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Assessing Social Security Reform Alternatives: A Report on EBRI's December 4, 1996, Policy Forum
This article, based on the December 4, 1996, EBRI-ERF Policy Forum, was written by EBRI Fellow Chris Conte. A former reporter with the Wall Street Journal, Conte has been an EBRI Fellow since 1995 and has written summaries of the EBRI-ERF Policy Forums and other articles on policy issues. Any views expressed in this article are those of the author and should not be ascribed to the officers, trustees, members, or other sponsors of EBRI, EBRI-ERF, or their staffs. Neither EBRI nor EBRI-ERF lobbies or takes positions on specific policy proposals. EBRI invites comment on all research.
The report of the 1994-1996 Advisory Council on Social Security settled one thing: we stand at a crossroads in deciding the future of the nation's retirement system.
But we are ill-prepared to choose which path to take. The options proposed by different factions of the divided council--large-scale government investment in the stock market, a new mandatory savings plan for individuals, or partial "privatization" of the current system--would lead us in profoundly different directions. Yet we understand only vaguely the impact each would have on our retirement security, social relationships, and economy.
On December 4, 1996, the Employee Benefit Research Institute (EBRI) hosted a policy forum to explore how we can better assess these and other Social Security reform alternatives. The session, partly an exploration of the intricacies of mathematical modeling and partly a preview of policy debates to come, gave some of the nation's leading authorities on Social Security a first look at SSASIM2, a state-of-the-art computer model that EBRI is developing to sort through the web of demographic, economic, psychological, social, and political factors that lie behind various proposals.
Their reaction could best be described as cautious enthusiasm: EBRI won praise for its bold effort but was reminded about the considerable uncertainties and guesswork involved in any project that is so complicated. Beyond that, many participants said, some of the biggest challenges will arise after the model is built, when the implications of its results will have to be interpreted for a public that has barely started to focus on the tough choices that lie ahead.
Still, it was widely agreed, the modeling exercise is an important start in what is sure to be a long journey. "When you begin to look at these issues, you discover right away that a great deal of systematic analysis is necessary to even describe them," noted William Beeman, vice president and director of economic studies for the Committee for Economic Development. "And even more sophisticated analysis is necessary to prescribe policies to deal with them."
The Context: Pitfalls and Possibilities
In the most fundamental sense, the issues surrounding Social Security today are as old as the program itself. "Here we are again debating the role of social insurance in a market economy, trying to define the appropriate balance between individual and collective responsibility, [and] what is fair and efficient at individual, family, and aggregate society levels," noted Robert Friedland, director of the National Academy on Aging.
These are difficult questions, but recent reform proposals pose analytical challenges far more daunting than the relatively modest, incremental changes that have been considered in the past. Instead of seeking a single change--an adjustment in the payroll tax rate or a rise in the normal retirement age, for instance--many current proposals would modify diverse parts of the system simultaneously and add entirely new elements, such as self-directed individual accounts, to Social Security's traditional, defined benefit structure. To complicate matters further, reform advocates say Social Security should be judged in part by criteria that were hardly considered in the past, including whether it provides beneficiaries a favorable "rate of return" on their tax payments and whether it fosters economic growth by encouraging savings.
"The complexity of the proposals undoubtedly outstrips our ability to carefully analyze them at this point, and that's the genesis of a model of this sort," said Marilyn Moon, a Social Security trustee and senior fellow at the Urban Institute.
Against this backdrop, EBRI President Dallas L. Salisbury argued that we can't continue to rely exclusively, as we have in the past, on either qualitative analysis or the work of the "extremely small" staff in the office of the actuary of the Social Security Administration. Noting that advocates of various reform alternatives employ tremendously different assumptions and methodologies, he described the Institute's modeling exercise as "an effort to create an analytic capability that is able to do quantitative, apples-to-apples comparisons across proposals."
While joining others in welcoming the undertaking, Moon added a note of caution, pointing out that there are pitfalls as well as possibilities in modeling. It's often difficult to predict, she noted, whether trends from the past will continue into the future; can we assume, for instance, that women will continue to outlive men as they have in the past, even though recent experience suggests this may no longer be true? Moreover, she noted, some policies are particularly susceptible to modification after they are adopted, rendering earlier assumptions moot. If people are given ownership of their own Social Security accounts, she argued, they inevitably will seek to use those funds for activities other than retirement; what confidence can we have, then, about predictions concerning how many assets they will carry into the later years under such a reform? In other cases, totally unexpected factors can neutralize the impact of variables we know and understand.
