Personal Accounts for Social Security: Facts and Fantasies

Personal Accounts for Social Security:Facts and Fantasies Social Security University February 20, 2003 Presented by: Andrew G. Biggs, Social Security Analyst The Cato Institute, Washington, D.C. www.socialsecurity.org

Challenges Facing Social Security • It’s going broke: Social Security will begin running payroll tax deficits within 15 years. By 2041, it will be legally and financially unable to pay full promised benefits, resulting in cuts of 25 percent or more. • It’s unfair: Social Security often discriminates against working women; divorcees; African Americans; and younger Americans. • It hurts wealth creation: asset ownership brings a host of economic and social benefits. Social Security discourages saving by the poor, reducing wealth accumulation and increasing economic inequality. • It’s risky: workers have no legal right to their benefits, even after a lifetime of contributions. The lack of a legal obligation encourages the government to make promises it cannot keep, and to delay action on reform.

Social Security reform should… • Increase economic growth:In the future, smaller numbers of workers will support larger populations of retirees. Social Security reform can help make each worker more productive by raising national saving, thereby increasing worker productivity and boosting economic growth. • Increase personal control:Reform should give workers true legal ownership of their retirement savings, prevent the government from “raiding” Social Security for other purposes, and give all Americans the opportunity to build wealth and pass it on. • Increase fairness:The current system can be unfair to African Americans, who often do not survive to retirement age; to working women, who often do not receive spousal benefits; and the young, who must pay high taxes into a system that will be insolvent by the time they retire. Reform should correct these flaws so all Social Security participants feel they are treated fairly.

A solution: personal accounts • Workers could invest part or all of their payroll taxes in accounts holding diversified stock and bond mutual funds. In return, they would give up part of their traditional benefits. • At retirement, workers could purchase an annuity or take gradual withdrawals of their money. • If the worker died before the account was exhausted, the remainder would pass onto his spouse, children or a chosen charity. • Many plans exist: Congressional proposals, the President’s reform commission, think tanks and other interested groups. • Nevertheless, many people have doubts. Others seeks to play on the public’s fears…

The tough questions about Social Security reform Is there really a crisis? Wouldn’t personal accounts cut benefits? Isn’t it cheaper just to fix the current system? Aren’t personal accounts too risky? Won’t accounts reduce Social Security’s progressivity? Won’t personal accounts would drain money from the system? Isn’t reform too expensive? The trust fund will keep Social Security solvent for decades. What’s the hurry? Would personal accounts “Enron” Social Security? Would personal account shred the safety net? Can ordinary workers invest wisely? Will stocks continue to pay high returns in the future? Won’t personal accounts increase the retirement age?

What do these questions show? None of the questions are deal-breakers: Some are simply wrong on the facts. Others highlight the costs of reform, while ignoring the costs of inaction. Others show legitimate difficulties with personal accounts, which reform supporters must work to overcome. But even legitimate difficulties must be weighed against the advantages of reform.

Is there really a Social Security crisis? Some people say Social Security’s financing problems are just a function of pessimistic economic projections. Some even accuse Social Security’s trustees of rigging the numbers to make the program look bad. If the economy grows faster, they say, Social Security won’t go broke. Why make big changes now for a problem that may never occur?? This is a very interesting view at first. Unfortunately, it is wrong.

Both sides acknowledge need for reform But…Politicians from both parties have stressed the need for reform – and sooner rather than later. President Clinton spent a year highlighting Social Security’s problems. Two independent panels of experts examined the trustees projections. They found them to be reasonable or maybe even a little optimistic regarding Social Security’s financing. In other words, instead of a “phony crisis,” we might have something even worse than expected.

Here’s why the crisis is real • Social Security’s trustees believe the economy will slow tomorrow because birth rates are low today: fewer new workers equals slower economic growth. • Faster economic growth won’t help much. Tax revenues will increase, but so will the amount that Social Security must pay in benefits. Economic growth could double and Social Security would still go broke. • The trustees’ “low cost” projections do show Social Security solvent for 75 years, but this assumes higher economic growth, increased birth rates, reduced improvements in life expectancies, lower unemployment, higher inflation, higher interest rates, a one-third increase in immigration, and lower incidence of disability. No one seriously believes this will happen. • Many demographers believe life expectancies will increase faster than the trustees project. If so, Social Security’s deficits will be bigger – MUCH bigger.

