Social Security Reform without Illusion: The Five Percent Solution
Friday, December 17, 2004
by Andrew J. Rettenmaier & Thomas R. Saving
Table of Contents
The Five Percent Solution
“In return, workers are able to deposit payroll taxes that otherwise would have been paid to the government.”
Given the current federal budget environment, we sought to develop a Social Security reform plan that incorporates a personal investment component without requiring more government revenue than is already promised to Social Security through payroll taxes and the bonds in the Trust Fund. Our plan creates personal retirement accounts funded partly from existing payroll taxes and partly from a small additional investment by participating workers and their employers. [See the sidebar, “Proposal Outline.”]
Personal Retirement Accounts (PRAs). Workers who have not yet reached the retirement age will 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 $55,000.2 Thus for a worker who earns $7,650 per year or less, the PRA deposit will equal 10 percent of wages. For a worker who earns $27,000, the PRA deposit will equal about 5 percent of wages.
“For each dollar an averageincome worker invests, three dollars is invested by someone else.”
Contributions . In order to fund their PRA accounts, all workers will be able to divert a portion of their payroll taxes. Also, workers must initially make their own additional contribution of 1.25 percent of wages, to be matched by their employer. In general, lower-income workers will be able to invest more of their payroll taxes than higher-income workers. [See Table I.]
Roughly speaking, for each dollar an average-income worker invests in their 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 by diverted payroll tax dollars. The PRAs of the highest-income workers will be almost totally funded by the employee and employer 1.25 percent contributions, with little or no payroll tax diversion.
“Employer and employee contributions to personal accounts would rise to 1.75 percent of wages after eight years.”
The worker’s contribution (matched by the employer) will gradually rise to 1.75 percent after eight years and payroll tax diversions will fall. [See Table II.] At this point, employer and government contributions fall to about two dollars for every dollar the average-income worker invests, and about five dollars for every dollar the low-income worker invests. The contribution rates will remain at these levels until 2038 when the current payroll tax rate is no longer needed to sustain the system.
A few examples for the first year of the program illustrate how the contribution rates would work:
- Example 1: A Low-Wage Worker. A worker who earns $7,000 per year contributes $700 = (10 percent x $7,000). The realized contribution rate for this worker is 10 percent. Of that amount, the worker contributes $87.50 (1.25 percent x $7,000) and the employer contributes another $87.50 for a total of $175. The rest, $525 (7.5 percent) is deposited by the government from diverted payroll taxes.
- Example 2: A Medium-Wage Worker. A worker who earns $35,000 per year has earnings between the first and second thresholds and contributes $1,585.50 (10 percent x $7,650 + 3 percent x ($35,000 – $7,650). The realized contribution rate for this worker is 4.53 percent. The worker and employer each contribute 1.25 percent and the government contributes 2.03 percent.
- Example 3: A Higher-Wage Worker. The individual who earns $60,000, above the second threshold of $55,000, contributes $2,235.50 (10 percent x $7,650 + 3 percent x ($55,000 – $7,650) + 1 percent x ($60,000 – $55,000)). This contribution results in a realized contribution rate of 3.73 percent. The worker and employer each contribute 1.25 percent and the government contributes 1.23 percent.
In future years the two income thresholds will rise by the growth in the Social Security Wage index. With this contribution rate structure, the average contribution is 5.14 percent.3
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 be allowed a year’s delay before matching their employee’s contributions.
Funding the Personal Accounts. There are three current dedicated revenue sources for Social Security: payroll taxes, taxes on benefits and the Trust Fund. While the Trust Fund does not provide additional revenues to the Treasury, it does represent a commitment by the Treasury to provide resources to Social Security. In our reform, we require the Treasury to honor its commitment and aid in the transition to a retirement system with individually-owned retirement accounts. This year, Old Age and Survivors Insurance (OASI) revenues will exceed spending by an amount equal to 1.56 percent of payroll. The surpluses are expected to grow to 2.01 percent by 2008 and will continue until 2017. Thus, for the next 4 to 5 years, the government can contribute to PRAs without significant draws on the Trust Fund.
“Total deposits to low income workers’ accounts will equal about 10 percent of wages.”
Investments. Workers will not be able to buy and sell individual stocks and bonds with their PRA funds. Instead, they will be able to invest in approved diversified funds that reflect the economy as a whole. They also will have investment options, including stock index funds, bond funds and government securities funds. The management of these funds will be subject to strict accounting and financial standards.
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. The employees would make their investment selections with the government — not with employers, who bear no additional administrative burden. However, firms already administering defined contribution plans would be allowed to make deposits directly to PRAs on behalf of their employees, just as they do now with their 401(k) plans.
“Administrative costs can be minimized.”