"This is an interesting and important exercise but is an exercise," Moon said. "We all know, those of us who engage in this, that we're going to be wrong. We just don't know how we're going to be wrong."
Other participants pointed out that models can be helpful even if they can't tell us with certainty what will happen under different circumstances. Beeman, for instance, argued that they help force us to think more systematically. "There is a great deal of very loose thinking" about Social Security right now, he said, pointing out, for instance, that some reform advocates completely ignore the potentially sizable transition costs their proposals would entail.
Martin Holmer, who is president of Policy Simulation Group, EBRI's contractor in developing the Social Security simulation model, suggested that one of the greatest values of models can be to show us not what the future will bring but rather where the greatest risk of unanticipated or unwanted outcomes lies.
Holmer gave conference participants a "look under the hood" at how the EBRI model works. It starts with the same demographic and economic assumptions used by the Social Security Administration but adds some variables, such as return on equity, that haven't traditionally been considered relevant. It also analyzes some issues, such as the likely return on individual investment accounts, that are beyond the scope of the current program.
Most significantly, the EBRI model employs "stochastic," or "Monte Carlo," techniques, which enable analysts to develop not a single projection--or, in the case of the Social Security Administration, "low," "high" and "intermediate" projections--but rather a whole range of possible outcomes. Using probability theory, the model then shows the chances of various outcomes actually occurring. This is an improvement over traditional methods, most participants agreed, because it shows the odds that things will turn out worse, or better, than projected. With that information, policymakers can design reforms that "hedge" against the biggest risks, Holmer said.
The Mortality Debate
One example of the uncertainty surrounding the modeling process is the assumption we must make concerning the mortality rate. The Social Security Administration assumes that mortality will decline at a far slower rate in the future than it did during the 20th century. But this view is controversial, noted Jack VanDerhei, associate professor at Temple University and research director for EBRI's Fellows Program. While the intermediate projection by the Social Security actuaries assumes that the number of people over age 85 will rise to 14.6 million in 2050 from 3.3 million in 1994, the Census Bureau puts that figure considerably higher, at 18.2 million. Running the Census Bureau figures through SSASIM2 suggests that Social Security's actuarial deficit will rise to 7.05 percent of taxable payroll in 2070, compared with the 5.52 percent projected by the Social Security Administration.
James Smith, senior economist at the RAND Corp., said even the Census Bureau figures underestimate the probable decline in mortality. He said a reasonable forecast would be that the number of people over age 85 could total 21 million by 2050 and that some "reputable scientists" believe it could reach as high as 50 million, more than triple the Social Security Administration's estimate. Moreover, Smith said official estimates fail to account for the fact that higher-income people tend to live longer than low-income people, thus adding disproportionately to benefit costs. That factor alone could drive costs 10 percent above official projections, he argued.
Stephen Goss, deputy chief actuary for the Social Security Administration, defended the agency's mortality assumptions. Not long ago, he said, a technical panel found that if Social Security were to change its mortality assumptions, it would have to adjust them for people of all ages, not just for old people. But a lower death rate among young people would mean there will be more workers than expected paying payroll taxes, thus negating much of the adverse financial consequences of larger population of senior citizens. Moreover, according to Goss, the same panel found that the government had underestimated future fertility rates, neutralizing the effect of changed mortality figures entirely.
To hedge against the possibility of larger-than-anticipated gains in life expectancy, Holmer noted, the government of Switzerland has been exploring the idea of indexing benefits to age expectancy for different cohorts of the population. A less precise variation of this strategy, of course, would be simply to increase the normal age of retirement for Social Security purposes. Robert Myers, who spent 23 years as chief actuary for the Social Security Commission, recommended just that. Raising the retirement age to 70 by the year 2037 shouldn't even be considered a cut in benefits, he argued, since by then a person who retires at that age will have the same life expectancy as someone who retires at 65 today.
Predicting Rates of Return
If Social Security actuaries have trouble projecting long-term mortality trends, which they have studied since the program's inception in 1935, how much harder would it be to estimate what returns the system could expect by allowing equity investment?