Faster growth increases short-term surpluses and long-term deficits

Would personal accounts cut benefits? “President Bush's own Social Security commission has developed privatization plans that would require drastic reductions in future Social Security benefits. For some seniors, these cuts could exceed 25 percent. In the future, seniors could face far deeper cuts in benefits, up to 45 percent." (Sen. Jon Corzine, D-NJ). Is this true? The short answer: NO!Here’s the proof: One plan from the President’s Commission did nothing other than add personal accounts. Social Security’s actuaries certify that a low-wage worker retiring in 2052 could expect 5 percent higher benefits than he is promised by the current program. Moreover, beginning in 2042, it would always be cheaper than the current system, while paying higher benefits to everyone. We must do more to fix Social Security than just add personal accounts, and those steps could be painful. If changes aren’t made, retirees face cuts of over 25 percent when Social Security becomes insolvent. But by raising benefits, accounts make whatever combination of steps we choose to restore solvency less painful. In other words, personal accounts don’t cause cuts, they actually make them smaller.

So why all the talk of “cuts”? Anatomy of a benefit “cut”: Critics compare the current program’s promised benefits to the traditional benefit paid by the Commission’s Plan 2.

Benefit comparisons are “fundamentally flawed” and “misleading.” “Comparing a proposal’s projected benefits to those resulting from the rules of current law can be misleading, since the full amount of benefits promised under current law would not be payable under the trustees’ projections. For example, a proposal that is shown to result in benefits that are 10% or 20% lower than under current law may at first glance appear politically unattractive, but may appear less so if compared to the 27% reduction in benefits that would have to occur … if policymakers were to take no action.” (Congressional Research Service). “There’s a lot of people that want to compare Social Security reform proposals just to promised benefits. That is fundamentally flawed and unfair because all of promised benefits are not funded. There is a huge shortfall between what's been promised and what's been funded, and you’ve got to figure out how you're going to close that shortfall. So, any analyses, including the [Diamond-Orszag study], that compare the benefit cuts based upon promised benefits solely rather than funded and promised, is unfair, unbalanced, in my opinion inappropriate.” (General Accounting Office head David Walker).

Social Security can’t meet its promises Compared to what Social Security can actually pay, the reform plan’s traditional benefit is often much higher.

Including the account, it’s game over… A low-wage worker retiring in 2052 can expect benefits 45 percent higher than Social Security can afford to pay, and 5 percent higher than the current system even promises.

Here’s the proof… • A 25-year-old low-wage woman retiring in 2042 is “promised” $896 per month (in $2001) from Social Security. • However, because Social Security will be insolvent in 2042, by law the program can pay her only $655 per month (with larger cuts in future years). • Under one proposal from the President’s Commission, this same woman could expect to receive $611 in benefits from the traditional system plus $375 from her account, for a total of $986 per month. • Her benefits would be $331 per month more than Social Security will by law be able to pay, and $90 more than Social Security even promises. • This is what reform opponents consider a “deep cut” in benefits.

Isn’t it cheaper just to fix the current system? All personal account plans use a certain amount of general tax revenue to cover temporary “transition costs.” The National Committee to Preserve Social Security and Medicare says, “It would be less expensive to extend the solvency of the program using the structure we have in place.“ Peter Orszag (Brookings) and Peter Diamond (MIT) make the same argument, that if we put those same resources into the current system, it could pay higher benefits than personal account plans. But is this true? To find out, Rep. Charlie Stenholm (D-TX) asked Social Security’s actuaries to determine what benefits the current system could pay if it received the same $1.3 trillion in general revenues used in the President’s Commission’s “Model 2.”

