social       the only consideration. As a former public trustee of Social Security and
Security Reform         Medicare, I am well aware of the central role these programs play in the
                        lives of millions of Americans. Social Security remains the foundation of
Proposals               the nation’s retirement system. It is also much more than just a retirement
                        program; it pays benefits to disabled workers and their dependents,
                        spouses and children of retired workers, and survivors of deceased
                        workers. Last year, Social Security paid almost $454 billion in benefits to
                        more than 46 million people. Since its inception, the program has
                        successfully reduced poverty among the elderly. In 1959, 35 percent of the
                        elderly were poor. In 2000, about 8 percent of beneficiaries aged 65 or
                        older were poor, and 48 percent would have been poor without Social
                        Security. It is precisely because the program is so deeply woven into the
                        fabric of our nation that any proposed reform must consider the program
                        in its entirety, rather than one aspect alone. Thus, GAO has developed a
                        broad framework for evaluating reform proposals that considers not only
                        solvency but other aspects of the program as well.

                        The analytic framework GAO has developed to assess proposals
                        comprises three basic criteria:

                    •   the extent to which a proposal achieves sustainable solvency and how it
                        would affect the economy and the federal budget;
                    •   the relative balance struck between the goals of individual equity and
                        income adequacy; and
                    •   how readily a proposal could be implemented, administered, and
                        explained to the public.

                        The weight that different policymakers may place on different criteria will
                        vary, depending on how they value different attributes. For example, if
                        offering individual choice and control is less important than maintaining
                        replacement rates for low-income workers, then a reform proposal
                        emphasizing adequacy considerations might be preferred. As they fashion
                        a comprehensive proposal, however, policymakers will ultimately have to
                        balance the relative importance they place on each of these criteria.


                        Page 15                                    GAO-03-1038T Social Security Reform
Financing Sustainable    Our sustainable solvency standard encompasses several different ways of
Solvency                 looking at the Social Security program’s financing needs. While 75-year
                         actuarial balance is generally used in evaluating the long-term financial
                         outlook of the Social Security program and reform proposals, it is not
                         sufficient in gauging the program’s solvency after the 75th year. For
                         example, under the Trustees’ intermediate assumptions, each year the 75-
                         year actuarial period changes, and a year with a surplus is replaced by a
                         new 75th year that has a significant deficit. As a result, changes made to
                         restore trust fund solvency only for the 75-year period can result in future
                         actuarial imbalances almost immediately. Reform plans that lead to
                         sustainable solvency would be those that consider the broader issues of
                         fiscal sustainability and affordability over the long term. Specifically, a
                         standard of sustainable solvency also involves looking at (1) the balance
                         between program income and cost beyond the 75th year and (2) the share
                         of the budget and economy consumed by Social Security spending.

                         As I have already discussed, reducing the relative future burdens of Social
                         Security and health programs is essential to a sustainable budget policy for
                         the longer term. It is also critical if we are to avoid putting unsupportable
                         financial pressures on future workers. Reforming Social Security and
                         federal health programs is essential to reclaiming our future fiscal
                         flexibility to address other national priorities.


Balancing Adequacy and   The current Social Security system’s benefit structure strikes a balance
Equity                   between the goals of retirement income adequacy and individual equity.
                         From the beginning, benefits were set in a way that focused especially on
                         replacing some portion of workers’ preretirement earnings. Over time
                         other changes were made that were intended to enhance the program’s
                         role in helping ensure adequate incomes. Retirement income adequacy,
                         therefore, is addressed in part through the program’s progressive benefit
                         structure, providing proportionately larger benefits to lower earners and
                         certain household types, such as those with dependents. Individual equity
                         refers to the relationship between contributions made and benefits
                         received. This can be thought of as the rate of return on individual
                         contributions. Balancing these seemingly conflicting objectives through
                         the political process has resulted in the design of the current Social
                         Security program and should still be taken into account in any proposed
                         reforms.

                         Policymakers could assess income adequacy, for example, by considering
                         the extent to which proposals ensure benefit levels that are adequate to
                         protect beneficiaries from poverty and ensure higher replacement rates for

                         Page 16                                     GAO-03-1038T Social Security Reform
                         low-income workers. In addition, policymakers could consider the impact
                         of proposed changes on various subpopulations, such as low-income
                         workers, women, minorities, and people with disabilities. Policymakers
                         could assess equity by considering the extent to which there are
                         reasonable returns on contributions at a reasonable level of risk to the
                         individual, improved intergenerational equity, and increased individual
                         choice and control. Differences in how various proposals balance each of
                         these goals will help determine which proposals will be acceptable to
                         policymakers and the public.


