Social Security: The Cost of Doing Nothing

Why Social Security Is in Trouble and What Economists Recommend To Fix It

Hey, everyone! My name is Jordan, and I have a Ph.D. in Economics from the University of Pennsylvania. I want to ask important questions and answer them meaningfully using the hard work economists have put into their research. If you learn anything interesting from this, please like and subscribe!

There’s been growing concern that the U.S. Social Security system could run out of funds by 2034. Why? Two main reasons: 1. People are living longer, which means many end up receiving more retirement benefits than they paid in. 2. The large Baby Boomer generation is retiring while fewer babies are being born, so there are fewer workers paying into the system. These trends are putting a strain on Social Security. What can we do to account for these trends?

Source: CDC

Social security is really complicated, so before going into the specifics, let’s explain the three main, broad types of programs in a way that’s easy to understand. Think of retirement systems as three different ways to get lunch:

1. Pay-as-you-go (PAYG) defined-benefit (DB) (the U.S. system) is like a fast food drive thru pay-it-forward system, except it is actually pay-it-backward. You (not retired) pay at the register for the person ahead of you in line, and the person ahead of you gets the food you paid for (current retirees). When you retire (get to the window), the next person in line covers your meal. Sometimes, the person paying may pay for more than the retiree can eat, so that money is added to a pool for future retirees. If the person paying for the food can’t afford as much as the previous person and the pool of money is empty, the retiree will get a smaller meal. Then, the fast food drive thru becomes “insolvent.” (Countries that have this system: Germany, Japan, France, Italy, Brazil, South Korea, …)

2. Fully funded defined-benefit (DB) plans are like a prepaid group banquet. While you work, you and your employer pay into a big shared pot that is invested into a future meal by the restaurant. Because the restaurant promises a fixed menu of food (i.e. 40 % of your final salary for life), the employer or restaurant must add cash if the investments come up short.

3. Mandatory defined-contribution (DC) accounts are like individual lunch boxes. A slice of every paycheck goes into your own lunch box and is invested for you. Whatever is in the lunch box when you retire is what you eat, good or bad; no one else tops it up, and you can’t take food (money) from someone else’s lunchbox. (Countries that have this system: Australia, New Zealand, Chile, Peru, Israel, …)

Actual simple accounting example: Joseph earns $50,000 a year.
– In PAYG, Joseph’s payroll taxes, which make up 5-10% of his earnings, go to today’s retirees; when Joseph retires, new workers’ taxes fund Joseph’s check.
– In a fully funded DB plan, Joseph contributes maybe 5-10% of his earnings, and these grow in the common fund. The plan guarantees a set pension no matter the state of the market.
– In a mandatory DC system, Joseph must put 5-10% of his earnings into a personal account that rises and falls with investment returns, and his retirement income depends entirely on that final balance.

One economics paper provides a nice summary of the different types of Social Security systems along with a history of the system in place in the U.S. But, why do we even have a social security system in place? When the Great Depression hit, the elderly struggled to support themselves, and their families struggled to support them as well. Having social security is a program intended to increase “welfare” in economics; in other words, it makes people “happier” through a method called “consumption smoothing,” where some consumption is moved from a person’s working age with income to their retirement age without income. Sometimes, people have imperfect expectations over how long they will live, or they face unexpected hard times before retirement.

A holistic evaluation comparing the current Social Security system to a private annuity market (where private annuity is just a fancy phrase for a private market program like social security that gives monthly payments after retirement) finds that a PAYG (pay-as-you-go) Social Security system slightly increases overall welfare (happiness), assuming private annuities charge based only on coverage amount, not individual characteristics. Another study finds that partially replacing Social Security with private annuities would be inefficient if the private market has “frictions” or “imperfections”.

One major issue facing the U.S. is that Social Security will become insolvent by 2034. But what does “insolvent” actually mean? In the past, the taxes collected for Social Security were higher than the payments made to retirees, which allowed a surplus (extra money) to build up. However, today, we’re paying retirees more than we collect in taxes. This means our surplus is quickly running out and will be gone by 2034. After that, Social Security won’t have enough money to fully cover promised benefits, so benefits will be cut to match incoming tax revenue. Insolvency is inevitable given the facts that retirees are living longer, younger generations are having less children, and multiple add-ons to the benefits over the years. As these trends continue, benefits will continue to be cut every year.

