Saving Social Security Proposals for Reform WEEK 2 Student - - PowerPoint PPT Presentation

Econ 21SI

Saving Social Security

Proposals for Reform

WEEK 2

Student Initiated Course Instructor: Sean Arenson Faculty Sponsor: Prof. John Shoven

Stanford University, Spring Quarter, 2006 Tuesdays, 4:15-5:30PM, Bldg 200 Rm 217 econ21si.stanford.edu

Econ 21SI

Last Week

• A Brief History of Social Security

– Convergence of industrialization, terrible economic conditions, and popular political movements led to passage of Social Security Act in 1935

• How Social Security Works Today

– Pay-as-you go system – Functions based on insurance principles – Provides coverage against poverty in retirement, disability, and death

• What is the Social Security Crisis?

– Promised benefits exceed expected revenues

Econ 21SI

Next Week

• Prof. John Cogan on “The Economic and Political Role
• f Personal Accounts in Reforming Social Security”
• Readings posted: Article by Cogan & Mitchell in Journal
• f Economic Perspectives and Op-Ed by Cogan in Wall

Street Journal

Econ 21SI

This Week

• What is the Social Security Crisis? (cont.)
• Major Options for Reform

The Social Security “Crisis”

• Simply: Promised benefits exceed expected funding
• Currently, Trust Fund surplus of $1.8 trillion
• 2005: $600 billion revenue, $500 billion outlays
• Future outlays increasing due to several factors

– Retirement of baby boomers – Longer life expectancy

• Future revenue stagnant

– No population growth

The Social Security “Crisis”

What’s the problem?

The Social Security “Crisis”

Increasing Life Expectancy

The Social Security “Crisis”

Increasing Dependency Ratio

• Pay-Go System:

t * Nw * W = Nb * B

• t = (Nb/Nw) * (B/W)
• tax = dependency ratio * replacement rate
• Currently: dependency ratio about 0.2 and replacement

rate about 0.45. t = 0.2 * 0.45 = 0.09

The Social Security “Crisis”

Pay-Go System Flaw

• By 2035, dependency ratio about 0.4
• t = 0.4 * 0.45 = 0.18
• But payroll tax not scheduled to increase

The Social Security “Crisis”

Pay-Go System Flaw

• Pay-Go a “Ponzi Scheme,” or a Nobel Prize winner?
• Ponzi (1919) promised investors 100% return within 90
• days. Paid claims with new investments. Eventually, shut

down by gov’t – last round of investors lost money

• Paul Samuelson – “Consumption Loan Model”

Each generation “loans” retirees money, following generation pays back loan with interest coming from real wage growth and population growth. Nobel Prize - 1970

The Social Security “Crisis”

Pay-Go System Flaw

The Social Security “Crisis”

Pay-Go System Flaw

Intergenerational transfers led to windfalls for early recipients, but slowed population growth has left burden

• n future recipients

The Social Security “Crisis”

Long Term Deficit

• Cut benefits to those currently under 55 by 25% across

the board

• Wait until 2041 and cut all benefits (including current

retirees) by 30%

The Social Security “Crisis”

Extreme Benefit Cut Alternatives

• Immediately increase payroll tax by 2% (to 14.4%)
• Wait until 2041 and increase payroll tax by at least 5%

The Social Security “Crisis”

Extreme Tax Increase Alternatives

• Such extreme solutions are merely band-aids! They do

nothing to fix the underlying flaws in the program

• “Terminal Year Problem”

The Social Security “Crisis”

These are NOT viable solutions!

Two Percent Payroll Tax Increase: Only a Temporary Fix There is Still A Design Flaw

10.00 12.00 14.00 16.00 18.00 20.00 22.00 2005 2015 2025 2035 2045 2055 2065 2075 Year Percent of Covered Payroll

The Social Security “Crisis”

Terminal Year Problem

• Cut benefits
• Increase revenues
• …and that’s it… these are the ONLY ways to restore

solvency

• Personal Accounts DO NOT in and of themselves

address solvency

The Social Security “Crisis”

Menu of Options

• Explicit benefit cut – modify benefit calculation

– Ex: Change bend-point replacement from 90-32-15 to 90-21-10

• Index PIA to prices rather than wages

– Alternative: “Hybrid Indexing”

• Increase FRA

– Possibility: Index to increase in life expectancy

• Increase number of years included in benefit calculation

– Ex: Best 40 years included

The Social Security “Crisis”

