Social Security Reform: Responding to the Critics
Wednesday, November 16, 2005
by Andrew J. Rettenmaier and Zijun Wang
Table of Contents
- Executive Summary
- Social Security Reform
- Evaluating the President's Approach
- Examining the Options
- Results Using Historical Data
- Results Using Adjusted Historical Data
- Results Based on Simulated Data
- Protection against Downside Risk
- Flexible Annuitization Rules
- Summary and Conclusions
- Appendix: Basic Assumptions and Additional Findings
- About the Authors
Social Security Reform
"To pay benefits in 2017, and every year thereafter, Social Security will require transfers from the rest of the federal budget."
President Bush has made reforming Social Security a top priority. Students of Social Security know the program’s tax revenues will fall short of its costs beginning in 2017, and the gap between tax revenues and benefit payments grows each year thereafter. Based on past surpluses that have been credited to the Social Security Trust Fund and projected surpluses until 2017, the system has dedicated funding until 2041. However, drawing on these dedicated funds implies general revenue transfers that will require the federal government to reduce spending elsewhere, raise taxes and/or increase borrowing.
The President’s Plan. To close the funding gap, President Bush has outlined a plan that incorporates paying for a portion of future benefits through individual investments. While the details of the president’s approach have yet to be determined, it appears the reform has two major components: 1) reduce the growth in initial benefit payments by changing the indexing formula from one based exclusively on wage growth to one based on progressive price indexation, and 2) establish PRAs for younger workers. The two reforms combined will produce total benefits for all income groups that are similar to currently scheduled benefits, and produce potentially much higher benefits for lower-income workers. 1
Progressive Price Indexing. Currently, Social Security calculates benefits for all new retirees by averaging a worker’s 35 highest-earning years and putting his or her average wage-indexed earnings through a benefit formula. The worker’s earnings are adjusted, or indexed, to the annual increase in average wages nationwide. Given that wages typically rise faster than prices, the real purchasing power of the average Social Security benefit paid to new retirees will increase more than 60 percent over the next 50 years while maintaining the current replacement rate of about 41 percent of preretirement earnings.
"Robert Pozen has proposed indexing benefits for higher income workers to prices rather than wages."
Unfortunately, under current law, Social Security cannot afford to pay what is scheduled. Robert Pozen, a member of President Bush’s 2001 Commission to Strengthen Social Security, has proposed progressive indexing as part of a reform that results in a sustainable program in the long run. Under the Pozen approach: 2
- Benefit calculations would not change for current retirees, near retirees or income earners in the bottom 30 percent of lifetime earnings (about $25,000 a year or less). These workers would receive the same Social Security benefits scheduled under current law.
- However, starting in 2012, initial benefits for the highest earners would be determined by the growth in prices, rather than wages.
- The growth each year in initial benefits for workers between $25,000 and the maximum would be set by a progressive mix of prices and wages.
Thus, Social Security benefits of lower earning workers would be the same as those currently scheduled, while benefits for the highest earners would grow with inflation but not reap the additional boost from real wage growth.
"Progressive price indexing can be combined with PRAs funded by 4 percentage points of workers' payroll taxes."
Personal Retirement Accounts. The current outline of the president’s proposal also calls for depositing 4 percentage points of a worker’s payroll taxes into a personal account — up to $1,000 annually — starting in 2009. After 2009, the maximum contribution would rise each year by $100 plus wage growth, ultimately resulting in 4 percent accounts for all workers. At retirement, a worker’s account balance would be used to purchase an inflation-protected lifetime annuity, which would supplement the new price-indexed benefit from the traditional Social Security system.