Social Security Reform: Alternatives to Personal Retirement Accounts

1. Social Security Reform: Alternatives to Personal Retirement Accounts Social Security University August 28, 2002 Presented by: Michael Tanner, Director of Health and Welfare Studies Andrew G. Biggs, Social Security Analyst The Cato Institute, Washington, D.C. www.socialsecurity.org

2. Opposing accounts isn’t enough Many honest people oppose personal accounts. But the alternative to personal accounts isn’t doing nothing. One way or another, Social Security’s financing problems will resolve themselves. If we choose not to implement personal accounts, what are the other options open to us? What are the costs and benefits, and the risks and rewards, of these non-account reform proposals?

3. How Does Social Security Work? • Each worker pays 12.4 percent of the first $84,900 of his wages into Social Security. (Technically, his employer pays half, but economists agree that employers reduce wages to make up for this, so the whole burden is on the worker.) • 10.6 percent of the tax pays for Old Age and Survivors Insurance (OASI); the remaining 1.8 percent pays for Disability Insurance (DI) • At retirement, the SSA calculates a monthly benefit based on the worker’s average earnings. • Low-wage workers get relatively higher benefits, though much of this is offset because they have shorter life-spans (collect fewer years of benefits) and are less likely to be married (collect less in spousal benefits).

4. Social Security’s Pay-as-you-go Financing • Unlike a conventional pension plan, where each generation provides for its own retirement by saving and investing its contributions over time, Social Security is pay-as-you-go. • Taxes collected today are used to pay today’s retirees. Your own retirement will be paid for by workers in the future. • Advantages: • can begin paying benefits quickly; • provides big windfalls to early retirees; • simple to administer • Disadvantages: • very sensitive to the ratio of workers paying into the system to retirees collecting; • pays very low rate of return to post-windfall generations.

5. Lower birth rates and increasing life expectancies mean fewer workers to support each Social Security recipient 1960: 5.1 to 1 Today: 3.4 to 1 2030: 2.1 to 1 Worker-to-Retiree Ratio

6. The cost of paying benefits has risen…and will rise much more if the current system is not reformed.

8. But won’t the Social Security trust fund help pay benefits? No – there is no cash in the fund, just government bonds. These bonds represent a commitment to raise the money needed to pay full benefits, but to get that money we must raise taxes, cut other spending or borrow. But if there were no trust fund, we would still have to raise taxes, cut other spending or borrow – and by the exact same amount. The fund is an IOU to ourselves, and cannot put off the need for new revenue by a day or a dollar. The Congressional Budget Office: “Although there is no money in the Treasury to pay for future obligations, the obligations to people eligible for Social Security benefits are real. And most important, those obligations are a direct result of federal law, not a consequence of whatever may or may not be credited to the Trust Funds. In particular, the size of the balances in the Social Security Trust Funds – be it $2 trillion, $10 trillion, or zero – does not affect the obligations that the federal government has to the program’s beneficiaries. Nor does it affect the government’s ability to pay those benefits.”(CBO Director Dan L. Crippen and Deputy Director Barry B. Anderson, testimony before the House Ways and Means Committee, Feb. 23, 1999)

9. How Any Kind of Reform Must Work “Increased funding to raise pension reserves is possible only with some combination of additional tax revenues, reduced benefits, or increased investment returns from investing in higher yielding assets.” Henry Aaron, The Brookings Institution January 19, 1999

10. A Menu of Choices • Revenue increases • Increasing payroll tax rates. • Raising or lifting the cap on wages to which payroll taxes are applied. • Transfer general tax revenues; a de facto income tax increase. • Force state and local workers, who currently have their own pension plans, into Social Security. • Benefit reductions • Increase the normal and/or early retirement ages. • Increasing the benefit computation period; instead of basing benefits on the highest 35 years of earnings, use greater number of years. • Increase taxation of Social Security benefits; remove exemption for low-income retirees. • Reduce annual cost of living adjustments (COLAs). • Increased return • Collective investment of trust fund in the stock market.

11. Cato’s Criteria for Reform…More Than Just Solvency • Increase future economic growth:In the future, smaller numbers of workers will need to support larger populations of retirees. Social Security 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.

12. One 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 reject solutions based on personal accounts. What would they offer?