SSA Confirms: Personal Account Plans Give More Bang for the Buck Social Security's actuaries found that even if the current system received the same general revenue transfers as Commission Model 2, virtually all low- and average-wage account holders under Model 2 would receive higher retirement benefits. By 2075, a low-wage account holder could expect 30 percent higher benefits under the personal account plan than the current system. This provides the best head-to-head, apples-to-apples comparison of personal accounts to the current system, as measured by Social Security’s non-partisan actuaries. Reps. Jim Kolbe (R-AZ) and Stenholm concluded, "The new analysis by the nonpartisan Social Security Administration Office of the Chief Actuary (OACT) shows that a Social Security reform plan with personal accounts can provide more 'bang for the buck' than simply pumping more money into the current Social Security system."

Detailed Results: Dollar for Dollar, Personal Accounts Pay More

Isn’t the stock market too risky? “After what’s happened in the stock market the last few weeks, we think it’s a terrible idea…. Imagine if you were retiring this week, with most major stock indexes hitting five-year lows.” (Sen. Tom Daschle, D-SD, July 12) A worker with a personal account invested only in the S&P 500 and retiring today would have received around a 6 percent real return – even after the market decline. A single male worker retiring today can expect a 1.74 percent real return from Social Security. Married couples can expect around 2.5 percent. Recent market drops don’t show personal accounts are too risky; in fact, they show just the opposite. Even in the biggest bear market since the Great Depression, a worker would have more than doubled his money with a personal account holding stocks.

Even a big crash wouldn’t leave account holders worse than Social Security. Assumptions: single male, average wage, retiring 2002. Employee share of payroll tax (6.2 percent) paid into account, versus same tax paid into current program.

Even stocks’ worst returns beat Social Security. Stocks’ lowest annualized returns over various holding periods

Social Security’s Progressivity • “Private accounts ... would eliminate the progressive aspects of the current system that provide more help for low-income people." (Maya Rockeymore, National Urban League). • Social Security seems progressive, since low-wage workers receive relatively higher monthly benefits than those with higher wages. But many economists now conclude it is barely progressive at all. Why? • Life expectancies: The rich live longer than the poor, collecting benefits for more years. Progressivity reduction: 16 percent. • Spousal benefits: spouses of high-wage earners receive higher spousal benefits. Progressivity reduction: 30 percent. • Intra-household redistribution: Social Security often “redistributes” from a richer member of a household to a poorer member, not from rich households to poor households. Progressivity reduction: 14 percent. • Potential earnings: many people appear poor not because of low wages, but because they work short hours or leave the workforce. This is particularly true when the person’s spouse has high wages. Progressivity reduction: 20 percent.

Progressivity “Greatly Exaggerated.” Result: Only about 2.5 percent of total benefits redistributed from rich to poor. Economists Alan Gustman (Dartmouth) and Thomas Steinmeier (Texas Tech) state: “It is clear from these results that the general perception that a great deal of redistribution from the rich to the poor is accomplished by the progressive Social Security benefit formula is greatly exaggerated. As a result, adoption of a Social Security scheme with individual accounts designed to be neutral with regard to redistribution would make much less difference to the distribution of Social Security benefits and taxes among families with different earnings capacities than is commonly believed.”

Actual Social Security redistribution one-fifth of what basic benefit formula implies

Personal accounts can substantially increase progressivity. Progressive personal accounts: low-income workers make larger contributions. Since accounts are a better deal than the current program, the more you can contribute the better you are. Enhanced safety net: new minimum benefits, increases for widows. More progressivity in traditional program: low-wage workers most protections against reductions in traditional benefits to restore solvency. General tax revenues would pay the “transition”: wow-wage workers, who pay little income taxes, would receive a pure shift from low pay-as-you-go returns to market

Here’s the proof… • Under the current program, a low-wage retiree receives benefits equal to 46 percent of a high-wage retirees’ benefits. (Even though the low-wage retiree earned just 28 percent as much as the high-wage individual.) • Under the President’s Commission’s two comprehensive reform plans, benefits to low-wage workers would rise to 50 and 56 percent of those paid to high-wage workers. • These plans are clearly more progressive than the current program. • And because account balances could be passed on at death and would be split evenly at divorce, true progressivity is likely higher than these numbers show.

