Comparing Proposals for Social Security Reform

Policy Reports | Social Security

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

Types of Reform

Figure I - Social Security Reform Plans

There are two fundamental approaches to reforming Social Security. One maintains the current system of pay-as-you-go finance and solves the system's unfunded liability by cutting benefits and/or raising taxes. The other replaces pay-as-you-go financing with a system in which each generation saves and invests in order to pay for its own retirement benefits.

"Most reform plans provide for the creation of personal retirement accounts."

Given the problems inherent in cutting benefits or raising taxes, most reform proposals provide for the creation of personal retirement accounts, with proceeds from the accounts used to reduce the government's obligation to pay benefits. Most reform plans that create personal retirement accounts propose to fund those accounts by using the budget surplus, but the mechanism differs from plan to plan, as Figure I shows.

Carve-Out Option. Under a "carve-out," some portion of a worker's Social Security payroll tax is redirected into a personal retirement account. Funds in these accounts are invested in stocks and bonds, and the accounts are owned by the individual worker.

For example, under the proposal of Sens. Phil Gramm (R-Texas) and Pete Domenici (R-N.M.),11 workers who choose the private sector option redirect 2.5 percentage points12 from their payroll taxes into their personal retirement account, with the remaining 9.9 percentage points continuing to go to the Social Security Trust Fund.

Examples of 2 percent carve-out plans include a bipartisan proposal by Sens. Judd Gregg (R-N.H.), John Breaux (D-La.), Bob Kerrey (D-Neb.) and others and a House version by Reps. Jim Kolbe (R-Ariz.) and Charlie Stenholm (D-Texas). In addition, Sen. Rick Santorum (R-Pa.) has proposed a carve-out option that varies the allowed deposit by income level - ranging from 4 percent for low-income workers to 3 percent for high-income workers. A proposal by Sen. Pat Moynihan (D-N.Y.) contains a 2 percent carve-out as a way of reducing the Social Security surplus, but it does not require that the money be saved and invested.

Add-On Option. As an alternative to carve-outs, "add-on" proposals fund private retirement accounts in some way other than by diverting the payroll tax. During his State of the Union address, President Clinton proposed Universal Savings Accounts (USA accounts). Under this proposal, workers automatically receive a tax credit of up to $600 per couple per year, deposited in their USA account. The couple can save up to $700 per year more in the account, and the government will match their savings dollar-for-dollar. With the automatic tax credit of $600 plus the matched tax credit of $700, the family will add $2,000, including the $1,300 tax credit, to their retirement savings each year. At retirement, seniors can draw on their USA accounts in addition to drawing Social Security. Thus the president's add-on proposal has no impact on the financial obligations of the existing Social Security system.

An add-on plan that does reduce Social Security's long-term liability has been proposed by Reps. Bill Archer (R-Texas) and Clay Shaw (R-Fla.). Their plan creates private retirement accounts financed by a 2 percent refundable income tax credit. At retirement each worker's monthly benefit would be paid from two sources: the funds that accumulate in a private retirement account and traditional Social Security.

Despite the apparent difference between the funding source of add-on plans and carve-out plans, the practical difference is small. In all cases, deposits to private accounts would be funded from projected budget surpluses.

The Claw-Back Option. All reform proposals that seek to replace the current pay-as-you-go system with a system funded by personal retirement accounts have a mechanism for reducing the government's obligation to pay benefits. One such mechanism is known as a "claw-back."

"Under a 'claw-back' approach, the benefit paid by Social Security is reduced by the amount funded from the private account."

Under this approach, each individual's monthly retirement benefit paid by Social Security is reduced by the amount funded from that individual's private account. For example, if the private retirement account is able to fund 60 percent of a retiree's monthly benefit, the government pays the other 40 percent. As private accounts accumulate, Social Security's financial obligation declines.

Some claw-back proposals permit workers who participate in the private system to receive a "bonus" at retirement over and above what they would have gotten under the current Social Security system. This bonus is a percent of their private retirement account that does not trigger a dollar-for-dollar claw-back of government-paid benefits.

A criticism of claw-back plans is that workers gain little from their private investments, since each dollar they save reduces the monthly pension they receive from the government. The same criticism, however, applies to one degree or another to all plans that replace pay-as-you-go Social Security with a funded system. The primary purpose of these proposals is first to achieve retirement security and then, if possible, to increase retirement benefits. Retiree benefits become more secure because they are funded with real assets rather than depending on the willingness of future taxpayers to pay high taxes.

An advantage of claw-back proposals is that they come with a government guarantee that every retiree will receive at least the same benefits as those promised under the current Social Security system. As a result, individuals making private investments face few of the risks that critics of change warn about. Because of the full integration of benefits and investments, no one can be worse off than under the current system - regardless of what happens in financial markets.

This guarantee means that claw-back proposals must narrow the range of individuals' investment options. Since everyone knows that he or she will get the promised benefits, many will be tempted to make risky investments. For this reason, claw-back proposals limit investment choices to conservative, diversified portfolios.

"The 'drop-back' option offers more investment choices, but individuals risk getting lower benefits."

The Drop-Back Option. As in the case of the claw-back, "drop-back" plans reduce the government's financial obligation as private account balances grow. But with the drop-back plan, a person can benefit from the internal growth of the private account by taking a little more risk. An advantage of the drop-back option is that individuals have more investment options, and they benefit from wise choices. A disadvantage is that individuals can do worse than they would have done under the current system if their investments perform poorly.

For example, under the bipartisan plan, at retirement government-paid benefits are reduced by the amount that could have been funded from private funds had they been invested in Treasury bonds. A stock or corporate bond fund is likely to earn a higher return than government bonds, thus workers who choose investments that outperform the Treasury bill rate will in effect receive a bonus. But they risk being penalized if their funds earn less than Treasury bills.

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