All three factions of the advisory council assume that the historic advantage of equities over bonds will continue in the future (in recent decades, the yield on equities has averaged 7 percent more than inflation, while Treasury bonds have paid only 2.3 percent more). But Robert Shapiro, founder and vice president of the Progressive Policy Institute, warned that projecting future investment returns, for markets as a whole and especially for individual investors compared with other individual investors, will be very hazardous. "I question our ability to sensibly model behavior of financial asset and debt markets over time," he said.
For individual accounts, in particular, how individuals allocate their assets among different types of assets will be a crucial variable. On this point, at least, EBRI has a growing base of information on which to build the model. Salisbury noted that EBRI's own defined contribution project now has data on how one million individual investors allocate assets in their retirement accounts, and that database eventually will grow to 10 million.
When it comes to asset allocation, the stakes, both for model-designers and investors, are very high. VanDerhei produced figures from the simulation showing that a "life cycle" approach to investing, in which a person puts his or her investments initially in equities and then gradually switches to bonds over time will produce substantially better results than maintaining a consistent allocation over an entire lifetime. But even in the second case, where the hypothetical worker puts 40 percent of his assets in equities, the pay-off would be higher than what would occur if the current Social Security structure were maintained and taxes were raised to cover rising benefit costs or if benefits were cut to fit the existing tax structure.
Significantly, the stochastic model also showed that returns under the privatization scheme would vary far more than under either of the "nonstructural" reforms. For critics of privatization, that was a crucial observation. "How about all the people who aren't going to get average returns, and may even lose?" asked Robert Ball, former Commissioner of Social Security under Presidents Kennedy, Johnson, and Nixon and a critic of privatization. "I think we need to look at the range of possible outcomes from these investments--particularly for low-income people--and worry about whether they're tolerable."
Girard Miller, president and chief executive officer of ICMA Retirement Corp., echoed that concern and added another: Will the Social Security "safety net" have to be extended to people who happen to retire during a bear market and hence have to cash in or annuitize their savings when their value is low? The possibility of such "cohort-specific" market losses concerns a number of baby boomers, in particular. Some analysts believe at least part of the run-up in stock prices in recent years is driven by the baby boom generation's growing demand for equity investments to help finance retirement. If so, some worry that their retirement, and the resulting sell-off of their stock portfolios, could bring a long bear market.
"It's been one of my constant worries that when I come to retire and sell my 401(k) plan, I'm not sure who I'm going to be selling it to," said William Cheney, chief economist for John Hancock Mutual Life Insurance Co.
Privatization advocates believe Cheney's fears won't be realized. If workers are encouraged, or compelled, to save more, net investment would rise. If so, demand for the baby boomers' portfolios could be strong despite the relatively smaller number of buyers. And, more importantly, increased savings would lead to higher productivity and faster economic growth, benefiting society as a whole, they argue.
That appears to be the premise behind a reform plan presented by the National Taxpayers Union. It would gradually phase out the existing Social Security system and replace it with a "national thrift plan." Taxpayers would be required to set aside an amount equal to 5 percent of their wages in "personal thrift accounts." The government would match contributions of low-wage workers, and guarantee a household income equal to the poverty level for all Americans over age 62.
While the plan would require sacrifices from current retirees by expanding taxation of benefits and reducing cost-of-living increases, Howe presented simulations that suggest its overall economic impact could be quite positive. Net national savings would quintuple to 5.9 percent of Gross Domestic Product by 2065, raising productivity and average wages by as much as 26 percent, he said. And he suggested that such gains would enable workers at all income levels to receive much greater benefits than under the current system--all without new government debt, new taxes, or unrelated reductions in government spending.
"The savings-productivity-real wages link is absolutely essential," argued Neil Howe, a consultant who presented the taxpayer group's plan. "It's this link that keeps Social Security reform from turning into something close to a zero-sum game."
Eugene Steuerle, a senior fellow at the Urban Institute, was skeptical about the economic-growth argument. Switching Social Security reserves out of government securities and into the stock market could unsettle the bond market and drive up interest rates, especially if other governments were to follow the federal government's lead, he said. More fundamentally, the retirement of the baby boom generation will result in a drop in "human capital" equal to a 20 percent or 25 percent rise in unemployment. Steuerle argued that it's hard to imagine any level of capital investment that would produce enough economic growth to boost incomes high enough to offset that dampening effect on the economy.
