Social Security Reform without Illusion: The Five Percent Solution

Studies | Social Security

No. 272
Friday, December 17, 2004
by Andrew J. Rettenmaier & Thomas R. Saving

Executive Summary

America’s entitlement programs for senior citizens are on an unsustainable course. Unless changes are made soon, we face the prospect of exorbitant tax rates or severe benefit cuts. Fortunately, there is a solution. Retirement benefits can be secured without raising payroll taxes by giving people the opportunity and incentive to save for their own retirement.

The Need for Reform. Although the federal payroll tax currently pays for almost all Social Security and Medicare benefits, the shortfall will grow rapidly during the baby boomer retirement years. Eventually, retirement benefits paid to the elderly will consume the entire federal budget, crowding out every other spending program. For example:

  • This year, for the first time in more than 20 years, the combined deficit in Social Security and Medicare will require a net transfer from the Treasury equal to almost 4 percent of federal income tax revenues.
  • That figure will double in the next five years and double again in the five years after that.
  • Ten years from now we will need one-in-seven income tax dollars, in addition to the payroll tax, to pay retirement benefits.
  • By 2020, elderly entitlements will consume one-in-four income tax dollars and by 2030 they will consume one of every two.
  • By mid-century, when today’s college students retire, we will need three-fourths of all federal income taxes to pay their retirement benefits.

To avoid this unpleasant and unsustainable future, we must move quickly to a funded system, under which each generation pays its own way. The transition to a new system will not be easy. But each year we delay increases the cost of making it. What follows are the main features of our reform proposal.

Creating Personal Retirement Accounts. All workers who have not yet reached retirement age will be able to set aside part of their earnings in a personal retirement account (PRA). Specifically, PRA deposits will equal 10 percent of the first $7,650 in annual earnings, 3 percent of earnings between $7,650 and $55,000, and 1 percent of earnings above $55,000. Thus for a worker who earns $7,650 per year or less, the PRA deposit will equal 10 percent of wages. For an average-income worker, the PRA deposit will equal about 5 percent of wages. (The PRA contribution rates are specifically designed to replicate the progressivity of the current system.) Funds in these accounts will be invested in assets, and as the balances grow over time, they will replace the government’s promises to pay benefits. The youngest workers will completely pay their own way as the private accumulations provide a retirement income equal, on the average, to what the current system promises.

Funding the Accounts. Workers will be able to divert a portion of their payroll taxes into a PRA, with lower-income workers able to divert more than higher-income workers. In return, workers must make their own additional contribution of 1.25 percent of wages, to be matched by their employer. Roughly speaking, for each dollar an average-income worker invests in a PRA, three additional dollars will be invested by an employer and funds that otherwise would have been paid to the government. For each dollar invested by the lowest-income workers, seven dollars will be invested by an employer and diverted payroll tax dollars. The PRAs of the highest-income workers will be almost totally funded by the 1.25 percent contributions of employees and their employers, with little or no payroll tax diversion.

After eight years, the worker’s contribution (matched by the employer) will gradually rise to 1.75 percent and the percent of payroll taxes diverted will fall. At that point, for each dollar an average-income worker contributes to his PRA, about two dollars will be contributed by his employer or the government. For each dollar a low-income worker contributes, almost five dollars will be contributed by someone else. The contribution rates will remain at these levels until 2038 when the current payroll tax rates are no longer needed to sustain the program.

Easing the Transition. To make the transition easier, for the first five years of the program employees and their employers could divert monies currently sent to defined contribution retirement plans — such as 401(k)s — to meet their 1.25 percent PRA contribution requirement. Additionally, small businesses could also be allowed a year’s delay before matching their employees’ contributions.

Choosing to Participate. A worker’s participation in the reformed system will be voluntary. However, since there will be no increase in the Social Security payroll tax, those who choose to remain in the current system will have to accept lower benefits in future years as payroll tax revenues fail to keep pace with Social Security’s promises. By contrast, those who participate in the reformed system can expect benefits that will equal currently promised benefits, on the average.

Investing Prudently. Workers will not buy and sell individual stocks and bonds with their PRA funds. Instead, they will invest in approved, diversified funds that reflect the performance of the market as a whole, including stock index funds, bond funds and government securities funds. The management of these funds will be subject to strict accounting and financial standards. Funds will be approved by an independent governing board responsible for establishing safety and soundness criteria.

Administration. To avoid creating additional burdens for employers, all the administration and paperwork could be done internally at the Social Security Administration. Employers would send employee and employer contributions to the government, just as they do under current law. However, firms already administering defined contribution plans could make deposits directly to PRAs on behalf of their employees, just as they do now with their 401(k) plans.

Securing a Retirement Income. Over time, the Social Security benefits paid by the government to retired workers who participate in the PRA system will be gradually reduced by a predetermined formula. In general, increased PRA account balances will offset these reductions. During retirement, individuals will receive two monthly checks — one from the Social Security Administration (as under the current system) and one based on their private accumulation.

At the time they retire, individuals will use their accumulated PRA balances to purchase annuities. If the sum of their annuity check and Social Security check equals at least 150 percent of the poverty level, any surplus PRA funds may be used for other purposes — including certain tax-free health care expenses. As an alternative to purchasing an annuity, retirees may be given the opportunity to leave their account with a pension fund manager and withdraw an amount set each year by law, as is currently done in Chile.

Reducing Risk. This proposal has two explicit guarantees to PRA participants:
(1) Everyone at or near retirement will receive all promised Social Security benefits; and (2) Everyone else with at least 35 years of full-time work will have a retirement income equal to at least 150 percent of the poverty level. If any qualifying worker’s total benefit falls below 150 percent of the level of poverty, the federal government will supplement that worker’s benefit up to the 150 percent level.

Taxes During Retirement. Like deposits to Roth IRAs, individual deposits and payroll taxes diverted to PRAs will be made with after (income) tax dollars; thus withdrawals of these funds will be tax free. The portion resulting from employer contributions will be taxed as ordinary income at the time of withdrawal.

Accommodating Modern Family Life. To accommodate the changing nature of marriage and family life, all PRA contributions will be treated as community property. That is, PRA deposits will be divided fifty-fifty between a husband’s and wife’s accounts, regardless of who earns the wages.

Paying for Long-Term Care. Retired workers who have accumulated more than the amount required for the minimum annuity can use additional PRA balances to purchase long-term care insurance and to pay for long-term care directly during retirement. Tax-free withdrawals will be allowed for certain health care expenses, including long-term care expenses for debilitating end-of-life diseases such as Alzheimer’s disease, and for nursing home or stay-at-home care.

Paying for Reform. Unlike other reform proposals advanced in recent years, this proposal is fully funded. Deposits to PRA accounts are not funded by government borrowing. They are funded by expected Social Security payroll tax surpluses, the government’s promise to redeem the Social Security Trust Fund and new contributions to be made by employees and their employers.

Consequences of Reform. After about three decades, the reformed Social Security system will finance itself. At this point, workers’ Social Security payroll taxes and contributions will be more than sufficient to pay benefits and make contributions to PRA accounts. As a result, government can reduce the Social Security payroll tax, and over the next three decades, the combined contribution rate could be cut in half.

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