Comparing Proposals for Social Security Reform

Studies | Social Security

No. 227
Wednesday, September 01, 1999
by Liqun Liu and Andrew J. Rettenmaier


Executive Summary

This study uses a simulation model to evaluate a number of proposals to reform the Social Security system. Our analysis is sufficiently broad to allow us to form some general conclusions about the process of Social Security reform:

  1. According to the latest Trustees Report, our Social Security system will require (a) increasing the payroll tax by more than one-half (b) cutting benefits by one-third or (c) some combination of the two sometime during the next century.
  2. Any major increase in taxes is likely to lower productivity and lower incomes for future generations, and any substantial cut in benefits will lower the standard of living of future retirees unless other policies are adopted to encourage Americans to increase their savings during their working years.
  3. It is possible to secure currently promised Social Security benefits indefinitely into the future without increasing tax rates or increasing government debt.
  4. However, achieving this goal requires at least partially replacing our current system of pay-as-you-go finance with a funded system that makes investments in income-earning assets.
  5. Partial funding of future Social Security benefits can also eliminate Social Security's unfunded liability - currently estimated at $4.5 trillion over the next 75 years.
  6. Although the cost of transition to the new system is high - requiring almost all of the projected budget surpluses - changing the system now will more than pay for itself in future years.
  7. If the funding mechanism is personal retirement accounts (PRAs), it is possible to design the transition so the generation currently entering the labor market - and each succeeding generation - can fully fund its retirement benefits from its PRAs.
  8. Beyond that point, it will be possible to completely eliminate the regressive payroll tax that currently funds Social Security.
  9. The federal government can guarantee that every retiree will receive a pension at least as great as that promised by the current system and can do so at a fraction of the current system's cost; however, in the face of such a guarantee PRA funds must be invested conservatively in broadly diversified portfolios.
  10. The new, fully funded system can have progressive features, including (a) guaranteeing the current system's progressive schedule of benefits, (b) enabling those with shorter life expectancies to leave their PRA accumulations to their heirs, prior to retirement, and (c) allowing policymakers to eventually use the income tax rather than the payroll tax to pay minimum benefits to low-income retirees with insufficient savings.

Recognition is growing in Congress among both Democrats and Republicans that Social Security reform needs to be an urgent national priority. To help think through this process, we have completed a detailed analysis of four specific reform plans using a computer simulation model developed by the Private Enterprise Research Center (PERC) and the National Center for Policy Analysis (NCPA). This model differs from the one used by the Social Security Administration (SSA) in three important ways. First, our projections of Social Security revenues and expenditures are more conservative (pessimistic) than SSA's. Second, we do not treat the government bonds held by the Social Security trust funds, nor the interest paid thereon, as real assets that can fund future spending. Since the government cannot pay benefits with IOUs it has written to itself, any reform plan must be funded from real tax revenues. Finally, our model predicts that an increase in privately invested funds will increase the capital stock, which will in turn increase future government revenue at existing tax rates. We treat this new revenue as a potential funding source to pay Social Security benefits to the baby boomer generation as well as later generations of retirees.

Sens. Phil Gramm (R-Texas) and Pete Domenici (R-N.M.) propose to allow workers to divert a portion of their payroll taxes into personal retirement accounts, invested in professionally managed funds holding diversified portfolios (60 percent equities, 40 percent bonds). Since the plan promises no new taxes and no benefit cuts, initial deposits must be limited to the amount that can be funded from projected budget surpluses - about 2.5 percent of wages. Over time the deposits made to PRAs, which reflect additions to the nation's capital stock, would lead to a larger economy, producing more tax revenues at existing tax rates. This extra revenue would fund larger deposits, eventually rising to 4.85 percent of wages - the amount needed to fund all promised benefits plus a 20 percent bonus for the average worker.

The benefits workers receive on retirement would be guaranteed to equal the benefits scheduled under the current system, plus an amount equal to 20 percent of the annuity they can purchase with their private account. At the time of retirement, the balance in a worker's PRA would be turned into an annuity and Social Security would pay the difference between the annuity and the guaranteed benefit. Under the plan, we project that:

  • By 2030 new retirees would receive one-fourth of their monthly benefit from private annuities, and by 2050 the annuities would fund one-half of promised benefits.
  • By the year 2075 government funded benefits would equal only 7.1 percent of payroll, compared to a 19 percent payroll tax that would be needed if no reforms are adopted.

