Heritage Foundation Leadership for America

Reforming Social Security has become a front-burner issue in Washington, D.C., due in large part to growing recognition that the program is a very bad deal for younger workers. Social Security provides relatively meager benefits for the record amount of payroll taxes that workers send to the federal government. By contrast, if workers were allowed to invest the bulk of their payroll taxes in professionally managed individual retirement accounts, they could triple their retirement income.

Improving the security of future retirees, however, is only part of the story. Another reason policymakers are considering reform is that the Social Security system is bankrupt. Even though the program currently is collecting more in taxes each year than it needs to pay benefits, this surplus will disappear when the baby-boom generation begins to retire in about ten years. According to the Social Security Administration's own data, annual deficits will reach gargantuan levels, and the program's long-term, inflation-adjusted unfunded liability will be more than $20 trillion.

The long-term unfunded liability is immense because Social Security will begin paying out more than it collects in another 12 years. Although the cash deficit in 2010 is less than $1 billion, the numbers quickly climb to staggering levels thereafter. Specifically:

• Social Security's annual cash shortfall will reach $90 billion in 2015.

• By 2025, Social Security has promised to pay nearly $500 billion more than it will collect in taxes.

• In 2035, the annual deficit will be more than $1 trillion.

• In 2075, the last year for which the Social Security Administration provides numbers, the total annual shortfall will reach an incredible $7.5 trillion.

• Even after adjusting for inflation, the deficits are immense, reaching $200 billion in 2025 (in today's dollars), $300 billion in 2035, $400 billion in 2056, and $500 billion in 2068.

• The aggregate inflation-adjusted shortfall in the Social Security system between now and 2075 is more than $20 trillion. This unfunded liability is more than 6 percent higher than it was one year ago.

• The "present value" of the shortfall (which measures how much money would need to be invested today to finance future unfunded benefits) is more than $5 trillion.

Eliminating Social Security's future deficit would require a 54-percent increase in payroll taxes, a 33-percent reduction in benefits, or a combination of these approaches. This is the "transition cost" of keeping Social Security solvent. There is a transition cost for privatization as well. Because younger workers would be allowed to place the majority of their payroll taxes in private retirement accounts, lawmakers would have to come up with other sources of funding to pay benefits to current retirees and older workers who would remain dependent on the government.

Fortunately, the transition cost of privatization is considerably less than the transition cost of fixing Social Security. Moreover, the shift to a private system would be easier because lawmakers could use the budget surplus to cover part of the transition cost, whereas the surplus is projected to disappear when the time comes to bear the transition cost of keeping the current system in balance.

Privatization, however, is about more than numbers. Workers who chose the private option would reach retirement age with substantial nest eggs that would be capable of generating annual incomes well in excess of what Social Security currently promises them. This would occur because private income-producing assets generate much higher returns than Social Security. Adjusted for inflation, stocks historically have produced annual returns of more than 7 percent (including during the Great Depression). Private bonds generate returns of more than 4 percent. Social Security, by contrast, is a miserable investment. Dual-income couples born after 1960, for example, will receive an annual return of less than 1.4 percent. And if lawmakers tried to save the program with tax increases and benefit cuts, the rate of return would fall even further.

Daniel J. Mitchell is McKenna Senior Fellow in Political Economy for The Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.