Conservative Policy: Retirement Reform

One of the central topics of debate within the conservative movement concerns the role of government in our lives. The National Conservative Statement of Principles summarizes this role as follows:

Economic and cultural conditions that foster stable family and congregational life and child-raising are priorities of the highest order.

In other words, government should provide a kind of social stability that benefits private citizens in their families, businesses, congregations, and other forms of voluntary cooperation between individuals. The means with which government provides this stability must not be of such a kind that government involves itself in our daily lives. Instead, they must be designed to perpetuate  society itself.  

Tools for Conservative Practice

There are several ways in which this perpetual role can be played out, from protecting the constitution and law and order to the provision of public schooling and even health care. The exact boundary for government is often—but not always—a matter of principle. There are practical situations where we as conservatives need other instruments to help us put guardrails on government without jeopardizing its core conservative mission.

One such instrument is found in what economists refer to as the line between so-called public and private goods. This line is not what conventional wisdom would suggest, namely the line between what government provides and what private producers provide. Instead, the line is drawn by an economic principle: there are some products—using the word in its widest possible sense—that can be enjoyed by many without so-called ‘consumer exclusion.’

Economics textbooks often use streetlights as an example. I can walk down the street at night and enjoy the illumination that the streetlights provide without leaving less of the streetlight for others.

It is practically impossible to individually price a public good, but it is easy for so-called private goods. If I buy a chocolate bar, only I can consume it (unless my wife gets to it before I do). For this reason, it is easy to define the share of production costs that I am responsible for. That cost share is the basis for the price of each individual chocolate bar. 

The distinction between public and private goods is helpful in a conservative discussion about the role of government in our lives, but it is not more than that. We need to supplement it with conservative principles in both theory and practice. Once we combine these two instruments, we can delve into many policy areas, including education and health care. 

Retirement security is another good example. For two reasons, conservatives should pay more attention to it going forward. First, it is concerned with long-term social stability: it is practically impossible for people who are decades away from retirement to predict how much they need to set aside. A stabilizing contribution from government, in one form or another, helps private citizens plan their future with greater confidence.

Second, the uncertainty about the future includes the potential for financial disasters. A stock-market collapse, a protracted period of unemployment, or a government-enforced economic shutdown can all take such tolls on our personal finances that we are unable to restore our retirement savings.

A conservative launch into the issue of retirement security should center on the advantages that government has in fostering long-term stability through perennial institutions. This includes helping individuals and families avoid abject poverty, during workforce-active days as well as in retirement. 

This role has to be carefully crafted, conditioned by the economic demarcation line between public and private goods, as well as sound conservative theory. The latter suggests a role that is confined and unobtrusive in the daily life of our economy; the former implies government participation in a form that does not replace what private citizens can do for themselves within the framework of the free market.

Pay-As-You-Go: The System To Avoid

To see what difference conservatives can make, let us first address the problems with the one system that has dominated retirement benefit models in the past. This system, known as pay-as-you-go, or pay-go, was the preferred retirement benefit model in the 20th century. It is less dominant today, but it is still a component in the retirement benefit systems in many countries. Germany and Sweden, e.g., still base their pension systems on the pay-go model but add other, so-called funded models. 

The United States stalwartly holds on to its full pay-go model. Known as Social Security, this program is within a decade of a critical cash-flow shortage. Its trust fund, meant to protect the system from revenue shortfalls in hard economic times, will run out of money in 2033. From there on, the system will be unable to pay the benefits that new retirees have accrued. 

The pay-go model has been a preferred tool for those who wish to exercise economic redistribution. It conveniently lends itself to this method of practicing socialism: the benefits a retiree receives under this system are not funded by his or her historic payments into the system. They are instead paid for with the revenue from the retirement-tax payments that current taxpayers make.

All the taxpayer gets for his payments is a set of points. He can convert those points into benefits when he retires, but only if there is enough current tax revenue to cover his benefits. 

All pay-go systems operate this way, even the ones that are of limited importance to the overall funding of retirement benefits in a country. As mentioned, these systems can conveniently be used for economic redistribution–all it takes is that:

• More tax revenue for the system is collected from people with higher-than-average earnings, and 
• The benefits system replaces a higher share of working-year incomes for those who earn less, than for those who earn more.

