Magazine

Social Security: Three New Ideas


1 LET THE TRUST FUND INVEST IN STOCK INDEXES

The principal economic idea behind President George W. Bush's proposal for private Social Security accounts is to tap the power of the stock market. After all, the Social Security Trust Fund consists solely of government bonds whose returns have historically lagged those of stocks. But there could be a better way to achieve the same goal: Keep the current setup but invest some of the Trust Fund in stock market index funds.

The notion, first proposed by President Bill Clinton in his 1999 State of the Union Address, was killed after running into opposition. But now that Bush has laid out his personal-account scheme, it looks increasingly as if the direct-investment approach would be cheaper and entail less risk.

"GOOD ECONOMICS"

Of course, Bush's motives aren't just economic. Personal accounts are part of his broader philosophy of fostering a culture of ownership and personal responsibility. But the plan he proposed on Feb. 2 carries a host of restrictions, including no early withdrawals, only three stock-index funds and a bond fund to choose among, and strict limits on retirees' ability to take their earnings as a lump sum to spend or pass on to heirs. While these safeguards may be sensible ways to reduce the risk of individual investments in stock, they also gut much of the personal-ownership aspects of private accounts. So Americans would give up little if Social Security did their investing for them. "It's good economics for the Trust Fund to invest in stocks," says Massachusetts Institute of Technology economics professor Peter A. Diamond.

One of the chief advantages of letting the Trust Fund invest is that it would offer a less risky way for Americans to play the stock market with their retirement money. Although the restrictions in Bush's plan reduce individuals' exposure to market volatility, they still would have to worry that stocks could crash right when they want to retire. It makes more sense to spread the risk over millions of Americans, which would be the case if the Trust Fund bought the stock instead.

Investing through the Trust Fund would also entail sharply lower transition costs. Look at what would happen under the two different approaches. To set up private accounts, Washington would have to sell up to $2 trillion worth of bonds to cover payments to current retirees while workers divert a third of their 12.4% payroll tax into their accounts. This borrowing would raise the federal deficit, although the Trust Fund would get the money back over 75 years as account holders retired. At that point, they would be gaining from their stock holdings, but the fund would be paying lower Social Security benefits.

Direct investing, however, would put the Trust Fund ahead, slashing the transition costs and the deficit, and leaving more money for Social Security benefits. True, Washington also would have to float new bonds, pegged at 3%. The cash would be used for its stock buys to bulk up the fund. But in this scenario, stock returns would immediately accrue to the Fund, not individuals, say Diamond and others. So if stocks posted a 6.5% real return, Social Security's equity holdings would earn 22% more after 10 years than the Fund now earns in bonds and nearly 50% more after 20 years.

In addition, administrative overhead would be dramatically less without millions of individual accounts to manage. The cost under the Bush plan would run to about 30 basis points, the White House says. If all eligible Americans set up accounts, the tab over 75 years would total $425 billion in current dollars, according to University of Chicago economics professor Austan Goolsbee. In contrast, Trust Fund investment would cost one basis point, or just $15 billion, over 75 years, says MIT's Diamond.

AUTOMATIC SWITCH

While direct investing would mean giving up the personal ownership of a private account, the President's plan leaves little to actually own. Sure, individuals would have an account with their name on it, but they would be able to choose only among the three stock index funds and the bond fund. Employees couldn't withdraw any money before their retirement, even for a serious illness. And when employees turn 47, the government would automatically switch their accounts into a "life cycle portfolio" that is designed to gradually shift them from stocks to bonds over the second half of their careers.

The Bush plan also limits how much account holders could withdraw as a lump sum when they retire. The Administration wants to make sure retirees don't blow all their savings and wind up in poverty. So Bush would require retirees to buy annuities with their accounts sufficient to keep them above the poverty line until they die. This could leave as many as half of all retirees with nothing left over to take as a lump sum, since that's roughly how many now depend on Social Security to keep them out of poverty.

In other words, private accounts would leave millions of Americans in much the same place as their neighbor who just stuck with traditional Social Security. The latter would get one monthly check. Account holders would get two: a smaller check from the traditional plan, plus another that would put them ahead or behind the neighbor depending on how well their choice of index funds had fared. Neither would have a pot of money they could spend or will to their heirs.

POLITICAL TEMPTATIONS

Clinton abandoned the idea of the Trust Fund buying stock largely because Federal Reserve Board Chairman Alan Greenspan argued that it would pose too much of a temptation for politicians who might want to ban the government from buying, say, tobacco stocks. But Bush's plan doesn't ease this risk, since a new government entity would manage and run all private accounts. Even some private-account advocates concede that it would be just as easy for an activist President to purge the three indexes of tobacco stocks as it would if the Trust Fund owned shares in the same indexes.

Investing part of America's retirement assets in stocks may, in fact, be a wise idea. But it might be more prudent and cheaper to spread the risk by letting Social Security do it -- not through individual accounts that many Americans will barely be allowed to get their hands on anyway.

By Aaron Bernstein in Washington

2 ADD-ONS COULD BE THE GREAT COMPROMISE

In the Social Security debate, Democrats are walking a fine line. They don't want to oppose efforts to boost retirement savings or help workers accumulate assets -- the popular features of President Bush's private-account plan. But Dems don't like his idea of weakening the safety net of government-paid Social Security -- or the borrowing required to divert workers' payroll taxes into the accounts.

So they are quietly starting to promote an alternative known among Washington wonks as "add-on" accounts. The idea: encourage workers to save more for their retirement, without making any major changes to Social Security itself. Like Bush's private-account plan, add-ons fail to fix the Social Security funding shortfall that is expected in the future. Taxes would have to be raised or benefits trimmed to do that.