Implementing and         Program complexity makes implementation and administration both more
Administering Proposed   difficult and harder to explain to the public. Some degree of
Reforms                  implementation and administrative complexity arises in virtually all
                         proposed changes to Social Security, even those that make incremental
                         changes in the already existing structure. However, the greatest potential
                         implementation and administrative challenges are associated with
                         proposals that would create individual accounts. These include, for
                         example, issues concerning the management of the information and
                         money flow needed to maintain such a system, the degree of choice and
                         flexibility individuals would have over investment options and access to
                         their accounts, investment education and transitional efforts, and the
                         mechanisms that would be used to pay out benefits upon retirement.
                         Harmonizing a system that includes individual accounts with the
                         regulatory framework that governs our nation’s private pension system
                         would also be a complicated endeavor. However, the complexity of
                         meshing these systems should be weighed against the potential benefits of
                         extending participation in individual accounts to millions of workers who
                         currently lack private pension coverage.

                         Continued public acceptance and confidence in the Social Security
                         program require that any reforms and their implications for benefits be
                         well understood. This means that the American people must understand
                         why change is necessary, what the reforms are, why they are needed, how
                         they are to be implemented and administered, and how they will affect
                         their own retirement income. All reform proposals will require some
                         additional outreach to the public so that future beneficiaries can adjust
                         their retirement planning accordingly. The more transparent the
                         implementation and administration of reform, and the more carefully such
                         reform is phased in, the more likely it will be understood and accepted by
                         the American people.




                         Page 17                                   GAO-03-1038T Social Security Reform
                       As you requested, we applied our criteria to a scenario of Trust Fund
Social Security’s      Exhaustion. This scenario dramatically illustrates the need to take action
Long-Term Financing    sooner rather than later to address the program’s long-term fiscal
                       imbalance. Under this scenario, currently scheduled benefits would be
Shortfall Requires     paid in full until the combined OASDI Trust Funds are exhausted. After
Action Sooner Rather   exhaustion, monthly benefit checks are reduced in proportion to the
                       annual shortfall. In effect, after trust fund exhaustion, all beneficiaries
Than Later             would experience a sharp drop in benefits. Additional reductions in the
                       following years would result in benefits equal to about two-thirds of
                       currently scheduled levels by the end of the 75-year simulation period.
                       (See fig. 8.)

                       Figure 8: Change in Currently Scheduled Benefits under the Trust Fund Exhaustion
                       Scenario




                       We used our long-term economic model in assessing the Trust Fund
                       Exhaustion scenario against the first criterion, that of financing
                       sustainable solvency. To examine how the Commission reform models
                       balance adequacy and equity concerns, we used the GEMINI model, a
                       dynamic microsimulation model for analyzing the lifetime implications of
                       Social Security policies for a large sample of people born in the same year.
                       Our analysis examined the effects of the reform models for the 1955, 1970,
                       and 1985 birth cohorts. For this analysis, as in our report on the
                       Commission reform models, we used the 2001 Trustees’ intermediate
                       assumptions. Under these assumptions, the combined trust funds are
                       projected to reach exhaustion in 2038.




                       Page 18                                       GAO-03-1038T Social Security Reform
    Our analysis of the scenario used the same three benchmarks as in our
    January report on the Commission reform models:15

•   The “benefit reduction benchmark” assumes a gradual reduction in the
    currently scheduled Social Security defined benefit beginning with those
    newly eligible for retirement in 2005. Current tax rates are maintained.
•   The “tax increase benchmark” assumes an increase in the OASDI payroll
    tax beginning in 2002 sufficient to achieve an actuarial balance over the
    75-year period. Currently scheduled benefits are maintained. 16
•   The “baseline extended benchmark” is a fiscal policy path developed in
    our earlier long-term model work that assumes payment in full of currently
    scheduled Social Security benefits and no other changes in current
    spending or tax policies. 17

    The use of our criteria in evaluating the Trust Fund Exhaustion scenario
    underscores the need to take action sooner rather than later to address
    Social Security’s financing shortfall. In so doing, it illustrates trade-offs
    that exist between efforts to achieve sustainable solvency for the OASDI
    Trust Funds and efforts to maintain adequate retirement income for
    current and future beneficiaries.