"I don't think you can build enough steel mills to solve this problem," he said.
Even the assumption that the reform proposals would increase savings needs to be tested, Steuerle added. If the government creates incentives or requires more savings through Social Security, he suggested, people might simply reduce their savings outside the system by a comparable amount. As a result, reform proposals aimed at increasing savings could wind up having "very little effect."
While voicing doubts that Social Security reforms will have much impact on economic growth, Steuerle joined most forum participants in urging EBRI to press ahead in its study of the issue. The RAND Corporation's James Smith, for instance, argued that making no change in the program could have economic consequences just as significant as various reform proposals. According to Smith, the tax rate to pay for Social Security, Medicare, and other age-related transfers could climb to 40 percent during the next century if current trends continue. That would lead to tremendous pressures to cut other categories of government spending and could even choke off economic growth altogether.
"We have to be talking about encouraging savings and growth," Smith said. He proposed imposing a progressive consumption tax.
Robert Myers, however, dissented from the general sentiment that reform proposals should be judged partly by what effect they would have on the overall economy. "Social Security does not have the purpose of solving all national problems," he said, adding that economic growth, in particular, is "not Social Security's responsibility." The real purpose of the retirement system, he said, is to ensure all retirees a basic "floor of protection."
The importance of that floor was underscored by Robert Friedland, who noted that 61 percent of today's elderly--72 percent of those over age 75--derive at least one-half of their income from Social Security. Similarly, James Smith noted that one-half of all retirees over age 70 have financial assets totaling $10,500 or less. For those aged 51-61, the situation isn't much better; the median level of financial assets for that group is $17,300.
Smith also argued that the current Social Security system isn't as progressive as it appears. Conventional figures on life expectancy suggest that the typical minimum wage recipient will receive lifetime benefits equal to a 4 percent rate of return on his Social Security tax payments, compared with a 1.5 percent return for somebody whose wages equal the maximum subject to Social Security taxes. But if the figures are adjusted to reflect the shorter life expectancy for low-income people, the minimum wage recipient will realize a rate of return of only 3.1 percent, just slightly ahead of the 2.4 percent return for a wealthier person collecting the maximum in benefits, Smith said.
The Perception Gap
While trying to untangle all of these analytical questions might seem to be challenging enough, several forum participants suggested that EBRI's job won't be finished even after its model is built.
"Ultimately, what we want to do is try to find ways to understand the implications of various options and then to be able to explain them to people in ways that are meaningful," Moon said. "There's a translation that going to need to be made here."
She argued that many Americans don't fully understand concepts like risk, the trade-off between risk and return, and second-order effects, all of which are crucial to the analysis of policy alternatives. "My caution today would be that we not be too charmed with the elegance of the models and we opt for utilitarian approaches whenever possible."
Susan Dentzer, chief economics correspondent for U.S. News and World Report, underscored Moon's warning. "There is a very large potential perception gap between many of us who work on these very abstruse levels.and the way these things are likely to be perceived by the public," she said.
In particular, Dentzer questioned whether many Americans understand financial matters sufficiently to invest their own Social Security funds. She also suggested that the "linchpin" of privatization, the assumption that an "appropriate" annuities market will develop and be capable not only of having reliable returns but of securing investments once people retire, is far from assured. "Just hearing from financial market participants that it will take care of itself, frankly, does not increase my confidence that this is a salable plan," she said.
Even some analytically straightforward Social Security reforms won't be easy to sell, Dentzer added. Raising the retirement age, for instance, will be a "very, very difficult political proposition indeed," she said. And she warned that there is a greater potential for "perceived social injustice for different classes of individuals" in various reform proposals than experts recognize.
A number of forum participants urged EBRI to use its model not just to assess reform alternatives but also to develop a better understanding of the current Social Security system. Supporters of the existing system, for instance, voiced concerns that the public misunderstands the system's condition, believing it is in worse shape than it really is. Myers dismissed as "myth" the belief that Social Security will go bankrupt sometime around 2030; in fact, he said, the system's low-cost estimate shows it will stay "in great shape" for the agency's entire 75-year forecasting period. And members of the advisory council's most traditionally minded faction point out that, even under the agency's intermediate assumptions, Social Security still could cover three-fourths of its benefit costs after the year 2030 without any changes in policy.
