Investment-Based Social Security Saving Social: Security for Our Parents, for Our Children

Policy Reports | Social Security

No. 220
Tuesday, December 01, 1998
by Phil Gramm

Executive Summary

The exploding cost of Social Security threatens to become the greatest financial crisis in American history. The unfunded liability of the system is twice as large as our national debt and exceeds the combined cost of all the wars fought in our nation's history. More than a financial crisis, the current Social Security system is fast becoming a human tragedy that will force us to choose between economic opportunity for our children and retirement security for our parents.

The cause of this crisis is a debt-based system of finance. Taxes taken from today's workers are not invested in real assets to fund their future retirement. Instead they are being used to pay the benefits of current retirees and to fund other government programs. When today's workers retire, they will have to depend solely on future taxpayers to fund their benefits. Yet because of a growing ratio of retirees to taxpayers, the tax burden on future wage earners will explode.

Now at the peak of their earning power, 77 million baby boomers are paying 60 percent of all payroll taxes collected in America. Soon they will cease paying into the system and start drawing benefits from it. Twenty years after the Baby Boom generation starts to retire, the retirement rolls will be growing almost 4 1/2 times as fast as the employment rolls. By that time, we will face the choice of increasing the payroll tax on working Americans by 33 percent or reducing every Social Security benefit check by 25 percent.

Fortunately there is a better way. We can begin now a 40-year transition to an Investment-Based Social Security system in which workers will be allowed to place a portion of their payroll tax dollars in private investment accounts which they own. In contrast to the current system, which makes no investments and earns no interest, workers will invest a portion of their payroll taxes in investment funds managed by professional money managers certified for safety and soundness and regulated by a new Social Security Investment Board. By making real investments and creating real wealth, the Investment-Based Social Security system will benefit from what Albert Einstein called the most powerful force in the universe, the power of compound interest. These funds will be invested conservatively in stocks and bonds that will grow as the economy grows. The resulting pension benefits will be larger and more secure than those promised under the current system. During the transition and under the new Investment-Based system no worker will lose any benefit currently provided by the Social Security system. The higher benefits of Investment-Based Social Security will phase in gradually as the total level of worker investment grows:

  • The first baby boomers to retire will receive almost 10 percent of their retirement income from their Social Security investment accounts and 90 percent from the current Social Security system.
  • The last baby boomers to retire will receive about 50 percent of their retirement income from their Social Security investments and about 50 percent from the current system.
  • Today's 20-year-olds with average lifetime earnings will receive 100 percent of their retirement income from their Social Security investments and can expect to receive 20 percent more in benefits. Those who have low wages or who lose work time due to sickness or unemployment will have lost Social Security benefits made up out of the current system.

Investment-Based Social Security will have the following features:

Choice. All workers paying into the current Social Security system will have the right to continue to stay in the current system. As an alternative, they will have the right to participate in Investment-Based Social Security, to achieve greater security and higher benefits. All young workers entering the labor market for the first time will enter the new system.

Benefits secured for current retirees. The new, reformed system will begin to put Social Security on a sound financial footing, assuring that the federal government will be able to meet its commitments to all current retirees and to those who will retire in the future. Unlike most other reform plans, the Investment-Based Social Security reform plan guarantees that benefits for the elderly will not be reduced either directly or through such indirect means as raising the tax on benefits, lowering the cost-of-living adjustment, or raising the retirement age.

Higher benefits under the new system. Everyone who chooses to participate in the new system will be guaranteed a higher monthly pension than the one promised by the current system. Once fully implemented, the federal government will guarantee a pension 20 percent higher, but most retirees will do better than that. When fully implemented, young workers can look forward to Social Security pensions 2 1/2 times the size of those they would have received under the current system.

Benefits backed by real assets. Under the current system, the ability of the elderly to receive retirement benefits is totally dependent on the willingness of taxpayers to pay for those benefits. Under Investment-Based Social Security, by contrast, pension benefits will be secured by the real investments owned by the worker.

Benefits protected from politicians. The Supreme Court has ruled that people have no constitutionally protected right to Social Security benefits, even if they have paid Social Security taxes. As every Social Security retiree is painfully aware, benefits promised by one Congress can be revoked by a subsequent Congress. By contrast, investment accounts established by Investment-Based Social Security will be the worker's private property and will enjoy the full protection of the "takings" clause of the U.S. Constitution.

No new risk. Participants in Investment-Based Social Security retain all benefits guaranteed by the current system and can never be worse off than they would have been in the old system. As each worker's Social Security Investment Account grows, his retirement benefits grow larger and the ability of government to alter his benefits by changing the benefits paid under the old Social Security system declines.

New retirement options. At the time of retirement, people will be required to use the funds in their private investment accounts to purchase an annuity which will pay a monthly pension - equal ultimately to a minimum of 120 percent of the benefit promised under the current system. When the Investment-Based Social Security system is fully implemented, many people will have saved far more than the amount needed to purchase such an annuity. They will be free to use these savings to purchase a larger pension annuity, or to withdraw the extra funds as a lump sum and use them as they choose.

Freedom to retire. During a transition period, people will still be able to retire at the normal retirement age with a government-guaranteed minimum benefit. They will also be able to take early retirement at age 62, at the standard reduced government-guaranteed benefit. But once the new system is fully implemented, workers can choose when they want to retire, provided they have accumulated assets sufficient to pay a monthly pension equal to 120 percent of the benefit promised by the current system.

Freedom to work. Once the new system is fully implemented, people will also be free to continue working past their normal retirement age, without any loss of pension benefits. This is in contrast to the current system, under which retirees can lose $1 of benefits for every $3 of wages above a certain income level.

Inheritance rights. If a worker dies prior to retirement, a portion of the funds in that worker's private retirement account will be used to pay survivors benefits for a surviving spouse or other family members - equal to or better than those promised by the current system. All remaining funds will be bequeathed to the worker's heirs in one lump sum, free of all taxes.

The new Investment-Based Social Security system would be phased in over time:

  • Beginning in the year 2000, workers will be able to place three percentage points of the 12.4 percent Social Security payroll tax into private investment accounts.
  • By the year 2038, the new system will be saving Social Security more than it costs, and the percent of wages workers can put into their investment accounts can begin to rise.
  • By 2055, workers will be able to put aside 10 percent of wages - 8 percent to fund their retirement and 2 percent to fund disability insurance.
  • After 2065, the payroll tax will decline from the current 12.4 percent to 10 percent.

The transition to an investment-based system will require about 50 years, during which time existing benefits would not be cut and taxes would not be raised. In the interim, there will be a need for funds to finance the transition as we allow people to deposit a portion of their Social Security payroll taxes into investment accounts. Three sources of funds will finance the transition: (1) projected federal budget surpluses; (2) a recapture (for use by Social Security) of the federal corporate income taxes that will be collected on new investment made possible by the accumulation of capital in Social Security investment accounts; and (3) redemption of 29 percent of the Social Security Trust Fund's assets. The redemption of a portion of the Social Security Trust Fund will require the federal government to pay Social Security back 29 percent of what it has taken out of the system in the past to fund other government activities.

Saving Social Security requires that we save and invest now rather than tax and borrow later. And more than money is at stake. Save today and we save our children's dreams tomorrow. Invest today and we invest in our parents' security. Tax tomorrow and we diminish our children's future. Cut benefits tomorrow and we harden our parents' retirement.

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