    By definition this scenario would achieve sustainable solvency because
    after the combined trust funds had run out of assets, benefit payments
    would be adjusted each year to equal annual tax income. Before 2038, the
    Trust Fund Exhaustion scenario would result in lower unified surpluses
    and higher unified deficits compared to the tax increase benchmark by the
    same amounts as the baseline extended benchmark. Subsequently the
    Trust Fund Exhaustion scenario would result in unified fiscal results
    increasingly similar to both the tax increase benchmark and the benefit
    reduction scenario over the 75-year period. Before 2038, the Trust Fund
    Exhaustion scenario would require the same amounts of cash as the tax
    increase or baseline extended benchmarks; subsequently, the Trust Fund


    15
       From the perspective of analyzing benefit adequacy, the tax increase and baseline
    extended benchmarks are identical because both assume payment in full of scheduled
    Social Security benefits over the 75-year simulation period.
    16
      Our benchmarks are solvent for the 75-year projection period commonly used by the
    Social Security Administration’s (SSA) Office of the Chief Actuary, but they do not achieve
    sustainable solvency. Both the benefit reduction and tax increase benchmarks are
    explicitly fully funded and we worked closely with SSA’s Chief Actuary in their design.
    17
      Implicitly, therefore, after exhaustion benefits are paid in part by increased borrowing
    from the public.



    Page 19                                              GAO-03-1038T Social Security Reform
Exhaustion scenario would require less cash each year than any of the
three benchmarks.

Under the Trust Fund Exhaustion scenario, the effect on benefits would
differ sharply before and after exhaustion took place. Before exhaustion,
benefits would be the same as those currently scheduled, reflected in both
the tax increase and baseline extended benchmarks. Once the combined
trust funds had run out, benefits for all would be reduced across the board
and remain below currently scheduled levels. Accordingly, those receiving
benefits at the time of trust fund exhaustion would experience a sharp
drop in benefits; under the Trustees’ 2001 intermediate estimates, this drop
is estimated at 27 percent (to 73 percent of currently scheduled levels) in
2039. Small further reductions would need to be taken in successive years
such that by 2076 benefits would be only two-thirds of currently scheduled
levels (i.e., to 67 percent of currently scheduled levels). (See fig. 9.)

Figure 9: Monthly Benefits Under the Trust Fund Exhaustion Scenario for an
Illustrative Individual by Selected Birth Year




Note: Illustrative workers retire at age 65 and receive benefits equal to the median for the appropriate
GEMINI cohort under the Trust Fund Exhaustion scenario. In years after 2038, real benefits are
reduced according to the Trust Fund Exhaustion scenario. In GEMINI, the median age of death for
those living to age 65 years and receiving a retired workers benefit is 84, 85, and 86, for the 1955,
1970, and 1985 cohorts, respectively.




Page 20                                                    GAO-03-1038T Social Security Reform
                         Due to the timing of the reductions under the Trust Fund Exhaustion
                         scenario, younger generations would bear greater benefit reductions.
                         Those born in 1955 would not experience benefit reductions until they
                         reached age 83, while those born in 1985 would receive lower benefits
                         than under either GAO’s benefit reduction or tax increase benchmarks in
                         all years of retirement. Consequently, lifetime benefits would be reduced
                         more for younger generations. Under the Trust Fund Exhaustion scenario
                         we used, benefits would be adjusted proportionately for all recipients,
                         increasing the likelihood of hardship for lower income retirees and the
                         disabled.

                         Given a lack of historical precedent and legislative clarity on how SSA
                         would proceed in the event of trust fund exhaustion, the nature and scope
                         of SSA’s administrative challenges under the scenario are difficult to
                         describe or assess. At a minimum, a focus on cash management would be
                         needed for SSA to calculate and implement the ongoing benefit
                         adjustments required under the scenario.


                         It is likely that the structural changes required to restore Social Security’s
Conclusion: Choices      long-term viability generally will require some combination of reductions
and Trade-Offs Will Be   from currently scheduled benefits, revenue increases, and may include the
                         use of some general revenues. The proposals we have examined, both this
Part of Any Social       year and earlier, generally reflect this. Proposals employ possible benefit
Security Reform—         modifications within the current program structure, including modifying
                         the benefit formula, reconsidering current eligibility criteria, and reducing
Acting Soon Would        cost-of-living adjustments. Revenue increases might take the form of
Help                     increases in the payroll tax rate, expanding coverage to include the
                         relatively few workers who are still not covered under Social Security, or
                         allowing the trust funds to be invested in potentially higher-yielding
                         securities such as stocks.18 Similarly, some proposals rely on general
                         revenue transfers to increase the amount of money going towards the
                         Social Security program. Reforms that include individual accounts would
                         also involve Social Security benefit reductions and/or revenue increases,
                         and the use of general revenues. Whatever approach is taken to reform, we
                         must be able to continue to finance ongoing benefits to retirees in the




                         18
                           About 4 percent of the workforce remains uncovered, which mostly includes some state
                         and local government employees and federal employees hired before 1984.