13. The “Do Nothing” Plan Former Sens. Bob Kerrey (D-NE) and Warren Rudman (R-NH) say hundreds of Members of Congress already “support” this plan – because they have not advocated any specific measures to keep Social Security solvent: “Not acting is itself a choice -- one that has grim consequences for today's midlife adults and even bigger ones for their children. Politicians of both parties should get behind specific reform plans or be held accountable for supporting the consequences of the Do Nothing Plan.” Doing nothing is easy – but leads to large benefit cuts for younger Americans: 16 percent for today's 30-year-olds, 29 percent for today's 20-year-olds and 35 percent for today's newborns. When the trust fund runs out in 2041, by law benefits must be cut by 25 percent or more. If you are for doing nothing, you are for cutting benefits.

14. Comparisons to Current System Can Be Misleading Many compare the costs and benefits of various reform plans to a hypothetical Social Security system that can pay full benefits forever without raising taxes. Kerrey and Rudman: “It is certainly fair to criticize reform plans on policy grounds. But it is fundamentally unfair to judge them against a standard that assumes the current system can deliver everything it promises. It can't. Today's Social Security system promises far more in future benefits than it can possibly deliver. The relevant comparison for any reform plan is with what current law can deliver, not what it promises.” Only by comparing personal account-based plans to other plans that address Social Security’s financing problems, can we assess the options on a level playing field.

15. The Clinton-Gore Plan • Use Social Security surpluses to repay existing government debt. • Credit the interest savings to the Trust Fund by issuing new bonds. • These new bonds would keep Social Security technically solvent until 2055.

16. Issues with Clinton-Gore plan Debt reduction is a good thing but… • The Clinton-Gore plan uses “Enron accounting”: the trust fund is already credited for reducing interest costs. Crediting it twice creates “paper assets.” • Moreover, the trust fund would be credited with new bonds even if no government debt were repaid. • Putting more IOUs in the fund doesn’t solve the system’s problems.

17. What the Experts Say About the Clinton-Gore Proposal • “It would be tragic indeed if this proposal, through its budgetary accounting complexity, masked the urgency of the Social Security solvency problem and served to delay much-needed action… “I am very concerned that enhancing the financial condition of the trust fund alone without any comprehensive and meaningful program reforms may in fact undermine the case for fundamental program changes. Delay will only serve to make the necessary changes more painful down the road. The time has come for meaningful Social Security reform.” The administration proposal “does not represent a Social Security reform plan and does not come close to “saving Social Security.”GAO head David M. Walker • “Adding to the trust fund balances does nothing to ensure that the necessary economic resources will be there to support the programs; it simply shifts money from one government pocket to another. In fact, by relieving the most visible symptom of the program’s fiscal distress, additional transfers from the general fund may lull the nation into overlooking the funds’ less obvious problems… Plans that shift funds from one government pocket to another do nothing to address those programs’ actual financing problem…and in fact could postpone corrective action.” CBO Director Dan L. Crippen, • “The president also has a great deal of ‘pain’ in his plan -- a hidden pain in the form of income tax increases that will be borne by future generations of Americans. I strongly disapprove of a plan that provides a false complacency that Social Security has been ‘saved’ by this nebulous and vague idea of saving the surplus -- while failing to disclose the real pain that will be imposed on future generations.” Former Senator Bob Kerrey (D-Neb) • “Its very complexity pretends to have done something for Social Security, and it weakens the demand for reform.” Eugene Steuerle, senior fellow at the Urban Institute. • The plan “is not a solution to the question of paying for Social Security benefits. You have no fiscal discipline, you have no governing device on the program. It just becomes a black hole.” Concord Coalition executive director Robert Bixby. • The plan “in no way reduces the rate of growth of benefits. It does not alter the economic burden on the system. It will have to be paid for, and it will be painful” for future generations. Rudolph G. Penner, Urban Institute; former director of the Congressional Budget Office

18. USA Accounts Don’t Fix Social Security The Clinton administration and the Gore campaign proposed so-called Universal Savings Accounts – or USAs. Workers could make deposits to these supplemental accounts. Lower-income workers would receive an up to three-to-one match on their contributions. USA accounts could be a good idea…but they do nothing to fix Social Security. Even with USA accounts, Social Security would still become insolvent. Moreover, participation by lower-income workers would be low, even with a generous match. (Personal accounts for Social Security would let workers invest taxes they already pay, so participation would be higher.)

