Social Security Reform without Illusion: The Five Percent Solution

Policy Reports | Social Security

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


  1. The other dedicated revenues are taxes collected on Social Security benefits.
  2. These thresholds will be adjusted with the growth in the average wage index.
  3. A worker at the taxable maximum of $87,900 contributes $2,514.50. This contribution results in a realized maximum contribution rate of 2.86 percent. Of this amount, 2.50 percent is contributed by the worker and his or her employer, and the remaining 0.36 percent comes from payroll tax deductions. However, by the eighth year, when the combined employer and employee contribution rises to 3.5 percent of earnings, higher income workers will have higher taxes of, at most, 0.64 percent of earnings for those at the taxable maximum.
  4. The 2001 Commission to Strengthen Social Security outlined several key characteristics of administering PRAs. The Commission suggested a two-tier structure in which deposits are initially collected and invested centrally. In this first tier, investment options would include balanced indexed funds and inflation protected bond funds. After a worker’s PRA reaches a stipulated threshold, more investment options would be allowed, provided the investments met safety and soundness rules established by a governing board. The Commission also suggested that asset allocations could only be changed once a year, that preretirement access to PRAs not be allowed, and that the governing board be independent from political pressure. See Chapter 2 of “Strengthening Social Security and Creating Personal Wealth for All Americans,” Report of the President’s Commission, December 2001.
  5. Report of the 1994-1996 Advisory Council on Social Security, 1997, Volume I, p. 171.
  6. “Strengthening Social Security and Creating Personal Wealth for All Americans,” Report of the President’s Commission, December 2001, p. 97.
  7. See Estelle James, “Private Pension Annuities in Chile,” National Center for Policy Analysis, Policy Report No. 271, December 2004.
  8. Benefit
    The defined benefit from Social Security for workers 51 to 64 years of age in 2004 will be based on the formula: 
  9. Benefit
    Defined benefits from Social Security for workers 20 to 50 years of age in 2004 will be based on this formula:
  10. The reform defined benefit formula is guaranteed in that, unlike current Social Security, the right to the benefit would be assigned to each individual. The formula also identifies the rate at which benefits, as scheduled under the current benefit formula, will be phased out. This particular way of reducing the defined benefit portion of the program allows the future behavior of those older than 20 years of age to affect their ultimate benefit, just as it does in the current system. Alternatively, the defined benefit portion of the benefit could be based on accrued benefits, such that benefits are earned solely on past participation in the program. A standard way of calculating current earned benefits is to calculate the disability benefit that a worker would receive based on past earnings and participation; see Stephen C. Gross, “Measuring the Solvency in the Social Security System,” in Prospects for Social Security Reform, Olivia S. Mitchell, Robert J. Meyers, and Howard Young, eds. (Philadelphia: University of Pennsylvania Press, 1999). This benefit is then multiplied by a proportioning factor equal to (age – 22)/40 and the result determines accrued benefits. This accrued benefit can form the basis for issuing recognition bonds to be given to individuals to “recognize” their past participation in the program. These bonds mature when the individual reaches full retirement and have a face value equal to the amount that would generate an annuity equal to accrued benefits. For purposes of our estimates, we use the scaled benefit formula to value the future annual costs of the reformed defined benefit portion of Social Security.
  11. The simulations used in this report are limited to the Old-Age and Survivors Insurance (OASI) programs. PRA accumulations are expected to earn a 5.4 percent rate of return. The Commission to Strengthen Social Security assumed a 6.5 percent long-run rate of return on stocks and 3.5 percent on corporate bonds. Thus, a constant 70 percent stock/30 percent bond portfolio with administrative costs of 0.2 percent would produce a 5.4 percent rate of return.
  12. New retirees who have worked full-time for 35 years can be identified in several ways. The Social Security Administration records a worker’s earnings and quarters of work credits. A worker is granted credit for a quarter of work if his or her earnings in Social Security covered employment exceed a set threshold. This year the threshold is $900. Thus, a worker earns a quarter of coverage for each $900 in earnings in 2004, for up to 4 quarters of coverage. At the current minimum wage of $5.15, a credit for a quarter of work would be granted for working about 175 hours and a full year of credits would result from 700 hours of work in a given year. Alternatively, adopting the normal definition of full-time / full-year work, equal to 35 hours per week for 50 weeks, will result in a threshold of 1,750 annual hours. Thus, an alternative monetary threshold can be calculated for each year by multiplying the minimum wage by 1,750 hours. This new monetary threshold would then be compared to a retiree’s work history to determine quarters of coverage and whether he or she qualifies for the guarantee. Based on data from the New Beneficiary Survey, 27 percent to 29 percent of new retirees in 1980 and 1981 would have had enough quarters of coverage under the full-time / full-year definition to qualify for the guarantee. If the reform is successful in matching a retiree’s Primary Insurance Amount, on average 2 to 3 percent of new retirees would exercise the guarantee.
  13. We suggest a minimum benefit be provided for all those who participate through a normal work-life, defined as 35 years of full-time work. Considering that there are 47 years between 20 years of age and the normal retirement age (soon to be 67), requiring that participants work less than 75 percent of their available years does not seem onerous. Those unable to work will rely on other sources of welfare, like Supplement Security Income, the same sources that take care of them during their normal work years.Scaled back guarantees can be provided for participants with fewer years of active work. However, like the current Social Security program, the new program is not designed to replace contemporaneous transfers to low-income participants.
  14. For ease of comparison, we have presented the costs of the reform as a percent of taxable payroll. However, as has been suggested by Kotlikoff in “Fixing Social Security and Medicare for Good,” presented at Improving Social Insurance Programs, University of Maryland, September 2003, a broader based tax, such as a consumption tax, produces smaller economic losses than does a payroll tax. It also distributes the burden of the tax across generations rather than only on workers.
  15. Jagadeesh Gokhale and Laurence J. Kotlikoff, “Tax-Favored Savings Accounts: Who Gains? Who Loses?” National Center for Policy Analysis, Policy Report No. 249, January 2002.
  16. Ibid.
  17. Earnings sharing is not a perfect solution — retired widows who never worked or paid taxes would receive lower benefits. However, that problem will diminish with time; today, few women remain completely outside the labor market and the rate is likely to decline further in the future.
  18. The costs of such accounts are similar in magnitude to the long-run costs of prepayment as calculated by the Trustees of the Social Security system. Therefore, PRAs are no more costly than assuring solvency through the Trust Fund mechanism.

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