Is this the year the government finally gets around to reforming Social Security?
For one thing, it is an election year. If history is any guide, politicians will decide it is safer to put off until tomorrow what they could do today, especially with such a hot issue. In addition, the war on terrorism continues to occupy much of Washington’s attention.
What’s more, the President’s Commission to Strengthen Social Security, which in December issued a report containing options for making the system fiscally sound, has itself recommended that no action be taken for a year. The commission says the issue is so complex and rife with controversy that months will be needed to get people up to speed on the issues.
“A great deal of education needs to be done about Social Security,” says commission member Olivia S. Mitchell, professor of insurance and risk management and executive director of Wharton’s Pension Research Council. “It will take a year to get people to talk seriously about alternatives. It’s not just a matter of Congress, either; it’s a question of educating the American people about the need for reform.”
The commission, which began its work last spring and held a series of hearings through the summer and fall, was required to follow six guidelines established by the White House. Among them: Benefits cannot be changed for retirees and people soon to be retired, payroll taxes cannot be increased, and any reform package must include voluntary, individually-controlled personal retirement accounts that would augment Social Security.
The report by the 16-member commission, divided equally between Democrats and Republicans, concluded that Social Security would be strengthened if it were modernized to include voluntary personal accounts. Such accounts would “improve retirement security by facilitating wealth creation and providing participants with assets that they own and that can be inherited, rather than providing only claims to benefits that remain subject to political negotiation.” The commission says it believes personal accounts can be administered efficiently and in a cost-effective way, and that they would help Social Security become fiscally sustainable.
When Social Security was created during the Depression, it was intended to be a pre-funded plan. Shortly after President Franklin D. Roosevelt approved the bill, however, it was converted into a pay-as-you-go system. Workers do not have accounts with assets set aside for them; instead, the payroll taxes paid by current workers are used to pay benefits to current retirees.
Mitchell says reforming Social Security is essential. If the system is not changed, she says, the government will have to start cutting benefits to recipients around 2036 because system revenue will not be enough to pay promised benefits.
In its report, the commission outlines three models for reform. All three include a voluntary personal retirement account, giving workers some control over their retirement benefits. All three plans also require “transitional investments” – money temporarily taken from the general federal budget – to finance traditional benefits while moving to a system of personal accounts. It is also noteworthy that two of the three plans would increase retirement benefits significantly for low-income workers.
Under the option called Model One, workers would be able to redirect 2.0 percentage points of their payroll taxes to a personal account. In exchange, traditional Social Security benefits would be offset by the workers’ personal-account contributions, compounded at an interest rate of 3.5% above inflation. “If you think you can beat a real return of 3.5% by investing, you’ll do better by choosing the personal account option than by staying in the traditional system,” Mitchell explains.
No other changes to the current system would be made under this option. As a result, the system would face an uncertain future because additional money would still be needed to keep the system solvent, the report says.
Models Two and Three are more far-reaching in their approach to reform. Model Two would allow workers to redirect 4 percentage points of their payroll taxes, up to $1,000 annually, to voluntary personal accounts. The maximum contribution allowable would be indexed to wage growth – another important feature. In exchange, traditional Social Security benefits would be offset by the worker’s personal account contributions, compounded at an annual interest rate of 2% above inflation.
Under this model, future retirees would receive Social Security benefits that are at least equal to those received by today’s retirees, even after adjusting for inflation.
Importantly, this option also would increase Social Security benefits paid to low-income workers. A minimum benefit of 120% of the poverty line would be payable to minimum-wage employees with 30 years in the workforce. Plus, expected benefits payable to a medium wage earner choosing a personal account and retiring in 2052 would be 59% higher than benefits being paid to today’s retirees.
Taxes would not have to be raised under Model Two and workers would not be required to make additional contributions. However, “temporary transfers” from general federal revenue would be needed to keep Social Security solvent between 2025 and 2054. In the end, says the commission, this option “achieves solvency and balances Social Security revenues and costs.”
Model Three also would establish voluntary accounts, but with a twist. Personal accounts would be created by a match of part of the payroll tax – 2.5 percentage points up to $1,000 a year – but only for workers who contribute an additional 1% of their wages that are subject to the payroll tax. “You have to pay to play under this model,” says Mitchell. The extra contribution would be partially subsidized for workers by way of a refundable tax credit.
This option also helps poorer workers. It establishes a minimum benefit of 100% of the poverty line to 30-year minimum wage workers and 111% for people who have worked 40 years at the minimum wage. In addition, benefits for early retirees would be reduced, while benefits for people retiring later would be increased. Benefits payable at the normal retirement age would also be indexed to life expectancy. This model requires both a permanent increase in revenue worth about two-thirds of 1% of payroll, and also temporary transfers from general revenues to keep social security solvent from 2034-2063.
Mitchell, a Democrat, favors Model Two. “Fiscally, it’s the most sustainable,” she says, “and it does the best job of protecting low-income people. Another reason I like this plan is that it offers larger personal accounts. People would get a sense of ownership over a larger amount of money quickly.”
Mitchell says she would like to see Congress tackle the issue of Social Security reform early in 2003. “Every year that passes is one year less we have to work with. The time when income from payroll taxes becomes insufficient to pay promised benefits to future retirees cannot be pushed back indefinitely under any sensible economic or social assumptions.”