The ease by which economic redistribution could be built into pay-go systems made them a favorite feature in socialist welfare states. America built its Social Security already in the 1930s, but for reasons that its proponents have never been able to explain, it was destined for insolvency already from the start. In order to maintain its funding, Congress raised the Social Security income tax 20 times in the 40 years from 1950 to 1990. Since then, some changes have been made on the benefits side, all to postpone the inevitable point in time when the system can no longer fund its benefits.

Fortunately, we can explain the insolvency problem. First and foremost, all pay-go systems are vulnerable to the kind of demographic shift that has taken place in most of the Western world in recent decades with declining fertility rates and longer life spans. With benefits being paid out over a longer period of time for retirees and with, relatively speaking, fewer workers to pay for the benefits of every retiree, the cash outflow has grown faster than the cash inflow. 

This demographic shift has been assigned a dominant role in pay-go insolvency. However, as Francis G. Castles explains with clarity in The Future of the Welfare State (Oxford, 2004), the influence of negative demographics on retirement-system funding is not nearly as strong as is generally believed. 

The second reason for pay-go insolvency is more important, yet it has gone almost entirely unnoticed. Due to the design of the factors determining benefits and the factors determining funding, benefits will always outpace funding. The reason is called ‘generational income progress’ and refers to the pattern by which workers, over their active years in the workforce, experience a faster rise in earnings than the workforce as a whole. 

When we enter the workforce, we earn less than the average worker. This is natural: we have no real experience, we assume the most junior responsibilities at work, and we have just barely started to put our education and training to work. Over time, though, our income rises as a result of seniority, promotions, skills development, and career shifts. While this is happening, the workforce as a whole remains constant in its profile: new, more junior workers enter behind us, and more seasoned, experienced workers retire ahead of us.

Because of its constant profile, the workforce as a whole sees its income grow at an average of the earnings of all workers, from junior to senior. By contrast, each generation migrates income-wise upward to its most senior earnings at a faster rate than the workforce as a whole. 

Since funding of a pay-go system is based on the workforce as a whole, but benefits are based on the income career of each generation, this creates a built-in funding deficiency in the system. Figure 1 illustrates this problem, with a green function representing the income trajectory of the entire workforce and a red function representing one generation. So long as the green function is above the red function, this generation contributes to the system’s solidity: its accrued retirement benefits are small—and obviously so, since it is far from retirement. However, once its income trajectory rises above that of the entire workforce, its earning of retirement benefits now exceeds the ability of the workforce to pay for it:

Figure 1

The sooner the red line crosses the green line, i.e., the larger the red-shaded area is relative to the green-shaded area, the faster the pay-go system moves toward insolvency.

Unfortunately, there is a third reason why pay-go systems go insolvent: slower economic growth. In the past 15 years, the United States has shared in Europe’s experience of a lower long-term growth trajectory for the economy. When gross domestic product grows at a slower pace, personal income growth slows down as well. Since personal income is the tax base for the pay-go system, this leads to an accelerated path to insolvency. 

In terms of Figure 1, the green function flattens out the farther in time we go.

Fortunately, Europe has generally moved away from pay-go systems, with mixed success. The Swedish post-pay-go system, enacted in 1990, is institutionally stable but pays out paltry pensions. The Polish system is still, 24 years after the big reform, subject to reform. 

Denmark was fortunate enough to never create a traditional pay-go system. Their model is based on a lump-sum public pension, which all retirees except the very wealthiest are eligible for. On top of that, they have one mandatory and one voluntary component, both of which are individual and with benefits being fully funded by the workers themselves. 

America is in dire need of reforming its pay-go system. The Heritage Foundation, a right-of-center think tank in Washington, D.C., has proposed to replace Social Security with a flat-benefit system. Their reform idea is interesting for three reasons:

1. Given that it is paid for out of federal income taxes (the Social Security destined payroll taxes are taxes on income), but the benefit is not subject to generational income progress, the system is immune to the problem inherent to pay-go models. This vouches for its long-term fiscal stability.

2. Since there is no generational income progress, there will be no pressure on Congress to raise taxes over time. Higher taxes depress economic growth, which in turn erodes retirement system funding. With the flat-benefit model, this threat to the system’s insolvency is also removed.

3. A flat-benefit model that does not attempt to redistribute benefits between retirees, is consistent with conservative ideals. It provides a fundamental safety net for all, yet is unintrusive into the realm of pension funding that individual citizens can handle through private savings and other free-market-based arrangements.

Conservatism is a theoretically strong ideology. The move from theory to practice is often tricky and complex. As we have seen here, though, we can overcome those complexities; retirement funding is just one example of how we can put conservatism to work. 

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