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

A Simple Progressive Benefit Formula

Table II - Composition of Total Benefits with Progressive Indexing and 4 Percent Personal Retirement Accounts as a Percentage of Scheduled Benefits

In what follows, we combine the progressively price indexed benefits described above with personal retirement accounts funded by 4 percent payroll contributions. 5

Under the proposal by the Bush Administration, workers who elect to open a PRA must agree to have their reformed taxpayer-provided Social Security benefit reduced by a certain amount — called the benefit offset — to reflect the tax money diverted from traditional Social Security into the personal accounts. This is done by calculating the accumulated value of the worker’s personal account contributions using a specified rate of return for each preretirement year. The government borrowing rate of return is used to calculate this accumulation, which is generally called a shadow, hypothetical or notional account. The benefit offset is equal to the computed amount of a life annuity purchased with this hypothetical accumulation.

Basically, if a worker’s account earns a rate higher than the offset rate, he will earn a higher total benefit (reformed promised benefit plus personal retirement account annuity minus the benefit offset) than if he did not have the account. By contrast, if the worker’s rate of return falls below the offset rate, the worker would have been better off without the personal account.6

A New Progressive Price Indexing Formula. We have devised an adjustment to the current benefit formula that produces a simple form of progressive price indexation, and estimated the effects of this reform combined with a PRA funded by 4 percent of wages. The reformed benefits plus the net annuity value from the retiree’s PRA will produce total benefits which are ultimately on average greater than or equal to scheduled benefits for all income groups.

Figure II - Total Benefits as a Percentage of Scheduled Benefits for Workers Born in 1980

With our adjustment, retirees whose average indexed monthly earnings are less than the first bend point in the benefit formula will receive benefits from traditional Social Security equal to 100 percent of the benefits they are currently scheduled to receive. At the other end of the earnings distribution, maximum earners receive benefits from Social Security indexed for prices rather than wages. The price indexation is accomplished by calculating benefits according to the current schedule and deflating these benefits by a real wage index. Workers born in 1950 and later participate in the reform, while those born in 1949 and earlier remain in the current program and receive currently scheduled benefits.7 With this adjustment, retirees who earn the taxable maximum receive no real wage indexation, while those whose earnings are closer to the first bend point receive benefits similar to those that they are currently scheduled to receive.

Total Benefits by Age and Income. Table II summarizes the effect of progressive price indexing and personal retirement accounts on total benefits for workers who are born in 1960, 1980 and 2000 (individuals who are 45, 25 and 5, respectively, in 2005). The table presents the composition of total retirement benefits as a percentage of currently scheduled benefits. There are a few things to note in the table:

  • First, the progressive price-indexed benefit for very low income workers remains at 100 percent of scheduled benefits for all future birth years.
  • Second, price indexation has the greatest effect on the maximum earners; by the time today’s 5 year olds, who earn the taxable maximum for their 35 highest years, reach retirement, price indexation will result in benefits equal to 56 percent of scheduled benefits.
  • Third, the annuities of higher income workers provide an increasing percentage of their retirement benefits, due in large part to the fact that their scheduled benefits, as described earlier, are a smaller percentage of lifetime earnings.

Figure III - Total Benefits as a Percentage of Scheduled Benefits for Workers Born in 2000

Figures II and III show how total retirement benefits stack up against scheduled benefits for workers born in 1980 (today’s 25 year olds) and for those born in 2000 (today’s 5 year olds). The lower portion of each bar identifies the reformed benefit with progressive price indexing less the benefit offset, which is the difference between the first and second rows in each panel in Table II. As designed, the higher one’s lifetime earnings, the greater is the effect of price indexing and the greater is the size of the benefit offset relative to scheduled earnings. Further, the longer the reform is in place the greater the effect of price indexing and the benefit offset and the larger the contribution the personal account makes to a retiree’s total retirement benefits. Altogether, the reformed benefit paid by Social Security plus the net personal account annuity produces total retirement benefits comparable on average to the Social Security benefits scheduled under current law.8

Reform vs. Status Quo. Figure IV compares the costs and revenues of the reformed program to the status quo. Because the proposal’s primary focus is retirement benefits, this graph is limited to the Old Age and Survivors portion of the Social Security program, and thus excludes the disability insurance program, which is assumed to remain unchanged. The familiar status quo income and cost rates indicate that the OASI portion of the program is in surplus until 2018 and then experiences deficits in every year thereafter. The graph also shows the effects of progressive indexation alone on the costs of the program. These costs rise throughout the retirement of the baby boom generation and peak as a percentage of taxable payroll in the mid-2030s and then gradually decline.

The final two lines in the graph show the ultimate costs after taking into account the benefit offset and the ultimate income after taking into account the contributions to PRAs. These lines show that beginning in 2009, the surplus and additional revenues will be needed to fund the personal accounts. The difference between the status quo and the reform income series is equal to the contributions to the personal accounts for workers who are younger than retirement age. The ultimate reform cost rate shows how the benefit offset further reduces the costs of the program. These costs peak as percentage of taxable payroll in 2030 and then decline rapidly. By 2055 the reform costs are less than the reform income. The surpluses in the following years can be used to pay down the debt that has accumulated or to supplement the personal accounts.

Figure IV - Annual Revenues and Costs of OASI with and without Progressive Indexing and Personal Retirement Accounts

Figure V depicts the surpluses and deficits as a percentage of taxable payroll associated with continuing the current financing arrangement and with a reformed program. The lines in the graph show the net benefits or costs to the rest of the federal budget. Beginning in 2009 and continuing to 2040 the reformed program imposes higher net costs on the rest of the budget than continuing the current financing arrangement. In 2041 and later the reformed program is less of a burden on the government’s finances and, as previously mentioned, in 2055 begins to produce surpluses.

Filling the Gap. Figure V simply shows the net costs of the two financing arrangements as a percentage of taxable payroll and does not identify the funding source. Thus far, the president has ruled out tax increases as a funding source. If the deficits from 2009 to 2055 are funded through additional borrowing, then the federal debt would grow as a percentage of gross domestic product (GDP) throughout the projection period. Figure V also shows deficits in the current financing arrangement grow each year after 2017. If the initial surpluses under the current financing arrangement are used to reduce the debt and the subsequent deficits are funded through additional borrowing, the federal debt would also grow as a percentage of GDP. Toward the end of the projection period the debt under the current financing arrangement would exceed the debt under this formulation of the president’s proposal, with the accumulated debt approaching an amount equal to 100 percent of GDP in 2080.

Figure V - Income less Costs of OASI with and without Progressive Indexing and Personal Retirement Accounts

The Importance of Explicit vs. Implicit Debt. Accounting for changes in the explicit debts of the federal government does not recognize how the two alternative paths affect the federal government’s total explicit and implicit debts. Clearly, the combination of progressive indexing and personal retirement accounts eliminates more of the long run unfunded obligations of the Social Security program, and thus eliminates more of the implicit debt. This is not to say that the way in which the deficits are financed is irrelevant. The choice of financing bears critically on which generations ultimately shoulder the burden of the program’s costs. If one of the goals of reform is to reduce the burden on future generations of workers, the current working generation will have to pay some of the costs. This can be accomplished through additional general revenue transfers financed by reductions in other government programs, through increased general tax revenues, through mandatory contributions to the personal accounts or through additional payroll tax revenues. Several proposals have called for increasing payroll tax revenues by increasing the taxable maximum. Should such a change be made, it is of paramount importance that the additional surpluses be directed into personal retirement accounts rather than diverted to other uses.

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