Would personal accounts “drain money from the system”? • Today, Social Security’s surpluses are used to cover deficits in the rest of the budget. Reform opponents call this “saving” the money. • Personal accounts would save those surpluses only for paying benefits. Yet this supposedly “drains money from the system.” • If we do nothing, by 2075 Social Security would run debts of $3.2 trillion (in present value dollars). Under two plans from the President’s Commission, by 2075 the system as a whole (including accounts) would have assets exceeding $1.7 trillion. • Without reform Social Security will go broke. With reform, it would be solvent and hold $1.7 trillion in assets. It’s hard to see that as “draining the system.”

Would reform be too expensive? Plans from the President’s commission “are dependent upon large, multi-trillion dollar transfers from the rest of the budget.” (Peter Diamond and Peter Orszag.) But large compared to what? Not compared to paying full promised benefits under the current program (which is what reform critics assume when they talk about “benefit cuts”). Most major reform plans reduce the need for general revenue transfers relative to maintaining the current system. The only thing cheaper than reform is “doing nothing” – but that implies over 25 percent benefit cuts.

Plans from President’s Commission cut general revenue costs…by a LOT.

Do we have the money? Reform is cheaper over the long run: current system would demand $23 billion in general revenues over the next 75 years. Reform plans cut that by half or more. Money’s tight today – so Congress should cut corporate welfare and pork to help finance reform. Are those things more important than Social Security? The budget balance will only decline in the future. Social Security’s surpluses will fall after 2005. The rest of the budget will be squeezed as the baby boomers begin retiring in 2008. The budget may not be flush today, but will it be better tomorrow? Social Security reform is not a luxury to be undertaken when times are good. We have no choice but to reform Social Security, and acting sooner will always be less painful than leaving it for later.

The trust fund will keep Social Security solvent for decades. What’s the hurry? “The assertion that Social Security is going bust in 2016 flies in the face of all reality. The facts are Social Security has enough reserves in the trust fund to last until at least 2038.” (Rep. Richard Gephardt, D-MO) The trust fund cannot delay the need for tax increases or spending cuts by a day or reduce them by a dollar. The reason: the trust fund holds government bonds, and when Social Security redeems them the government must raise taxes or cut other spending to repay those bonds. Example: in 2020 Social Security will run a payroll tax deficit of $74 billion (in today’s dollars). Without a trust fund, we’d need to raise taxes or cut other spending by $74 billion to pay full benefits. With a trust fund, we need to raise taxes or cut other spending by $74 billion to repay the fund’s bonds. For the taxpayer, it’s all the same.

What the experts say… “Although government trust funds arguably have some value as an accounting mechanism, their projected solvency does nothing to ensure that economic resources are available to cover program costs.” (Congressional Budget Office.) “While the trust funds have an important role in monitoring the finances of the program and maintaining its fiscal discipline, they are basically accounting devices. The federal securities they hold are not assets for the government. When an individual buys a government bond, he or she has established a claim against the government. When the government issues a bond to one of its own accounts, it hasn’t purchased anything or established a claim against some other entity or person. It is simply creating a form of IOU from one of its accounts to another…. Those claims are not resources the government has at its disposal to pay for future Social Security claims. Simply put, the trust funds do not reflect an independent store of money for the program or the government…” (Congressional Research Service) “The changes to Social Security enacted in 1983 are not producing the result of lessening the burden of paying for the retirement benefits of the baby boom generation. The budgetary reality is that the payroll taxes are being used to finance the current operations of government and are masking the size of the on-budget deficit. The economic reality is that the Trust Fund reserves consisting of Treasury securities that are financing current consumption rather than productive investment are illusory. They will remain so until the rest of the government achieves approximate balance between revenues and outlays.” (General Accounting Office.)