19. Rep. Peter DeFazio’s Plan (HR 3315) • Tax Increase: Lifts “cap” on payroll taxes, which currently apply only to first $84,900 in wages. 12.4 percent tax would apply to all of worker’s wages, but workers wouldn’t receive credit for extra taxes. A worker earning $150,000 would pay an extra $8,100 in taxes each year, but receive no extra benefits. • Government Investment: Requires the government to invest 40 percent of the trust fund in private stocks and bonds. • Benefit Cuts: Bases benefits on worker’s 38 highest earning years, vs. 35 under current system. • Tax exemption: Exempts first $4,000 in wages from payroll taxes. • Miscellaneous: • Increases benefits 5 percent for retirees over age 85. • Allows parents three child care years without affecting their benefits.

20. Issues with DeFazio Plan • Lifting payroll tax cap is biggest tax increase in history, • Would raise taxes $1.2 trillion over ten years and increase the top federal tax rate to almost 55 percent, impacting economic growth and jobs. • Combination of tax increase and $4,000 exemption breaks link between contributions and benefits; turning Social Security into a “welfare” program could hurt public support. • Child care credits disproportionately benefit the wealthy, who can afford to leave the workforce to raise kids. Lower-income parents must work. • Not a permanent solution; would keep Social Security solvent only until 2075, large deficits beyond that.

21. Government investment • Other countries have tried collective investment; World Bank research shows most earned lower returns than a bank savings account, in part due to political consideration. State pension plans like CalPERS (California) have also been criticized for letting political considerations lead to investment losses (e.g., divesting tobacco stocks). • Al Gore: “The magnitude of the government’s stock ownership would be such that it would at least raise the question of whether or not we had begun to change the fundamental nature of our economy. Upon reflection, it seemed to me that those problems were quite serious.”(New York Times, May 25, 2000) • Alan Greenspan: I think it's very dangerous...I don't know of any way that you can essentially insulate government decisionmakers from having access to what will amount to very large investments in American private industry...I know there are those who believe it can be insulated from the political process, they go a long way to try to do that. I have been around long enough to realize that that is just not credible and not possible. Somewhere along the line, that breach will be broken. (Testimony before Senate Banking Committee, July 21, 1998)

22. Henry Aaron and Robert Reischauer Plan (Brookings Institution/Urban Institute) • Tax increases • Transfer around $100 billion of general revenues each year for the next 20 years. • Increase payroll tax ceiling to cover 90 percent of wages (raises ceiling to approx $105,000) • Government investment • 20 percent of the trust fund in the stock market. • Benefit cuts • Increase the normal and the early retirement age to 67 and 64 by 2011, then increase annually for longevity. • Make 85 percent of Social Security benefits subject to income taxes; eliminate exemptions of $25k for singles and $32k for couples. • Reduce the spousal benefit from one-half to one-third of the primary earner’s benefit. • Increase the benefit computation period from the 35 to 38 highest earning years.

23. Some issues with Aaron-Reischauer • General revenue transfers: personal account opponents decry the “transition costs” of funding accounts. Yet the costs of collective investment of the trust fund are the same. If personal account plans are unaffordable, then so are collective investment plans like Aaron-Reischauer. • Increases in both early and normal retirement age: workers could no longer receive benefits beginning at age 62. Would have to wait until 64 to collect. Could adversely affect those with shorter life expectancies. Increases in retirement age very unpopular.

24. Robert Ball’s “Maintain Benefits” Plan (1994-96 Advisory Council on Social Security) • Tax increases • The maximum wage subject to payroll taxes would immediately be increased by approximately $10,000. Beginning in 2050, the payroll tax rate would increase across the board by 1.6 percentage points. • Benefit cuts • Reduce annual cost of living increases. • Increase the benefit computation period from 35 to 38 years, or increase the current 12.4 percent payroll tax rates by 0.3 percentage points. • Increase taxation of Social Security benefits; phase out exemptions from taxation for low-income retirees. • Government investment in the stock market • Invest 40 percent of the Social Security trust fund in the stock market by 2014. • Miscellaneous • Force newly hired state and local workers into the system and redirect to the Social Security trust funds revenues from taxation of Social Security benefits currently going to the Medicare trust fund.