Nevertheless, "no one has confidence, it seems, that [Social Security] will be there," Friedland noted. "I'm not sure that they really believe it.Most people have not thought much about Social Security.What little they know seems to what they've heard, and what they've heard comes from television and the newspaper and what they've heard is that the program is going broke."
Gary Burtless, a senior fellow at the Brookings Institution, agreed that the press shares blame for the public's gloom. Seven years ago, he said, he co-authored the book, Can America Afford to Grow Old? Even though he and his colleagues concluded that the answer was yes, most press accounts and book reviews said the answer was no. "I think that's a congenital problem among journalists, who may reason they will never see their name in print if they write a story containing either good news or at least ambiguous news," Burtless said.
In any event, the public is eager to be educated and is less susceptible to partisan efforts to exploit fears about Social Security or other entitlements than it has been in the past, according to political analyst and commentator Charles Cook. "They understand that we have some very serious problems with our entitlement programs," he said. In a review of the 1996 elections, Cook argued that the Democrats succeeded for a time in charging that Republicans would cut too deeply into Medicare and other entitlement programs, but the issue "evaporated" toward the end of the campaign. In the final analysis, he said, Democratic claims didn't change the outcome of any congressional race in the country. And, he said, people will require proof before they allow themselves to be frightened by such claims in the future.
Cook said he didn't believe the political climate was particularly favorable for entitlement reform, though. He predicted that many Republicans, feeling burned by the Democrats' charges that they would wreck Medicare, probably will sit back and force President Clinton and his party to take the lead on the issue. Many congressional Democrats, meanwhile, don't feel a great sense of urgency about the matter.
When forced to act, many lawmakers will jump at easy solutions like making technical adjustments in the Consumer Price Index that would slow cost-of-living increases in Social Security benefits, rather than enacting more fundamental reforms, Cook predicted. Doing something that appears painless, or that pins the blame on somebody else "would be very, very, very appealing to most political people," he said.
Participants in the EBRI forum weren't offering many painless solutions, though. During the final phase of their discussion, they examined specific reform proposals, in the process demonstrating that while policy prescriptions can be significantly influenced by the results of economic modeling, they also are shaped significantly by views and judgments that transcend science.
Some described the issue as essentially a moral one. Myers, who argued forcefully that Social Security isn't "broke" and shouldn't be "thrown away," recommended raising the normal retirement age for Social Security to 70 by the year 2037 and increasing the payroll tax by 1.2 percentage points for both employers and employees between 2015 and 2035. He suggested normal economic growth should increase incomes enough that people easily could afford such a tax hike. "But even if they didn't rise, do Americans have to be so unaltruistic" as to oppose such an increase, he asked. "Do they have to be so concerned that they always have rising incomes and have five cars in every garage and three television sets in every room?"
Many others based their reform plans on a blend of economic analysis, value judgments, and realpolitik. Robert Ball, for instance, who was part of the advisory council group that recommended direct government investment in the stock market, seemed to defend the proposal more on political than financial grounds.
"We have to do something about the perception of younger people that they're not getting a good deal under Social Security," Ball said. "For the security of the system, the people who are going to vote in the future need to understand and support it and believe they are being treated fairly."
Most of the projected Social Security shortfall, Ball argued, could be covered in "quite traditional ways" without changing the system's basic structure. His "maintain benefits" group on the advisory council recommended, as first steps, extending Social Security coverage to state and local government employees, tighter taxation of Social Security benefits, modifying Social Security cost-of-living to reflect changes in the Consumer Price Index, and other changes.
But Ball acknowledged that all of these changes together won't get the system completely past the financial challenges posed by the retirement of the baby boom generation. Ball's group said the payroll tax would have to be increased around 2050. It also recommended taking a serious look at the idea of investing up to 40 percent of Social Security tax collections in the stock market.
Ball said the government should do the investing, rather than individuals, so as to maintain support for Social Security as a social insurance program. Allowing people to set up individual accounts in Social Security would sew the "seeds of destruction" for the system as a whole, he argued because "average and above-average investors," able to earn higher returns on their self-directed accounts than on the traditional part of the Social Security program, would demand that more and more funds be switched from the regular benefit program into individualized accounts.
