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Social Security Reform: The Problem and Proposed Solutions

Author: Roger M. Kubarych
December 15, 2004
Council on Foreign Relations

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Social Security Reform: The Problem and Proposed Solutions

Roger Kubarych

December 15, 2004

Many European and Japanese I’ve met recently have expressed an interest in a simple review of the US Social Security problem and proposed reforms. Here is my attempt to do that, drawing on official sources. It is not comprehensive or particularly original. But it is short!

Key facts:

Basics: Social Security is the US Government’s retirement income program. It covers almost all workers (e.g. most Federal, state and local Government workers are not covered; they have their own pension system). It is the primary source of retirement income for about two-thirds of American retirees. The other third either have defined benefit (provided by an employer, such as the GM pension plan) or a defined contribution plan (most commonly, a 401k plan) that the retiree contributed to while working.

The Fundamental Problem: Demographics. The number of workers per retiree is set to decline from about 3.2 workers per retiree now to about 2 workers per retiree by 2030. The retirement of the baby-boom generation will put exceptional strain on the current system, which is mainly a pay-as-you-go system. That means the current payroll taxes paid by workers (and their employers on their behalf) go to meeting current liabilities of the Social Security system, rather than building up assets which can be used in the future to pay benefits.

The Puzzling Question: Why isn’t the Social Security Trust Fund sufficient to pay benefits? According to one leading expert, former Congressional Budget Office Director June O’Neill:

The language of the Social Security Trust Fund gives the illusion that it is an investment fund with tradable economic assets that can be held until needed to pay the benefits of future employees. But it is a fund in name only. It holds no real assets. Consequently it does not generate funds to pay future benefits. These so-called trust fund “assets” (essentially US Treasury IOUs) simply reflect the accumulated sum of funds transferred from Social Security over the years to finance other government operations.

Possible solutions:

  • Raise payroll taxes.

  • Raise other taxes and earmark the revenues for Social Security.

  • Lower benefits.

  • Raise the retirement age.

  • Or privatize part of the system and let individuals invest in stocks, bonds, and mutual funds in order to attain higher rates of return on their payroll taxes.

President Bush’s reform principles:

  • Reform must not change Social Security benefits for current retirees or near-retirees.

  • The entire Social Security surplus must be dedicated to Social Security only. That means the funds shouldn’t be used to cover Federal budget deficits.

  • Payroll taxes must not be increased.

  • Government must not invest Social Security funds in the stock market. Otherwise there would be a danger of politics intruding into the economic system.

  • Reform must preserve Social Security’s disability and survivors components. Most widows outlive their husbands by a considerable period of time. Many never worked outside the home. They depend on survivor benefits to survive.

  • Reform must include individually controlled, voluntary personal retirement accounts, which will augment the Social Security safety net. In other words, everybody should have the ability to invest some amount of money each year in 401k type plans, even those whose employers do not sponsor such plans.

Three reform proposals

President Bush established a bipartisan Presidential commission on Social Security reform back in 2001. It was composed of leading members of Congress, along with distinguished scholars and financial market experts. They issued their final report, plus amendments, in mid 2002. They came up with alternative models for Social Security reforms that were faithful to President Bush’s principles. All three alternatives featured personal accounts as a central component.

Reform Model 1 establishes a voluntary personal account option but does not specify other changes in Social Security’s benefit and revenue structure to achieve full long-term fiscal sustainability.

  • Workers can invest 2% of taxable wages in a personal account.

  • In exchange, traditional Social Security benefits are offset by the worker’s personal account contributions compounded at an interest rate of 3.5% above inflation.

  • No other changes in Social Security are proposed.

  • Expected benefits to retirees rise while the annual cash deficit of the system falls by 2020.

  • However, a large financing gap remains, requiring later changes in benefits or substantial new sources of revenue by the 2030s.

Reform Model 2 enables future retirees to receive Social Security benefits that are at least as great as today’s retirees, even after adjusting for inflation, and increases benefits to low-income workers. It establishes a voluntary personal account with raising taxes or requiring additional worker contributions.

