Comparing Proposals for Social Security Reform
Wednesday, September 01, 1999
by Liqun Liu and Andrew J. Rettenmaier
Table of Contents
The Bipartisan Proposal
"The bipartisan proposal does lower scheduled benefits and raise taxes."
33Unlike the other proposals analyzed here, the bipartisan proposal includes measures that lower scheduled benefits and raise taxes. Workers would be allowed to divert 2 percent of their earnings into private accounts, and at retirement a portion of the accounts would be used to offset Social Security benefits. Other provisions would allow lower-income workers to receive federal matching funds to bolster their contributions.
Reducing Benefits. The three reforms that have the largest effects on promised benefits are: (1) indexing the retirement age, (2) a change in the method of calculating preretirement earnings and (3) a change in the method of indexing benefits for inflation.
Since Social Security's inception in 1935, life expectancy at birth and at all ages has risen significantly. Life expectancy for a person who has survived to age 65 has risen almost four years for men and six years for women over the last 60 years. Since the trend is expected to continue, the retirement period relative to the years in the labor force will rise. Under the bipartisan proposal, the normal retirement age (the age at which a beneficiary can receive full benefits) will increase to 67 by 2011, the year in which the oldest baby boomers reach 65 years of age. Under current law, the normal retirement age is not scheduled to rise to 67 until 2037. By speeding up the increase, the proposal effectively lowers the total benefits that will be paid out relative to those that are scheduled. But the proposal does not stop there. The life expectancy index will be used to continuously scale up the retirement age if longevity increases.
How that index would be calculated is not clear in the proposal. In our simulation, we adopt an indexation method that holds steady the ratio of retirement years to working years as life expectancy increases, based on life expectancy data from the Census Bureau. [For a discussion of indexation methods, see Appendix C.]
"The four proposed reforms in the bipartisan proposal will eliminate the unfunded Social Security liability."
Currently an individual's Average Indexed Monthly Earnings (AIME), which determines the size of a worker's initial monthly benefit, is based on the highest 35 earnings years. The bipartisan proposal would average over the highest 40 earnings years instead. This will have the effect of lowering the calculation of preretirement income and thus lowering benefit payments.34
The third change is "an adjustment of 0.5 percent in the Cost-of-Living Adjustment (COLA) to maintain more accurate cost-of-living indexes." We interpret this to mean that rather than the Social Security Trustees' ultimate assumption of a 3.5 percent annual increase in prices, the COLA would rise by 3 percent annually. Individuals who are 62 and older in 1999 would be unaffected by this change.
Raising Taxes. The bipartisan proposal maintains the taxable wage base at 86 percent of total wages. The effects of this change are subtle and their magnitudes are contingent on future changes in the distribution of wages. Under current law the maximum taxable wage, currently $72,600, is scheduled to rise at the same rate as average wages. If the earnings distribution does not change over time, the earnings under the taxable maximum would represent a constant proportion of total earnings. However, if the distribution is widening, as it has been over the last several decades, then increasing the taxable maximum at the same rate as the growth in average wages will result in a declining ratio of taxable earnings to total earnings. The bipartisan proposal increases the maximum taxable wage at a faster rate and this produces greater future tax revenues at the existing tax rate. Individuals with high earnings throughout their work years would, at retirement, have higher AIMEs, but because of the redistributive nature of the benefit formula, their benefits would grow less than the increase in taxes they would pay into the system. The result is that the system's revenues would rise by more than its expenditures in the long run.
The Impact of Tax and Benefit Changes. These tax and benefit changes get quite close to achieving actuarial balance, even without contributions to PRAs. As Table II shows, the four proposed reforms will eliminate the nation's unfunded $4.5 trillion Social Security liability in the following way:
- Maintaining the taxable wage base at 86 percent of total wages - broadening the tax base but not increasing the tax rate - will reduce the unfunded liability by one-third, to just under $3 trillion;35
- Indexing the retirement age in addition will reduce the liability by another third, to $1.25 trillion;
- Using the 40 highest earnings years instead of the 35 highest will further reduce the liability to $693 billion;
- Reducing the COLA on top of the above changes will create a $347 billion surplus.
The cumulative effect of the bipartisan proposal's reforms is to raise the present value of the system's revenues by 8.9 percent and lower the present value of aggregate benefits by 19.8 percent relative to the current system. As Figure VII shows, about one-third of the change is produced by tax increases and two-thirds by benefit cuts.36
"The bipartisan proposal has several provisions that encourage savings."
Individual Retirement Accounts. The bipartisan proposal has several provisions that encourage savings. Workers can divert 2 percent of their taxable earnings into individual accounts. The individual accounts would be privately managed. The way in which the accumulated savings offset an individual's expected Social Security benefits differs from both the Gramm proposal and the Archer-Shaw proposal. Here Social Security benefits are offset in an amount equal to the annuitized value of the contributions had they grown over the retiree's work life at the rate of return on government Treasury bills. Social Security is responsible for the remainder of the benefits. If the actual PRA return is higher than the Treasury bill rate, the individual gets to pocket the difference. Alternatively, if the actual return is less than the Treasury bill rate, the individual receives less than currently scheduled Social Security benefits. For example:
- If a worker 45 years old today earns $30,000 per year between now and retirement at age 67, the accumulated value of his or her 2 percent annual contributions would be $17,912 if the Treasury bill rate is 2.8 percent; this amount would be annuitized and the annuity would offset the expected annual Social Security payments dollar for dollar.
- However, the accumulated value of the contributions would be worth $23,941 if the savings were invested in a balanced portfolio and earned the market rate of 5.3 percent.
- The worker would then have $6,029 saved for retirement in addition to the Social Security benefits.
"The annuity from the private account would pay 70 percent of the average retiree's benefits by 2050."
Other Savings Incentives. The bipartisan proposal also includes incentives that encourage lower-income workers to save more. Workers whose 2 percent contribution is less than 1 percent of the taxable maximum in any year would receive $100 from the federal government when they make additional contributions to their individual account. The government further matches the lower income worker's contributions up to an amount equal to 1 percent of the taxable maximum. In our analysis, we do not attempt to estimate the degree to which lower-income individuals would pursue this option, and for the simulation results we limit the contribution to 2 percent for all workers.
"The payroll tax rate could be reduced to 8.2 percent by 2075."
Simulation Results. Under the Bipartisan proposal the tax revenues and expenditures change dramatically compared to current law. [See Appendix B, Table IV.] Bearing in mind that benefits are reduced under the Bipartisan plan, the effects of PRA investments are substantial [see Appendix B, Table V]:
- The annuity from the private account would replace 13 percent of Social Security benefits for the average new retiree in 2020, rising to 70 percent of benefits by 2050. [See Figure VIII.]
- The payroll tax rate could be reduced to 8.2 percent by 2075, compared to the 19 percent the current system requires.37 [See Figure IX.]