Source: CBO

This leaves us with three main options:

1. Stick with current rules: Starting in 2034, Social Security would only pay about 81% of promised benefits to retirees, mostly affecting people born from the 1970s onward. This would decrease over time.

2. Keep paying full benefits: Congress could change the rules so that Social Security keeps paying 100%, but this would increase our national deficit by about 1% of GDP each year. To put this in perspective, the U.S. deficit in 2024 was already about 6.5% of GDP ($1.8 trillion), so it would rise to roughly 7.5% ($2.2 trillion in today’s dollars).

3. Reform the system: Change Social Security, either partially or completely.

Choosing option 2 would lead to debates about whether our growing debt is sustainable, but that's a topic I'll cover in a future post.

If we want to avoid insolvency without increasing the deficit, we need to seriously consider changing the Social Security system (option 3). But what should this change look like? Should we eliminate Social Security completely? Should we switch entirely to a fully funded defined-benefit (DB) or mandatory defined-contribution (DC) system, as discussed earlier? Or should we just adjust specific parts of our current pay-as-you-go system? For the rest of the post, I will explore these three options based on what economists have found; in general, there is no universal consensus on an ultimate plan to save Social Security, but there are some evaluations of different plans.

Source: CBO

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Potential plan 1: Get rid of Social Security entirely

In general, economists agree that having Social Security is better than having nothing at all. Earlier in this post, I mentioned a study examining privatizing Social Security. In this study, people have a good idea about how long they'll live, and it found that Social Security usually makes people happier on average (improves overall welfare), although the benefit isn't as large as some other studies suggest. It also found that people who expect shorter lifespans would prefer private annuities (private retirement plans), but Social Security reduces demand for these annuities among people who expect to live longer. As a result, those expecting shorter retirements end up having to pay higher prices for private annuities. Either way, there is still welfare to be gained.

Another study looks at partially phasing out Social Security. It finds that doing this would be inefficient if private retirement markets aren't functioning smoothly (have frictions). The main issue is that people can’t easily insure themselves against unexpected income loss. However, this negative effect mostly impacts current generations. Future generations would eventually benefit because more money gets saved and invested over time, increasing the amount of capital in the economy. Similar results have been found by other studies, including ones that consider gender differences and marital status.

The key takeaway from these studies is this: Shifting to a private retirement market boosts economic growth because people invest more, and removing the payroll tax encourages more people to work. This leads to greater prosperity for future generations. However, there's a catch — people lose the safety net provided by Social Security, especially if their income ends up lower than expected. When they can’t insure against these income shocks or potentially dying early, they lose welfare because they don’t like risky situations — they are risk averse. Additionally, current generations face higher taxes to fund the shift away from Social Security.

While many studies show that problems in private retirement markets make people happier with our current Social Security system (even if it's pay-as-you-go), a few studies argue that privatization might work better under certain conditions. For instance, privatization could be beneficial if parents want to save money to pass on to their children, or if the government taxes savings (capital) to fund the transition. We still need more research on financing privatization with taxes on capital, but most economists agree that fully privatizing Social Security is generally not the best solution.

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Potential Plan 2: Keep PAYG and just alter

The most common plan is to keep the current pay-as-you-go (PAYG) Social Security system but make some changes like raising the retirement age, increasing payroll taxes, reducing benefits, or doing a mix of these. If we don’t make any changes, benefits will automatically be cut for everyone anyway. Several studies look at how different tweaks to the current system might work.

One study finds that, compared to raising payroll taxes or reducing benefits for wealthier people, increasing the retirement age or cutting benefits isn’t great for current generations — but it does help future generations. These changes would encourage more saving and work, which increases capital and output in the economy. However, this assumes people respond perfectly to smaller Social Security checks, and other research suggests that might not actually happen in real life.

Another study looks at what would happen if we raised the retirement age by two years. One realistic feature it includes is that health tends to decline with age, so delaying retirement comes with real costs for older workers. As expected, it finds that this would boost both saving (capital) and work (labor) in the economy to account for the lost years. But the paper stops short of saying whether this would actually make people better off overall or how the economy would adjust during the transition.

Raising the retirement age can boost savings, economic output, and overall well-being, according to two studies mentioned above. But there’s a big downside — it hits lower-income people the hardest, since they tend to live shorter lives and may not collect benefits for as long. It could also hurt certain regions, like the Southeast, more than others. While it does encourage people to save more, it's a tough sell for those nearing retirement or who don’t expect to live long after retiring. And as life expectancy keeps rising, the retirement age would need to keep rising too.