Lawrence Thompson, principle deputy commissioner of the Social Security Administration, presented the case for so-called "individualized accounts" with a different combination of economic thinking and practical politics. His starting point was that some combination of higher taxes and reduced benefits is inevitable. "If people are going to live longer, either they're going to have lower benefits in retirement, they're going to put more away each year while they're working, or they're going to have to work longer," he said.
The individualized accounts proposal was developed by Edward Gramlich, dean of the school of public policy at the University of Michigan and chairman of the advisory council. It essentially would "split the difference" between benefit cuts and tax increases, Thompson said, by trimming benefits to a level that could be supported by the current payroll tax and requiring individuals to pay an additional 1.6 percent of payroll into individual accounts. While individuals would have some control over how funds in their accounts would be invested, the choices would be limited, the money would be managed centrally, and all benefits would have to be paid out in the form of indexed annuities.
Thompson said the public wants greater individualization. But he said limiting investment choices would help minimize the risk that workers would reach retirement with insufficient savings. That's especially important, Thompson argued, because risk has increased in the private sector as many employers have come to favor defined contribution plans over defined benefit plans. "If the private sector is getting riskier, we should be very cautious about transferring a whole lot more risk onto individual workers by significantly shrinking the public system," he said.
While Ball and Thompson were concerned about maintaining a strong role for the government in the retirement security realm, Ann Combs, a principal with William M. Mercer, Inc., and a member of the advisory council, made it clear that a desire for less government underlies privatization proposals. Combs was part of the advisory council faction that developed the so-called "personal savings account" proposal. It would allow workers effectively to put 5 percent of their payroll earnings into the personal accounts, which they would be free to manage and wouldn't have to annuitize when they retire. The remaining 7.4 percentage points of the payroll tax would be used to pay a flat benefit to all retirees, initially $410 per month. In addition, a tax equal to 1.52 percent of payroll would be imposed to help finance the transition from the current system to the new one.
Combs said the plan would guarantee retirees an income equal to two-thirds of the poverty level and would eliminate some of the complexity of the current benefit formula while creating a "very direct link" between taxes paid and benefits received. The personal savings accounts, meanwhile, would lead to increased financial literacy and possibly would encourage more saving, she said.
Advocates of this approach contend that the individual account plan would leave too much control in the hands of government. The "maintain benefits" proposal of Ball and others would be even worse in this regard, they argue. Although Ball said that government investment should be entirely passive in its approach to equities investment, Combs questioned whether politicians could resist the opportunity to let social objectives shape public investment strategy. "In the end, it's politicians who make the decisions and can rewrite the rules," she argued, "and I believe the temptation for social investing or targeted investing.will be too great."
And while Ball and Thompson warned against imposing more financial risk on retirees, Combs argued that the new financial market risk on workers and retirees would be no greater than the "political risk" that they currently face--namely that the government will change the rules of the game by raising taxes or changing benefits.
Given the sharp divisions among experts, the uncertainty about what impact various reform proposals would have, and the fact that Social Security's projected insolvency is still some years off, EBRI should have plenty of time to complete development of its Social Security model. In the meantime, there's a good chance we'll see more experimentation and that may produce useful data the Institute can plug into its equations.
Stanford Ross, a senior partner in the law firm of Arnold and Porter and a former Social Security commissioner, proposed a cautious, pragmatic approach to reform that illustrates how we might evolve gradually toward a new Social Security arrangement.
The program should be brought into financial balance, Ross said, partly to calm the "sky is falling rhetoric" about the system. He also agreed that there should be a "personal account element" because younger people are "less accepting of government paternalism." But rather than setting out to solve the problem all at once, he said, we should first adopt many of the incremental changes that analysts like Ball have proposed and then let people voluntarily set aside additional funds in individual accounts.
"One advantage of a voluntary approach is it would give you valuable experience about how the people who would be affected really feel about putting away more for their retirement as opposed to consumption or other purposes," he argued. "You would get valuable information."
Ross's recommendations, less comprehensive than other proposals, would leave many questions about the future of Social Security unanswered. But in a sense, they summed up the current state of policy analysis and policy making--including both our lack of information and the need for greater understanding between the public and experts. Without these, consensus may remain elusive.
"Any changes are going to have to be broadly bipartisan and based on a great deal of public education," Ross said. "Different people make different calls on the economics and the politics and how they think people react to things."