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Is The (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities

IS THE (FISCAL) SKY FALLING?: AN EXAMINATION OF UNFUNDED SOCIAL SECURITY, MEDICARE, AND STATE AND LOCAL PENSION LIABILITIES

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CHAPTER OUTLINE

What Is the Source of the Problem?

How Big Is the Social Security and Medicare Problem?

How Big Is the State and Local Pension Problem?

Is It Possible That the Fiscal Sky Isn’t About to Fall?

Summary

LEARNING OBJECTIVES

LO1:Describe the source of the problem of the largest fiscal challenges facing the federal and state and local

governments as those associated with Social Security,Medicare, and pensions for state and local government

employees.

LO2:Compare and contrast defined benefit and definedcontribution pension plans and explain why defined

benefit plans can be unfunded or underfunded but defined contribution plans cannot.

LO3: Describe the scope and degree of underfunding of each of the sources of fiscal problems.

LO4: List and evaluate the likelihood of each of the scenariosin which the underfunding of Social Security,

Medicare, and pensions for state and local government employeespresents smaller problems than is expected.

KEY TERMS

Defined benefit program- A pension plan that defines eligibility for retirement and benefit according to a set of rules

and a formula.

Defined contributionprogram-Apension plan in which those enrolled, as well as their employer, contribution to an

accountaccording to a formula,and the investment ofthat account is under the

control of the employee.

Employee Retirement Income Security Act of1974 (ERISA) - A regulatory system for defined benefit plans.

DISCUSSION QUESTIONS

  1. What are defined benefit programs? Give examples of two such programs and state how these programs are funded.
  1. How is a defined benefit program different from a defined contribution program?
  1. Why do most employees in the private sector have defined contribution pension plans while most employees in the public sector have defined benefit pension plans?
  1. What is the primary requirement of the rules set by the Employee Retirement Income Security Act of 1974
  1. What is the main function of the Pension Guarantee Trust Corporation?
  1. What is the most crucial problem with public pensions in the U.S.?
  1. Mention one fatal operational assumption of the Social Security and Medicare system. What is the problem associated with this assumption?
  1. What measures were taken in 1982 to increasefunds for the Social Security and Medicare systems?
  1. What was the most important source of optimism regarding the possibility that the U.S. government will have sufficient funds for the Social Security and Medicare systems?
  1. What are some of the programmatic changes that could be made to social security to keep the problem of underfunding off the table?

THE WEB-BASED QUESTIONS

Part I.

Visit the following link to read an interesting article by Vance Ginn, a policy analyst for the Center for Fiscal Policy with theTexas Public Policy Foundation,a non-profit, free-market research institute based in Austin.

  • Briefly explain the generational accounting problem discussed in this article.
  • What are the two major problems challenging the funding of Employee Retirement System in Texas?
  • What reform does the author suggest to solve the issue of unfunded pension liabilities?

Part II.

Read the following blog entry by A. Barry Rand, CEO of AARP, the world’s largest nonprofit, nonpartisan membership organization, where he opines that there is need to broaden the current debate in

Washington from the narrow lens of deficit reduction toward the larger goal of economic growth and maintaining

the health and economic security of all Americans.

  • Why is it essential to tackle the high cost of health care?
  • What are the pros and cons of raising the Medicare eligibility age?

ANSWERS TO STUDY QUESTIONS

SUGGESTED ANSWERS TO THE DISCUSSION QUESTIONS

  1. A pension plan thatdefines eligibility for retirement and benefits according to a set of rules and a formula is called a defined benefit program.Medicare Part A and Social Security are two examples of defined benefit pensions. These programs are funded through a system of payroll taxes. Working 40 quarters and paying taxes entitles people to subsidized hospital care as well as a pension based on the highest 35 years of earnings.
  1. In a defined benefit pension plan, if an employee participates for the required period of time by paying payroll taxes, he gets a benefit according to a set of rules and a formula, whereas, in a defined contribution program, those enrolled, as well as their employer, contribute to an account according to a formula, and the investment of that account is under the control of the employee. Under defined contribution systems, retirees only get what their account accumulates.Under a defined benefit program, because the employee pays accordingto a formula and receives benefits accordingto a formula, there is the possibility that the formula willbe wrong (on either side), resulting in a surplus (morethan enough has been collected to pay the promised benefits) or a deficit (not enough has been collected and invested to pay the benefits).
  1. Under most defined benefit plans, there is a minimum years-of-service requirement and significantly fewer employees spend their careers with one private employer and a large number of public employees do stay with their original employer. Therefore, it is nowthe norm for employees in the private sector to have defined contribution plans and for public employees to have defined benefit plans.
  1. The Employee Retirement Income Security Act of 1974 requires that the funds in the accounts meet the actuarial requirements to keep them fully funded. This simply means that, accounting for expected returns on investments, life expectancy of pensioners, and so forth, the assets of the investments must be able to meet the liabilities, which to the fund are the pension payments to retirees.
  1. The Pension Guaranty Trust Corporation operates as a public insurance company in cases where the pension fund cannot meets its obligations and the company that is supposed to pay in goes bankrupt. It guarantees pensioners that their defined benefit plans will pay pensions if the company that sponsored them does not survive.
  1. The most crucial problem with public pensions is that it is underfunded. Social Security is, in present value terms, underfundedby more than $12 trillion dollars, state pensionfunds are underfunded by $3 trillion, and localgovernment pension funds are underfunded by more thanone-half trillion. On top of that, though it is not a pension fund, Medicare is underfunded by another $4 trillion.
  1. The Social Security andMedicare system had one gigantic, and perhaps even fatal,operational assumption: Current employees could pay forcurrent retirees. This assumption was necessary so thatpeople could begin collecting benefits when the programs passed. Unfortunately for both systems, that mechanismrequires that the number of babies born in a year remainroughly stable or grow at a steady rate so that eventually