But Democratic thinkers, such as former Clinton economic aides Peter R. Orszag and Gene B. Sperling, back the concept -- first proposed by Clinton in the late 1990s. No lawmakers have embraced add-ons, however, and they get a strong thumbs-down from most Republicans, who want to salvage the President's plan. Still, many observers believe add-ons could be part of a final compromise in the Great Social Security Debate. "If I could get a pure add-on account while [reducing] benefit growth, I'd grab that deal in a minute," says Urban Institute senior fellow Rudolph G. Penner.

Add-on backers have zeroed in on a serious problem: Participation in retirement plans is dismally low, especially for low-income workers. Less than one-quarter of those making $20,000 or less contribute to tax-deferred retirement plans; neither do almost half of those making $20,000 to $40,000. Among all income groups, a quarter of workers who are offered plans invest nothing, while only 5% contribute the maximum allowed. In 2001 (the latest numbers available) the median balance in 401(k) plans for workers 55 to 59 was just $10,000.

One approach to boost participation in retirement savings would be to fund add-on accounts with tax hikes. Bush would let workers divert four points of their payroll tax into private accounts. With add-ons, workers would not shift any of their payroll tax. Instead, add-on accounts would be funded with other taxes, avoiding hefty borrowing.

Add-ons could also be structured as enhancements to today's individual retirement accounts and 401(k)s. Some Democrats would make enrollment in 401(k)s automatic for eligible workers unless they opt out. Some companies that tried that saw participation double. Another idea: change tax breaks for savings so they benefit lower-wage workers rather than their better-paid colleagues. Replacing deductions with credits could help lower-income workers save new money. Also, the feds could create universal, government-funded savings accounts. Senators from Joseph I. Lieberman (D-Conn.) to Rick Santorum (R-Pa.) would grant every child a lump sum at birth to start a retirement account.

Democrats and advocates for the elderly love add-ons. But the politics are dicey. Bush could boost his chances of getting a bill through the Senate by accepting the idea. But he'd risk losing GOP votes in the House. Conservatives might be willing to cut promised Social Security benefits if, in return, they could also shrink workers' dependence on Big Government. But they'll be reluctant to back such cuts if Social Security is left intact.

For Bush, the choice is different. Add-on accounts are a long way from his vision for Social Security. But they might be his only path to a signing ceremony in the Rose Garden.

By Howard Gleckman in Washington

3 USE AFTERTAX INDEXING, NOT PRETAX

Since 1979, Social Security has offered the best protection against inflation of any pension plan in existence. First, benefits for existing retirees are bumped up enough each year to compensate for any increase in consumer prices. Nobody is talking about changing that.

More important, the initial benefits for a new retiree are determined in part by the overall level of wages in the economy today, not just by the person's past earnings. If overall wages rise by 6%, the Social Security formula is tweaked so that initial benefits rise by 6% as well. If wages go up by 1%, so do initial benefits. This adjustment process, called "wage-indexing," allows the living standard of new retirees to keep up with the living standard of the working population.

In his State of the Union address, President Bush floated the idea of getting rid of wage-indexing and tying initial benefits to prices instead. This seemingly technical change was vehemently attacked, and for good reason: Under this proposal, the real value of benefits would stay fixed over time, even as real wages for workers rise. Enormous sums would be saved, but retirees dependent on Social Security payments would fall further behind the working population.

There's a way the indexing formula can be changed to cut costs and also be fair to both retirees and workers. Under today's law, initial benefits are linked to pretax wages. A better option is to tie initial benefits to an appropriate measure of aftertax wages.

Aftertax indexing, while not part of the current policy debate, has several advantages. Aftertax wages are a better gauge of the true buying power of workers. Long-run, aftertax wages are also likely to rise slower than pretax wages, since most economists expect the tax burden on workers to rise sharply as the baby boomers retire. As a result, initial retiree benefits, which today are linked to pretax wages, will probably significantly outpace the living standards of workers, who depend on aftertax wages.

BIG BUCKS

How big a difference would this shift to aftertax indexing make? There are various approaches that could be used to answer this question, but one calculation done by BusinessWeek suggests that benefits for new retirees would rise by roughly 0.2 to 0.3 percentage points less than pretax wages each year. Under this policy of tying benefits to aftertax wages, someone who retires in 2080 will receive about 14% less than under the current system. By comparison, the proposal that Bush mentioned in his speech would call for a benefit cut of more than 50% in 2080.

Here's how the calculation for aftertax indexing is done. Today, the payroll tax for Social Security and Medicare together equals 15.3%, including employer and employee contributions. In 2080, each worker will be supporting almost twice as many beneficiaries as today, according to the Social Security Administration. That suggests the corresponding tax burden on workers should rise to keep pace with the increased number of beneficiaries, pushing the tax burden to about 27% by 2080. This money can either come from higher payroll taxes or additional income taxes.

This higher tax burden sharply affects aftertax wages. According to government projections, pretax real wages are expected to rise by about 1.1% per year over the next 75 years. But taking the rising cost of Social Security and Medicare into account, aftertax wages rise by an average of only 0.9% per year. This small yearly difference adds up to big bucks over time.

Far more detailed calculations of the effect of aftertax indexing could include factors such as personal income taxes and Medicare premiums for retirees. The upshot is the same: If benefits stay tied to pretax wages, the economic position of new retirees will get better relative to workers, and that could lead to a backlash. Indexing by aftertax wages will not solve all the financial problems of Social Security. But it's the right way to fairly share the burden.

By Michael J. Mandel in New York


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