It is reasonable to expect firms managing personal retirement account assets to receive compensation for their services; after all, there will be some 148 million accounts to manage. By limiting options and structuring the accounts carefully, administrative fees could be reduced.4
- The 1994-1996 Advisory Council on Social Security assumed administrative costs of 0.105 percentage points for the Individual Accounts option.5
- The President’s Commission to Strengthen Social Security assumed administrative costs of 0.3 percent.6
Retirement Benefits. 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, these reductions will be offset by increases in PRA account balances. 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.
Annuitization. At the time of retirement, individuals will use their PRA funds to purchase annuities. If the sum of the annuity check and the 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.
For the purpose of the simulations reported here, we assumed that all workers annuitize 100 percent of their retirement-age PRA accumulation. The unisex life table for each birth cohort was used to calculate the annuity amounts. This implies that no benefits are awarded to the annuitant’s survivors once the annuity has been purchased, but because each spouse has an account, the surviving spouse continues to receive annuity payments. However, annuitants could also choose an array of options including those with survivor’s benefits. (In Chile, joint annuities are required.)
“Workers will purchase annuities with their account funds at retirement.”
Periodic Withdrawals. The Chilean system of privately-owned individual accounts illustrates a successful way to handle personal retirement account payouts. Retirees in Chile can choose to purchase an annuity or make programmed withdrawals from their personal account. Workers choosing annuities receive an inflation-protected guaranteed income for life, but forgo the right to leave a bequest to heirs. Workers choosing programmed withdrawals leave the account with a pension fund manager and withdraw an amount each year set by law. Retirees can leave a bequest to their heirs, but run the risk of exhausting the account before they die. Regardless of the option chosen, the government provides a minimum benefit guarantee to all workers who have contributed to the system for at least 20 years.7
Government-Funded Benefits During the Transition. Workers close to retirement (those between 51 and 64 years of age, inclusive) will have their scheduled taxpayer-funded Social Security benefits reduced by 1 percentage point for each year between their current age and the age of 64.8 For example, 60-year-old workers will receive 96 percent of currently scheduled benefits from Social Security plus the annuities from their PRAs. Funds invested in the PRA earning a real 3 percent rate of return (the rate of return that is assumed to be earned on the Social Security Trust Fund bonds) will produce an annuity equal to 5 percent of scheduled benefits. Thus, the total benefit would equal 101 percent of scheduled benefits. Similarly, 55-year-old workers will receive 91 percent of currently scheduled benefits from Social Security, plus annuities equal to 9 percent of scheduled benefits, with their PRAs again earning a real return of 3 percent — a total of 103 percent of their anticipated benefits.
For workers 20 to 50 years of age, benefits will continue to accrue according to the current law schedule; but at the time of retirement, these workers will receive a preset proportion of these scheduled benefits.9 For example, upon reaching full retirement age, workers 50 years old at the time of reform will receive 85.7 percent of the benefit they would have received under the current Social Security system. Workers 30 years of age will receive 28.6 percent of the benefit they would have received under the current system. New workers, 20-year-olds in 2004, will be entirely in the new personal account system.
The combination of an individual’s personal account annuity and their entitlement to a share of scheduled benefits will, on the average, equal total currently scheduled benefits.10 With these contribution rates and a 5.4 percent rate of return on PRA accumulations and a 3 percent annuity return, workers will fully replace their scheduled benefits.11
Minimum Retirement Income. Any participant with at least 35 years of full-time participation in Social Security (cumulatively, both before and after the reform) will be guaranteed a retirement income of 150 percent of the poverty level for persons 65 years of age and over, adjusted for inflation.12 If a participant’s personal account annuity plus his or her share of scheduled benefits falls short of this amount, the government will supplement the individual’s monthly income to reach the 150 percent level. Married couples who have full work histories will be guaranteed 150 percent of the poverty level for two-person households above the age of 65.13
“Annuities from personal accounts will eventually replace Social Security benefits.”
Another approach to minimum benefits can be found in the reformed Swedish pension program, which includes a private account, a notional account and the guaranteed benefit amount. The private account represents the portion of the program that is prepaid in that a small share of payroll taxes are invested in the market and accumulate for retirement. The notional account generates a formula based benefit, but the payroll taxes are used to fund current retiree benefits. The base guaranteed pension is funded by tax revenues and is awarded regardless of one’s work history. The guarantee amount is means tested, based on the size of the flows from the notional and private accounts. Minimum benefit payments in a system like the Swedish program would be paid through contemporaneous general taxes rather than through payroll taxes. They would replace Supplemental Security Income (SSI) and could be paid to all elderly. In such a two-part system, PRA annuities would be intertwined with these minimum benefits. Since PRAs are not funding the totality of one’s retirement pension, the required PRA contribution rate would be smaller. The sidebar further addresses the topic of guaranteeing currently scheduled benefits. [See the “Guarantees” sidebar.]