the ratio of workers per retiree can remain roughly constant.With the dearth of babies born between 1931 and

1945, due first to the scarcity of food during the Great Depression,which made many women at least temporarilyinfertile, and, secondly, World War II, which made youngmen temporarily scarce, and the subsequent baby boom ofthe post-war era, that assumption did not hold.The result was that in 1982 analysts anticipated thatbeginning in 2008, as the first baby boomers becameeligible for early-retirement Social Security benefits,and extending until around 2040, both Social Security and Medicare would have insufficient funds to pay for the anticipated benefits.

  1. In 1982, analysts anticipated thatbeginning in 2008, as the first baby boomers becameeligible for early-retirement Social Security benefits,and extending until around 2040, both Social Securityand Medicare would have insufficient funds to pay for the anticipated benefits. In that year a compromise was worked out that significantly raised payroll taxes inorder to create the Social Security and Medicare trustfunds and raised the full-benefit retirement age from 65 to 67.
  1. The most important source for optimism regarding the possibility that the U.S. government will have sufficient funds is that taxable incomes could grow at the rate they did in the 1980s and 1990s and do so for a sustained period. Similarly, productivity and/ or technological improvementscould be sufficient to raise real GDP growth expectations from 2.5 percent to 3.5 percent and from 3.5 percent to 4.5 percent. A one percentage point increase in growth would make the U.S. real GDP much higher than it is now projected to be at that time, and that would be more than enough to make the funding of those particular programs substantially less onerous.
  1. Some programmatic changes could be made to social security that could keep the problem of underfunding off the table. For instance, some combination of tax increases (either eliminatingthe maximum taxable earnings for Social Security, increasingtax rates 1 percent across the board on bothemployers and employees, or extending Social Securitytaxes to unearned income) or benefits changes (eliminating the option for taking benefits at 62, raising theretirement age to 70, using price inflation rather than wage inflation to adjust benefits for the cost of living)could be enacted. If these were enacted in the next fiveyears, most of the problem in Social Security could beeliminated.

SUGGESTED ANSWER TO THE WEB-BASED QUESTION

Part I.

  • The Social Security and Medicare system are based on the assumption that current employees could pay for the current retirees. However, the dependency ratio of retirees to the working population is increasing in the United States due to an aging population. This has rendered the federal and state Social Securityand Medicare liabilities unfunded. This problem has been referred to as the generational accounting problem.
  • The generational accounting problem burdening programs at the federal level also burden Texas’ pensions. In addition to this, another problem creating substantial challenges with funding the Employee Retirement system is that many state pension portfolio managers face: low rates of return on risk-free assets, such as a one-year Treasury security that returns less than 1 percent.
  • The author suggests that the best long-term approach to fully fund the Employee Retirement System is to convert it from a defined benefit plan to a defined contribution plan.

Part II.

  • The high cost of healthcare needs to be tackled because rising costs have a negative impact on federal programs such as Medicare and Medicaid, as well as on the costs for state governments, employers and individuals. Moreover, it is impossible to sustain an ever-increasing share of the nation's output going to health care, especially when the Institute of Medicine estimates that as much as one third of health care spending is wasteful or inefficient.
  • Raising the Medicare eligibility age lowers federal health costs for the program. However, it shifts costs from the federal government to employers, states and families on Medicare. This only drives seniors to more costly and less efficient providers, which, in turn, raises total health spending in the economy.

A better approach would be to lower the growth in health care spending system-wide, which will also lower the cost of Medicare and Medicaid. Health care needs to be more efficient and less costly to keep it sustainable for generations to come.