Would personal accounts “Enron” Social Security? • Sen. Tom Daschle said: "I don't want to 'Enron' the people of the United States,. I don't want to see them holding the bag at the end of the day, just like Enron employees have held the bag. I don't want to destroy their Social Security system." • Personal accounts are nothing like Enron. Workers could invest only in diversified, approved mutual funds, not in single stocks. What happened at Enron simply couldn’t happen under any existing personal account plan. • The current system is actually more like Enron. Like Enron, Social Security… • Uses murky “trust fund” accounting that exaggerates its assets and hides its liabilities. • Gives workers little control over their savings. • Doesn’t allow workers to diversify. Low-wage workers have nothing but Social Security. • Is going broke. Not as fast as Enron, but that won’t matter to workers who are affected.

The real message of Enron… • In a July 2002 Cato Institute/Zogby International poll, likely voters were asked, “Which statement to you more agree with?”: • “The Enron scandal shows the dangers of the stock market and why we must maintain Social Security as it is and not allow individuals to invest their payroll taxes in personal retirement accounts.” • “The Enron scandal shows that people need more choice and more control over their retirement savings, including allowing workers the option to invest part of their payroll taxes in a personal retirement account.” • By a more than 2-to-1 margin, likely voters said the Enron scandal was a reason to favor personal accounts not a reason to oppose market investment by workers.

Would personal accounts “shred” Social Security’s safety net? People like Sen. Jon Corzine (D-NJ) worry that personal accounts would “shred the safety net.” But… • Today, a low-wage worker could pay an eighth of his wages into Social Security all his life and still retire below the poverty line. • Today, Social Security allows 12 percent of women to retire into poverty, versus only 7 percent of men. Among widows, divorcées or never-married women, poverty rates can approach 25 percent. • Today, one-third of black men entering the workforce will not live to collect a penny in retirement benefits. • Tomorrow, Social Security will become insolvent, forcing benefit cuts of 25 percent or more. The poor will be hit the hardest when Social Security goes broke.

An enhanced safety net • Personal account plans like those from the President’s commission include provisions to: • Increase the program’s progressivity; • Guarantee that low-wage workers don’t retire into poverty; • Increase benefits for lower-income widows; • Give divorced women a right to half their husband’s account balance. • Could we take these steps without personal accounts? Sure, but an insolvent system can’t afford to improve the safety net. Personal account plans that restore solvency can build a stronger net. • A solvent system is the best safety net.

Can ordinary workers invest wisely? Millions of ordinary workers have already begun investing successfully through IRA and 401(k) plans. Will low-wage workers take too much risk? Not likely: the average worker aged 60-65 and earning $15-25k has just 23 percent of his 401(k) account in stocks, and the rest in bonds. He would have made money in the market last year. Workers in dozens of countries around the world already invest in personal accounts. Are workers in Chile, Australia or Mexico smarter than Americans? Personal accounts would be modeled after the federal Thrift Saving Plan – simple, cheap and easy to use. What the opposition is REALLY saying is “low-income workers are too stupid to invest.” This is patronizing and demeaning – particularly since opponents usually have investment accounts of their own!

Will stocks pay the same returns in the future? • Some argue that because the economy will slow in the future, stock returns must also fall. No one knows for sure, but… • Stock returns – which have averaged 7 percent -- would have fall a lot to be below Social Security’s 2 percent returns. • Social Security’s independent actuaries forecast 6.5 percent real annual returns. • Much of the argument for lower future returns hinged on an overvalued market – and that’s no longer true. • Historically, long-term stock returns have no correlation to growth of the total economy. Instead, returns correlate to economic growth per worker. GDP growth per worker will remain strong, even if slow labor force growth reduces total economic growth.

Won’t personal accounts increase the retirement age? You can call any change in benefits a change in the retirement age, since by working longer you would earn higher benefits.

Personal accounts could make earlier retirement possible. The normal retirement age – currently 65, gradually rising to 67 – is entirely separate from personal accounts. None of the plans from the President’s Commission raise the retirement age. You could still retire as early as 62, and the normal age would remain the same as in current law. Moreover, workers retiring at any given age would receive higher benefits than under the insolvent current program. For instance, a 25-year-old low-wage woman would have to work past age 70 under the current program to receive the same benefits she could receive at age 65 under the President’s Commission’s Plan 2.

Personal Accounts for Social Security: Facts and Fantasies