Reps. Bill Archer (R-Texas) and Clay Shaw (R-Fla.) propose that workers receive an annual refundable income tax credit equal to 2 percent of wages for deposits to PRAs. Although the mechanism for funding PRA accounts appears substantially different from the Gramm plan, the initial funding source is the same - projected budget surpluses. In contrast to the Gramm plan, however, Archer-Shaw would have the Social Security Administration, rather than private firms, administer the annuities during a worker's retirement years. Retirees are guaranteed they will receive at least as much as currently scheduled benefits. We estimate that:

  • Like the Gramm plan, the Archer-Shaw plan would allow annuities funded from PRA accumulations to replace one-fourth of promised benefits by 2030 and one-half of benefits by 2050.
  • Beyond that point, however, the Archer-Shaw plan continues this division - with PRAs and tax-supported payments each sharing roughly half the burden indefinitely into the future.
  • Even so, by 2075 Archer-Shaw requires taxes equal to only 10 percent of payroll, compared to a needed tax of 19 percent with no reform.

A bipartisan proposal sponsored by members of both houses of Congress and both parties would eliminate Social Security's unfunded liability by raising taxes (one-third) and reducing benefits (the other two-thirds). After 75 years, Social Security benefits would only be about 78 percent of what is promised under current law. Under the plan, workers would be allowed to divert 2 percent of their earnings into private accounts, with low-income workers receiving federal matching funds to bolster their contributions. At retirement, a portion of the accounts would be used to offset Social Security benefits.

The bipartisan plan has no explicit guarantee of monthly pension benefits, other than a minimum guaranteed income. For this reason, the plan can afford to allow PRA holders more investment choices than the other plans. If workers invest their PRA funds in U.S. government bonds, they will be assured of getting a private annuity payment equal to what the current system would have paid. If they make riskier investments (i.e., stocks and corporate bonds), they could receive a higher or lower monthly pension.

Because the bipartisan plan substantially reduces promised benefits, the fraction of benefits funded by PRAs is greater than under Gramm-Domenici or Archer-Shaw. We estimate that:

  • By 2030 private annuities would pay 28 percent of promised benefits, rising to 70 percent by 2050.
  • The savings to the government are comparable to the other two plans: government-funded benefits would equal only 8.2 percent of taxable payroll by 2075.

Like the Gramm-Domenici and Archer-Shaw plans, a plan developed by the National Center for Policy Analysis (NCPA) and the Private Enterprise Research Center (PERC) at Texas A&M proposes to reform Social Security without raising taxes or lowering benefits. However, under this plan, younger workers would contribute at a higher rate, and older workers at a lower rate. This would insure that the current generation entering the labor market, and every succeeding generation, is able to completely fund its promised benefits from its PRA accounts. Benefits would be guaranteed to equal currently projected Social Security benefits plus a bonus of 10 percent of PRA accumulations.

In the early years of the transition, the proportion of retirement benefits funded from PRAs would be lower than under the other plans. However, the higher contribution rate of younger workers would add to the nation's stock of capital more quickly, allowing a shorter transition to a system funded by individually owned PRAs rather than payroll taxes. Specifically:

  • By 2030 only 26 percent of new retiree benefits would be funded by private annuities.
  • By 2050 new retirees would rely on their PRAs for 100 percent of their benefits.
  • By 2070 the payroll tax funding Social Security retirement benefits could be completely eliminated.

While transition to a funded system would be costly, the current era of budget surpluses presents a unique opportunity to do so without raising taxes or cutting benefits. Among the benefits of reform are providing a more secure retirement for all workers, allowing workers to own their own retirement savings, giving workers the right to bequeath the buildup to their heirs, increasing national savings and ultimately increasing in national income. The cost of not making necessary reforms now is the growing certainty that taxes will be raised and benefits will be cut in the future.

So let me say to you tonight, I reach out my hand to all of you in both houses, in both parties, and ask that we join together in saying to the American people: We will save Social Security now.

President William Jefferson Clinton
State of The Union Address, January 19, 1999

We can't wait until next year to start saving Social Security.

Senator Phil Gramm, April 28, 1998

....the time for action is now upon us. If Congress is to reach agreement in 1999 on needed changes to the Social Security system, we must begin consideration immediately of legislative options to address the long-run solvency of this vitally important program.

Bipartisan Social Security Coalition. Founding members include Senators Daniel Patrick Moynihan, Judd Gregg, J. Robert Kerrey, John B. Breaux, Dan Coats, Charles S. Robb, Craig Thomas and Fred Thompson, September 24, 1998


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