25. Increasing benefit computation period The Ball plan and some others increase the “benefit computation period.” At present, benefits are based on highest 35 years of earnings. Increasing the benefit computation period by definition introduces years of lower earnings, thereby reducing benefits. Would disproportionately impact women, who have shorter working lives and would therefore have more years of zero earnings averaged in.

26. Robert Matsui-Bob Graham 1990 Plan • Invest Social Security surpluses in municipal bonds issued by states and cities. • Trust Fund could purchase up to 25% of new municipal bonds issued, • Since municipal bonds earn lower interest rates than the trust fund’s bonds, the investment would hurt Social Security’s financing. • General revenues would be transferred to make up the difference, meaning tax increases/spending cuts. • A new board would rate the municipal bonds’ value, giving Washington more power over state/local govts. • Bonds would be for financing roads, bridges, schools, mass transportation systems, ports and water-treatment facilities. But many economists find these projects are less productive than market investments.

27. National Committee To Preserve Social Security And Medicare • Repeal tax cuts and use general revenues to supplement payroll taxes. • Raise payroll tax cap to cover 90 percent of wages. • Require all newly hired state and local workers to join Social Security system. • Government invest of the Social Security trust fund in stocks should be “seriously considered.”

28. Issue with repealing tax cut Some plans advocate repealing the recent tax cuts in order to fund Social Security reform. But we would still need to do something with the extra money. Simply crediting it to the trust fund would not help. We could invest it centrally in the stock market, but that has political risks. We could use it to retire debt, but that’s not a long-term solution. Tax cut repeal must be coupled with an investment strategy and with other steps to maintain solvency. By itself, it’s not a permanent solution.

29. Gary Burtless (Brookings Institution) • Increase payroll tax by .8%, divided equally between employer and employee. • Increase the benefit computation period from 35 to 38 years, reducing benefits for all retirees. • Require all newly hired state and local workers to join Social Security system • Fully incorporate recent changes in CPI formula into Trust Fund projections. • Note: this plan would not make Social Security solvent.

30. Inclusion of state/local workers Many state/local government employees exempt from Social Security. Pay into their own pension plans, which generally provide superior benefits. Forcing new state/local workers into Social Security would provide temporary increase in revenues, but eventually these workers would be eligible for benefits. Very small long-term financing gains. State/local workers, and the politicians who represent them, would fight inclusion. Could be a deal-killer for reform.

31. Dean Baker (Center for Economic and Policy Research) • Index payroll tax rates to increases in life expectancy or alternately transfer general revenues to Social Security System. • General revenue transfers can be supported by repealing tax cuts, increasing capital gains tax from 18 to 28%, and/or imposing a .25 percent transaction tax on all stock transactions. • Repeal payroll tax cap for employer’s portion of payroll taxes. • Fully incorporate recent changes in CPI formula into Trust Fund projections.

32. National Coalition Of Women’s Organizations • Increase payroll tax in future by 1.8 percentage points, to 14.2 percent of wages. • Repeal payroll tax cap, so taxes are applied to all of a worker’s wages (rather than just the first $85,000). • Government investment of 40 percent of Social Security Trust Fund in the stock market.

33. Issues with raising payroll tax rates Some plans advocate raising payroll tax rates, as we have done many times in the past. But payroll tax rates are already high, and payroll taxes are the biggest tax for about three-quarters of American households. Increased rates would translate into lower wages, making it harder for businesses to attract workers. Could increase unemployment. Unless payroll tax increases today were effectively saved for tomorrow, would not really address the problem. 1983 payroll tax increases created large trust fund “balance,” but the fund will not truly help pay benefits after 2017.

34. AFL-CIO • Raise payroll tax cap to cover 90 percent of wages. • Transfer general revenues to Social Security System. • Consider allowing the federal government to invest a portion of Social security Trust Fund surpluses. • Note: such a plan would not keep Social Security solvent unless large and ongoing general revenue transfers are made.

35. Divide and Conquer Matched head-to-head, the alternatives to personal accounts often do not fare well. Knowing this, account opponents seek to avoid a direct comparison; many refuse to put forward their own plans until personal accounts are taken off the table. Instead, they follow a two step plan; First, they will try to defeat personal accounts politically by comparing them to a current system that faces no problems. This is misleading, but could be effective. If personal accounts are defeated, they will then introduce their own proposals. This strategy makes it all the more important that honest head-to-head comparisons are made now.