                         Page 21                                          GAO-03-1038T Social Security Reform
short term. The longer we delay reform, the larger the “transition costs”
and the more disruptive the actions will be.

In evaluating Social Security reform proposals, the choice among various
benefit reductions and revenue increases will affect the balance between
income adequacy and individual equity. Benefit reductions could pose the
risk of diminishing adequacy, especially for specific subpopulations. Both
benefit reductions and tax increases that have been proposed could
diminish individual equity by reducing the implicit rates of return the
workers earn on their contributions to the system. In contrast, increasing
revenues by investing retirement funds in the stock market could improve
rates of return but potentially expose individuals to investment risk and
losses of expected retirement income.

Similarly, the choice among various benefit reductions and revenue
increases—for example, raising the retirement age—will ultimately
determine not just how much income retirees will have but also how long
they will be expected to continue working and how long their retirements
will be. Reforms will determine how much consumption workers will give
up during their working years to provide for more consumption during
retirement.

The use of our criteria to evaluate approaches to Social Security reform
highlights the trade-offs that exist between efforts to achieve sustainable
solvency and to maintain adequate retirement income for current and
future beneficiaries. These trade-offs can be described as differences in
the extent and nature of the risks for individuals and the nation as a whole.

At the same time, the defined benefit under the current Social Security
system is also uncertain. The primary risk is that a significant funding gap
exists between currently scheduled and funded benefits which, although it
will not occur for a number of years, is significant and will grow over time.
Other risks stem from uncertainty in, for example, future levels of
productivity growth, real wage growth, and demographics. The Congress
has revised Social Security many times in the past, and future Congresses
could decide to revise benefits in ways that leave those affected little time
to adjust. As the Congress deliberates various approaches to Social
Security, the national debate also needs to include discussion of the
various types of risk implicit in each approach and in the timing of reform.

Early action to change these programs would yield the highest fiscal
dividends for the federal budget and would provide a longer period for
prospective beneficiaries to make adjustments in their own planning.

Page 22                                     GAO-03-1038T Social Security Reform
Waiting to build economic resources and reform future claims entails
risks. First, we lose an important window where today’s relatively large
workforce can increase saving and enhance productivity, two elements
critical to growing the future economy. We lose the opportunity to reduce
the burden of interest payments, thereby creating a legacy of higher debt
as well as elderly entitlement spending for the relatively smaller workforce
of the future. Most critically, we risk losing the opportunity to phase in
changes gradually so that all can make the adjustments needed in private
and public plans to accommodate this historic shift. Unfortunately, the
long-range challenge has become more difficult, and the window of
opportunity to address the entitlement challenge is narrowing.

As the baby boom generation retires and the numbers of those entitled to
these retirement benefits grow, the difficulties of reform will be
compounded. Accordingly, it remains more important than ever to deal
with these issues over the next several years. In their March 2003 report,
the Trustees emphasized the need for action sooner rather than later,
stating that the sooner Social Security’s financial challenges are addressed,
the more varied and less disruptive can be their solutions.

Today many retirees and near-retirees fear cuts that will affect them while
young people believe they will get little or no Social Security benefits. As I
have said before, I believe it is possible to structure a Social Security
reform proposal that will exceed the expectations of all generations of
Americans. In my view there is a window of opportunity to craft a solution
that will protect Social Security benefits for the nation’s current and near-
term retirees, while ensuring that the system will be there for future
generations. However, this window of opportunity will close as the baby
boom generation begins to retire. As a result, we must move forward to
address Social Security because we have other major challenges
confronting us. The fact is, compared to addressing our long-range health
care financing problem; reforming Social Security will be easy lifting.

It is my hope that we will think about the unprecedented challenge facing
future generations in our aging society. Relieving them of some of the
burden of today’s financing commitments would help fulfill this
generation’s stewardship responsibility to future generations. It would also
preserve some capacity for them to make their own choices by
strengthening both the budget and the economy they inherit. We need to
act now to address the structural imbalances in Social Security, Medicare,
and other entitlement programs before the approaching demographic tidal
wave makes the imbalances more difficult, dramatic, and disruptive.



Page 23                                     GAO-03-1038T Social Security Reform
           We at GAO look forward to continuing to work with this Committee and
           the Congress in addressing this and other important issues facing our
           nation.

           Mr. Chairman, Members of the Committee, that concludes my statement.
           I’d be happy to answer any questions you may have.




(450246)
           Page 24                                 GAO-03-1038T Social Security Reform
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