Types of Benefit Cuts

57% 85% Reduce Benefit formula gradually from 90,32,15 to 90,21,10 25% 25% Index Retirement Age to life expectancy improvements 70% 72% Hybrid Indexing 116% 100% Replace Wage Indexing with Price Indexing 75 Years 2080

The Social Security “Crisis”

Types of Benefit Cuts

• Explicitly increase payroll tax

– Ex: Increase to 14.4%

• Increase maximum taxable base

– Ex: Increase to $150,000

• Relax immigration laws
• Create “add-on” individual accounts
• General revenue transfers (“magic asterisk”)

The Social Security “Crisis”

Types of Revenue Increases

75 Years 2080 14% 40% Raise the Payroll Tax Cutoff to $150,000 34% 104% Raise the OASDI Payroll Tax from 12.4% to 14.4%

The Social Security “Crisis”

Types of Revenue Increases

• There are several plans that will restore solvency
• “Personal Security Accounts 2005” – Schieber & Shoven

– Two-tiered system with flat “traditional” benefit and large mandatory individual accounts

• Diamond-Orszag Plan

– Raise taxes and reduce benefits equally, concentrate burden on middle and high income participants

• President’s Commission Plan #2

– Cut promised benefits (no tax increase) and introduce voluntary individual accounts

The Social Security “Crisis”

Viable Plans

The Social Security “Crisis”

What is the best plan?

• That depends on who you ask!
• Key roadblock to reform – differences in values, not lack
• f solutions

Proposals for Reform

• Restores solvency over 75 year horizon
• To some extent, solves terminal year problem
• Does not affect benefits for those currently over 55
• Retains important social functions of Social Security
• Involves painful choices between benefits reductions and

revenue increases

Proposals for Reform

What constitutes a viable plan?

• Longer wait means fewer, more painful options

– Can’t leverage few years of surplus remaining – Lose opportunity to spread pain among generations

• All proposals calculated based on enactment today
• Reality: no one expects reform before 2009, and perhaps

even 2013

Proposals for Reform

How long can we wait?

• Scheduled benefits are benefits statutory

– Rising in real terms – Meaningless without reform

• Payable benefits assume no reform

– Benefits payable based on projected availability of funds – No deficit under payable benefits

• Proposals for reform generally cut scheduled benefits and

aim to increase payable benefits

Proposals for Reform

Scheduled vs. payable benefits

• Goals: Restore solvency and update social insurance

features

• Approach: Examine sources of imbalance and outdated

features and address each with balance of benefit cuts and revenue increases

Proposals for Reform

Diamond-Orszag Plan

• Longer lives mean higher average lifetime benefits -

higher costs

• Idea: How would individuals react to longer life in absense
• f Social Security?

– Increase saving during working years – Work longer – Spend less during retirement

Proposals for Reform

Diamond-Orszag Plan

Increasing Life Expectancy

• Longer career already encouraged by benefit formula (not

actually true!)

• Increase saving corresponds with increase payroll tax
• Spend less during retirement means reduce benefits

Proposals for Reform

Diamond-Orszag Plan

Increasing Life Expectancy

• Increasing life expectancy unpredictable – dynamic

adjustments required

• Office of Chief Actuary should calculate cost to Social

Security from annual improvements in life expectancy and divide costs between benefit reductions and tax increases

• Preferable to simply indexing benefits to age?
• Reduces 75-year actuarial deficit by nearly 30%

Proposals for Reform

Diamond-Orszag Plan

Increasing Life Expectancy

• Maximum taxable base indexed to average wage growth,

but income of wealthiest growing faster

• 1983: 10% of all earnings above max

2004: 15% of all earnings above max

• Proposal: Gradually raise max base to exclude only 13% of

earnings by 2063

• Amounts to tax on top 6% of earners

Proposals for Reform

Diamond-Orszag Plan

Increasing Earnings Inequality

• Legacy debt is the difference between a funded system

and a pay-go system

• Currently legacy debt is $11.6 trillion
• Legacy debt incurred due to generosity to previous
• generations. Therefore, all should share in funding it

Proposals for Reform

Diamond-Orszag Plan

Burden of the Legacy Debt

• Universal coverage brings 6 mil state and local workers

into program to share in legacy debt

• 3% tax on income above max taxable base

– Very controversial – tax not tied to benefits

• Universal legacy charge in the form of benefit reduction of

0.31%/year and tax increase of 0.26%/year beginning in 2023

Proposals for Reform

Diamond-Orszag Plan

Burden of the Legacy Debt

• Poverty rate very high among widows (more than 15%)

– Raise survivor benefit to min of 75% of couple’s benefit – Also eliminates incentive to single earner families