  • Workers can voluntarily redirect 4% of their payroll taxes up to $1000 annually (indexed to wage inflation). No additional contribution from the worker would be required.

  • In exchange for the account, traditional Social Security benefits are offset by the worker’s personal account contributions compounded at an interest rate of 2% above inflation.

  • The plan makes Social Security more progressive by establishing a minimum benefit payable to 30-year minimum wage workers of 120% of the poverty line.

  • Benefits under the traditional component of Social Security would be price indexed, beginning in 2009.

  • Expected benefits payable to a medium-income earner choosing a personal account and retiring in 2052 (i.e. today’s entry level employee) would be 59% above benefits currently paid to today’s retirees.

  • Temporary transfers from general revenue would be needed to keep the Social Security Trust Fund solvent between 2025 and 2054.

  • The model achieves (on paper, anyway) a positive system cash flow at the end of the assumed 75-year valuation period under all participation rates (not every worker will choose to take part in the plan).

While the White House hasn’t endorsed any of the plans, Model 2 is thought to be the closest to President Bush’s own preferences.

Reform Model 3 establishes a voluntary personal account option that generally enables workers to reach or exceed current-law scheduled benefits and wage replacement ratios. It achieves Social Security system solvency by adding revenues and by slowing benefit growth less than price indexing.

  • Personal accounts are created by a match of part of the payroll tax – 2.5% up to $1000 annually (indexed for wage inflation) – for any worker who contributes an additional 1% of wages.

  • The add-on contribution is partially subsidized for workers in a progressive manner by a refundable tax credit.

  • In exchange, traditional Social Security benefits are offset by the worker’s personal account contributions compounded at an interest rate of 2.5% above inflation.

  • It establishes a minimum benefit payable to a 30-year minimum wage worker to keep retirees above the poverty line.

  • Benefits under the traditional component of Social Security would be modified by:

    • Adjusting the growth rate in benefits for actual future changes in life expectancy.

    • Increasing work incentives by decreasing benefits for early retirement and increasing benefits for late retirement, and

    • Flattening out the benefit formula

  • New sources of dedicated revenue are added in the equivalent amount of 0.6% of payroll over the next 75 years, and continuing thereafter.

  • Additional temporary transfers from general revenues would be needed to keep the Trust Fund solvent between 2034 and 2063.

The Critics:

Democrats in Congress have rejected the Commission’s three models. The following is drawn from Senate Resolution 432, introduced by Senator (and former Goldman Sachs CEO) Jon Corzine in September 2004.

  • Social Security is based on a promise to the American people that if you work hard and contribute to Social Security, you will be able to retire and live in dignity.

  • Social Security is the primary source of income for 2/3 of American seniors.

  • Social Security benefits for retirees average only about $900 a month, insufficient to maintain a decent standard of living in many parts of the US.

  • President Bush created a Commission that only included those who were already in favor of partial privatization of Social Security.

  • The three models require deep cuts in Social Security benefits, by as much as 46%.

  • The cuts would apply to all retirees, not just those seniors who had chosen to participate in privatized accounts.

  • Cuts could be even deeper for those who do shift funds to privatized accounts.

  • Privatization advocates attempt to justify cuts in Social Security benefits by pointing to future projected shortfall in the Social Security Trust Fund, but diversion of payroll tax revenues from the Trust Fund into privatized accounts would accelerate the date by which the Trust Fund becomes insolvent.

  • To avoid the insolvency, the Social Security Commission had to propose that the Federal Government incur as much as $4.7 trillion in new debt by 2041.

  • Therefore, the Bush approach should not be legislated.

The Prognosis:

Democrats are not united. If they were, they could block any Bush proposal through use of the filibuster. However, several Senators favor partial privatization if taxes are raised to finance the transition costs – and those costs are indeed considerable. Thus, there is ample room for compromise, despite the hostility of most Congressional Democrats.

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