Social Security: Is there a third way out?

When the federal government starts coming apart at its fiscal seams, Social Security will be the first thing to unravel. It is among the country’s largest financial challenges at over $50 trillion in unfunded obligations — Medicare is the largest.

The Social Security Board of Trustees predicts that the Old-Age and Survivors Insurance trust fund will become insolvent in 2033.

Social Security cannot continue as it is. Keeping at least a modified version will require either tax hikes, which millions of workers will oppose, or benefits cuts, which millions of retirees will oppose.

But is there a third way? Hypothetically, if it were possible to phase out Social Security without cutting retirees’ benefits and without raising workers’ taxes, would Americans go for it?

Social Security’s Old-Age and Survivors Insurance tax takes 10.6 percent from workers’ paychecks. The government collects half of the tax from employees and half from employers, but employees pay almost all of the employers’ half of the tax in the form of reduced wages.

Assuming steady full-time employment with no career breaks and retirement at 67, today’s median 20-year-old can expect to pay (in 2025 dollars) $296,000 in Social Security tax and receive roughly $30,000 per year in retirement benefits. Adjusted for mortality, that’s a return of only 1.6 percent above inflation.

But had the median 20-year-old been allowed to keep and invest that 10.6 percent tax in a private retirement account earning just 4 percent above inflation — a reasonable rate of return for a mix of stocks and bonds — he could have expected to withdraw annual amounts more than twice what Social Security provides.

But of course, if workers’ Social Security taxes were diverted to private accounts instead, there would be no tax revenue to fund current retirees’ Social Security benefits. And this is where Social Security’s paltry return comes in.

Suppose we phased out the retirement portion of Social Security by requiring workers to leave the system at age 35. They would pay their usual Social Security taxes up until age 35, then forfeit future benefits in exchange for having their remaining taxes deposited into their own private retirement accounts.

Social Security’s 1.6 percent-above-inflation return is so low that the median worker would be better off walking away at age 35 than continuing to pay into the system. For example, the median worker who, starting at age 35, diverts his 10.6 percent Social Security taxes to a balanced portfolio of stocks and bonds, could end up with retirement income 10 to 20 percent greater than his forfeited Social Security benefits.

A phase-out could achieve four things: First, for people born through 2005, nothing would change. They would continue in the Social Security system as before. Second, people born after 2005 would pay the Old-Age and Survivors Insurance tax until age 35, then leave the system, ultimately retiring with more income than Social Security would have provided. Third, over the next 80 years, the number of people drawing Social Security retirement benefits would decline to near zero, and Social Security retirement costs would simply disappear. Finally, with all workers continuing to pay the payroll taxes through age 35 and fewer drawing benefits over time, the program would eventually generate surpluses.

Win-win-win.

The catch is that, during the decades-long transition a phase-out would dramatically increase Social Security’s deficits. However, the surpluses that would eventually emerge as the program phased out would, approximately, finance those increased deficits.

Social security was not designed as, and is not, a savings plan. Long ago, the Supreme Court ruled that Social Security taxes were not earmarked for Social Security benefits (Helvering v. Davis, 1937), and that retirement benefits were not a contractual right (Flemming v. Nestor, 1960). Yet, today half of retirees depend on Social Security for at least half of their incomes and, according to a recent Cato poll, more than 20 percent of Americans already erroneously believe that they have personal Social Security accounts.

But to get politicians to fix this mess, we need to de-power Social Security as a political third-rail. That will require either convincing Americans of the reality that Social Security isn’t, and never was, a savings program and that we should think about cutting its budget like we would any other runaway government program. Or, it will require going along with Americans’ misconception that Social Security is a savings program and demonstrating what a poor one it is.

It took a century for us to dig the financial hole we’re now in, and a phase-out would require almost a century to refill it. The key question is, which is the heavier lift: expecting Congress to stick to an eight-decade plan, or convincing Americans that they must stop treating Social Security like a savings plan?

Antony Davies is an adjunct scholar at The Cato Institute and James R. Harrigan is COO of Polyhymnia.org.