• Poverty high among disabled workers (22% poverty rate)

– In aggregate, hold disabled workers harmless from proposed benefit reductions – Reduce initial benefits, but increase annually faster than inflation – prevents young workers from becoming locked into low real benefit

• Life expectancy increasing faster among high earners

– Lower marginal benefit in top tier of formula from 15% to 10%

Proposals for Reform

Diamond-Orszag Plan

Improving Social Insurance & Progressivity

• If policymakers do not like an element of the Diamond-

Orszag plan, they could substitute the estate tax

• Estate tax currently repealed. Reenactment dedicating

revenue to SS Trust would account for 20% of deficit

• Advantages: Limited labor market distortions, redistributive,

dedicated stream of revenue

Proposals for Reform

Diamond-Orszag Plan

An Alternative

• Reduce actuarial deficit by 104% over 75 year horizon
• Increase progressivity and insurance functions
• Workers 55 and older held harmless, and reduction in

benefits gradual for successive cohorts. Real benefits still rise each generation

• Generally requires modest changes to system

Proposals for Reform

Diamond-Orszag Plan

Overall effects

Proposals for Reform

Diamond-Orszag Plan

• Transition from pay-go, defined benefit system to a mixed

system with a funded, defined contribution component

• Advantage: Money less accessible to Congress
• Advantage: Potential for higher returns and improved

diversity

• Two principle ways of doing this: personal accounts and

investment of the trust in equities

Proposals for Reform

Mixed Systems

• Pros:

– Spread risk between cohorts – Low administrative costs – Retain ability to redistribute – Eliminate political pressures to allow access to funds

• Cons:

– Potential conflict of interest – Pressure for “social investment”

• Ex: California state employee pension fund divested of tobacco stocks

Proposals for Reform

Mixed Systems

Investing Trust in Equities

• No change for retirees or near retirees
• No direct governmental investment of the Trust
• No increase in payroll taxes
• Incorporate voluntary personal accounts

Proposals for Reform

President’s Commission

Guidelines

• Index “traditional” benefits to inflation

– Makes up 100% of insolvency over 75 year horizon – Effectively cuts scheduled benefits to payable benefits

• Slightly increase benefits for low-income households

including widows

– Relative to payable, not scheduled benefits!

• Voluntarily allow 4% diversion of payroll tax into a

personal account, up to $1000 (wage indexed) annually.

– Reduce traditional benefits by amount diverted plus 2% real rate of return

Proposals for Reform

President’s Commission

Commission Model 2

• No withdrawals allowed prior to retirement
• Upon retirement, individual can choose inflation-protected

annuity, gradual withdrawals, or lump sum

Proposals for Reform

President’s Commission

Commission Model 2

Proposals for Reform

President’s Commission

• Indexation to inflation alone restores solvency
• Commission acknowledges that personal accounts

actually hurt Social Security balance over next 75

• Transition costs of personal accounts funded by general

revenue transfers (“magic asterisk”) of $2 trillion or 1.2% of payroll (nearly 2/3 of SS insolvency)

Proposals for Reform

President’s Commission

Effect on Solvency

• By 2052, median worker receives benefits 59% higher

than currently scheduled

• All income groups receive higher expected benefits
• Even “conservative” estimates predict minimal drop in

benefits

• Increase “transparency” in goals of adequacy and equity

Proposals for Reform

President’s Commission

So then why offer personal accounts?

• Accounts <$5000 are in Tier 1 – modeled after Federal

employees’ Thrift Savings Plan

– 3 balanced funds, 5 index funds, TIPS (3% real return)

• Larger accounts allowed to invest in Tier 2 private sector

funds - diversified portfolios required

• Default portfolio must be developed

Proposals for Reform

President’s Commission

Investment Options

• Successive cohorts could receive substantially different

benefits

• Compromises “cornerstone” benefits
• Lump-sum settlement compromises “insurance against
• utliving assets”
• Diversification already available – Traditional Social

Security is a unique “investment” whereas market-based investment opportunities are numerous

Proposals for Reform

President’s Commission

Personal Account Cons

• Inheritability of personal accounts benefits those with short

life expectancy

– Ex: 1 of 3 African-American males dies before eligibility

• Divorced spouses would have claim on part of account

based on marriage length

• Disability benefits cut (along with all benefits), but little

chance for disabled to make up for this with personal accounts

Proposals for Reform

President’s Commission

Social Effects

• Restores solvency
• Represents a “viable” personal account option
• Requires tweaking, as do all plans

Proposals for Reform

President’s Commission

Overall