One interesting way to make Social Security sustainable is through means-testing, which means reducing benefits for people with a lot of wealth while keeping full benefits for those with less. This makes some sense, since wealthier people tend to live longer and collect more. Effectively, this could either make the total sum of benefits the same across the poor and rich or even be a little more progressive. A study on this approach finds that carefully reducing benefits for the wealthy can improve overall welfare (or at least prevent harm), even though it slightly reduces savings in the economy. Still, it helps balance Social Security’s budget. In some ways, another paper makes similar claims on progressive retirement subsidies. Combining this alteration with others could increase welfare relative to just slashing benefits.

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Potential Plan 3: Transition to mandatory DC

Maybe it’s time to completely rethink Social Security. The current pay-as-you-go (PAYG) system isn’t built for an aging population. To keep benefits at today’s levels, we’d have to keep cutting benefits, raising taxes, pushing back the retirement age, or increasing government spending and making Social Security a welfare system if we’re willing to change the law. But there’s another option: transitioning to a mandatory defined-contribution (DC) system — a long-term solution where everyone contributes to their own private retirement account (like a required version of an IRA).

One comprehensive study finds that switching from a PAYG system to a mandatory DC system could significantly boost both economic growth and overall welfare (again, happiness) in the long run. However, it might hurt current generations during the transition. Letting people opt out of Social Security gives the best short-term economic boost, since those who leave give up their benefits while those who stay keep theirs; new workers would have to join the mandatory system. If the transition is funded with a consumption tax, it could also encourage more people to work in the short term. But adding an additional flat benefit for everyone reduces the potential gains from the reform.

More research shows that switching to a mandatory DC system can improve overall welfare. Like the previous study, one paper finds that this kind of system boosts welfare — especially if the transition is funded through capital or consumption taxes, with capital taxes working better to support current retirees. It’s also important to factor in rising life expectancy when evaluating these policies. Chile actually adopted a mandatory DC system in 1980, and a study found it led to strong long-term benefits for the country. Still, as with other reforms, the first generations going through the transition saw a drop in welfare. Therefore, mandatory DC is the best long term solution.

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Which plan should we adopt?

I’m not going to claim to be one giant Social Security welfare calculator. I think we need more quantitative economic work done in this area. However, based on the studies above, I would argue for two broad plans over the rest:

MY Proposed Plan 1 (the most politically likely): Raise the retirement age by 1–2 years and reduce benefits for wealthier retirees (means-testing). Raising the retirement age would mostly affect lower-income workers, but it would boost savings and working hours in the economy while being an adjustment people would actually understand. Means-testing, on the other hand, is more progressive; it protects lower-wealth individuals but might discourage saving. This approach strikes a balance, though it would still place some burden on older generations. Based on the research discussed earlier, this plan could help stabilize the Social Security budget in the long run while slightly boosting savings and overall welfare. It’s also a simpler fix than overhauling the entire system, making it more appealing to Congress.

MY Proposed Plan 2 (less likely to pass Congress, but stronger long-term): Transition to a mandatory defined-contribution (DC) system. Research, even beyond what I’ve mentioned, strongly supports the long-term benefits of this approach. The government wouldn’t need to overhaul the entire system at once; it could start gradually by letting people opt into private retirement accounts. As a study I mentioned above suggests, a small capital tax could help fund the transition until the PAYG system is gone. Another feature could include automatically calculating the per month withdrawal needed based on the person’s age, health, and demographics. The biggest challenge? Overcoming resistance to change and making sure the public understands the benefits. A similar reform was attempted by the Bush administration in 2005, but it failed to gain enough support.

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So, will we actually do anything?

As you may have noticed, a clear pattern emerges across all the possible solutions: current generations have to make sacrifices so future generations can benefit. It’s a bit of a catch-22: people are living longer, birth rates are falling, and without changes, Social Security benefits will continue to shrink every year — but voters don’t want to change the current system. Solving this requires thinking ahead, not just about today, but about what’s best for the next generation. Maybe we’re underestimating how much today’s older adults care about leaving government programs better for their children. Most studies don’t assume parents are motivated by that, but if they did, the impact on current generations might not look quite so harsh. This is my optimistic take if we can inform the older generation of the outlook. We just need to do our part to inform everyone we know.