Will the President’s Proposal Solve Social Security’s Crisis?

Studies | Social Security

No. 280
Wednesday, November 16, 2005
by Andrew J. Rettenmaier and Thomas R. Saving


Notes

  1. See Sita Nataraj and John B. Shoven, “Has the Unified Budget Undermined the Federal Government Trust Funds?” National Bureau of Economic Research, Working Paper No. 10953, December 2004, and Kent Smetters, “Is the Social Security Trust Fund Worth Anything?” unpublished monograph, June 2003.
  2. See Peter A. Diamond and Peter R. Orszag, “Reforming Social Security: A Balanced Plan,” Brookings Institution, Policy Brief No. 126, December 2003. Social Security’s Chief Actuary, Stephen C. Goss, scored the proposal and the evaluation can be found online here.
  3. Andrew J. Rettenmaier and Thomas R. Saving, “Social Security Reform without Illusion: The Five Percent Solution,” National Center for Policy Analysis, Policy Report No. 272, December 2004.
  4. Solvency memorandum from Stephen C. Goss, Chief Actuary of Social Security, to Bob Pozen, February 10, 2005.
  5. Following the outline of the President’s proposal, contributions are initially capped at $1,000 per year, but the cap rises in each year with the growth in Social Security average earnings plus $100, which also grows with average earnings. Eventually all workers, even those earning the taxable maximum, will be able to invest 4 percent of their earnings in a personal account. The calculations for the PRA component of the reform follow the portfolio assumptions used by the Social Security Actuaries to evaluate the Pozen proposal. Specifically, the accounts are assumed to be invested in 60 percent stocks, 24 percent corporate bonds and 16 percent government bonds while workers are between 21 and 57 years of age. The returns assumed are 6.5, 3.5, and 3.0 percent, respectively. The share of stocks begins to decline at age 57, reaching 20 percent by age 62. At retirement, the accounts are annuitized using the unisex conditional life expectancy and the government bond rate of return. Given that under the president’s proposal the accounts are assumed to be funded by additional borrowing rather than mandatory contributions, a parallel account or notional account and annuity are also calculated. This notional account is assumed to earn a rate of return equal to the government borrowing rate. At retirement, worker’s reformed benefits are further offset by the annuity value of the notional account. In this way the funding of the accounts does not affect the federal government’s balance sheet.
  6. See Andrew J. Rettenmaier and Zijun Wang, “Social Security Reform: Responding to the Critics,” National Center for Policy Analysis, Policy Report No. 279, September 2005, for an analysis of the frequency with which the accumulations in the personal accounts may fall short of the benefit offset account accumulations. In exchange for the benefit reduction through the reformed benefit formula, the enabling legislation could set the benefit offset to the minimum of the accumulation in personal retirement account and the notional account.
  7. rwiThe real wage index begins in 2012, when the workers born in 1950 reach the age of 62. The real wage index rwi in year t is equal to:

    aimewhere w tis the Social Security average wage in year t, w 2012 is the Social Security average wage in 2012, cpi t is the consumer price index in year t, and cpi 2012 is the consumer price index in 2012. Lifetime earners whose average indexed monthly earnings are below the first bend point receive scheduled benefits while those whose earnings fall between the first bend point and the average indexed monthly earnings for maximum earners receive partial price indexed benefits as follows:
  8. Note that the reform could have alternatively been depicted with the top portion of each bar showing the net annuity (the annuity – the benefit offset) and the bottom portion showing the progressively price indexed benefit.
  9. bendProgressive price indexing as suggested by Bob Pozen begins with the calculation of a new bend point in the benefit formula at which indexation begins. Following the description in the solvency memorandum from Stephen C. Goss, chief actuary of Social Security, to Bob Pozen, February 10, 2005, we interpret the new bend point in year t to be equal to:

    aimeLifetime earners whose average indexed monthly earnings are below the new bend point receive scheduled benefits while those whose earnings fall between the new bend point and the average indexed monthly earnings for maximum earners receive partial price indexed benefits as follows:

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