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WebMemo #733 on Social Security

May 2, 2005

Bush's Progressive Indexation Plan: A Key Step to Preserve Social Security

By and

Two key changes in the Social Security system are needed to achieve retirement security for all Americans. The first is to phase in changes to the structure of traditional Social Security benefits to create a system of real benefits on which workers and retirees can depend rather than promised benefits that cannot be paid. This step requires Congress to slow the growth of traditional benefits for middle- and upper-income Americans, who are much less dependent on Social Security for their retirement income, so that the benefits of lower-income Americans can be protected and improved. President George W. Bush's bold call for "progressive indexation" recognizes this need, and Congress should incorporate it into reform legislation.

The second step is to allow workers the opportunity to supplement traditional Social Security benefits by using part of their current payroll taxes to create voluntary personal retirements account (PRAs) that they own. This step is also in the Bush proposal. These accounts would be invested in safe bonds and mutual funds in order to produce an additional monthly retirement benefit and a retirement nest egg. The key to getting the full retirement advantage of PRAs is to let workers invest as large a slice of their payroll taxes as is reasonably possible in their PRAs. In this respect, President Bush's 4-percent "carve out" proposal is the minimum acceptable, and Congress would do well to expand on it.

With this two-step reform in place, workers could look forward to larger monthly retirement checks than today's Social Security can afford to pay and a nest egg that they could use during retirement or pass on to their heirs.

The Two Steps To Save Social Security
Bringing Social Security's benefit promises closer to the reality of its revenues is an essential part of preserving the program's ability to provide retirement security. President Bush recognizes this and has endorsed a fair and equitable way to structure future benefit increases to protect those who rely on Social Security the most. Called "progressive indexation," this method provides real retirement income insurance for workers by focusing traditional Social Security benefits on those who need them the most during retirement-lower income workers-while preserving the principle that all Americans both pay into Social Security and receive benefits.

Washington today makes the false promise that it can pay workers the benefits that they expect. This is a false promise because previous Congresses scheduled increases in future benefits that far exceed projected payroll tax revenues. The money simply will not be there. While current retirees and those close to retirement will be able to receive every cent that have been promised, scheduled increases in benefits for future retirees will need to be scaled back to more realistic levels.

Fortunately for workers, slowing future increases in traditional Social Security benefits is only one part of the effort to fix Social Security. Combining changes in traditional benefits with the opportunity for workers to establish Personal Retirement Accounts would allow younger workers to receive the same type of retirement security as their parents and grandparents. With PRAs, workers could improve their benefits through a carefully managed investment pro­gram that would yield better returns than the declining rate the government can pay on the payroll taxes it collects from workers. The combination of realistic government-paid benefits and a PRA would be far more secure than today's empty promises.

Running out of Money
Today's Social Security will require trillions of dollars in damaging tax hikes if it is to pay all of the benefits that it has promised. Social Security's monthly checks will begin to exceed projected payroll tax collections in 2017. This gap will quickly balloon to alarming levels. After adjusting for inflation, annual deficits in Social Security will exceed $100 billion in 2022 and top $200 billion in 2027-just over 20 years from now. In 30 years, Social Security's annual deficit will be more than $300 billion. If promised benefits are to be paid, Congress will have to fill this funding gap by raising taxes.

Congress would have to raise and invest $5.7 trillion today to pay all of Social Security's promised benefits between 2017 and 2080. That includes $1.7 trillion, in net present value terms, to repay the bonds in Social Security's trust fund and $4.0 trillion to pay benefits after the trust fund is exhausted in 2041. This money would be in addition to what Social Security receives during those years from its payroll taxes.

Focusing Benefits on Those Who Need Them the Most
Social Security was created to insure Americans against the risk of running out of money in retirement and to ensure all an adequate monthly income to afford a decent retirement. The way to give that assurance real meaning is to focus the system's resources on those who face the greatest hardship. President Bush's "progressive indexation" proposed would do that. It would gradually change Social Security's benefit formula so that lower-income workers (those who earn less than $25,000 today) who retire in the future would receive higher traditional Social Security benefits than lower-income workers who retire in 2005. This is only fair, because lower-income workers are less likely than other workers to have any other retirement savings and more likely depend on Social Security benefits for almost all of their retirement income.

In addition, under the President's plan, workers would be promised, for the first time, a minimum Social Security benefit that will keep them above the poverty line. This is more than Social Security offers today. Under today's system, a worker can retire with a Social Security income that is beneath the poverty line.

Meanwhile, middle- and upper-income workers, who are typically able to put aside money for retirement, would receive smaller increases in traditional benefits. Under the Bush plan, the benefits of upper-income workers (those who earn over $100,000 today) would increase at the rate of inflation, instead of at the rate of wage growth as they do today. While future upper-income retirees would not receive any less than upper-income workers who retire today-and their benefits would still be protected against inflation-their benefits would also not grow as fast as under today's unsustainable formula.

This change for upper-income workers is fair and prudent, given Social Security's finances, because upper-income workers almost always have significant retirement savings in Individual Retirement Accounts, 401(k) plans, and other investment vehicles. So while they would still receive traditional Social Security benefits, their benefits would just not increase as rapidly as under current law-and they would be able to rely on retirement income from their savings.

Workers with incomes between those two levels ($25,000 ands $100,000) would fall somewhere in between, depending on their earnings-the lower the income, the higher the level of benefit growth. No one at any level would receive benefits less than a worker with a comparable income retiring today. Again, this change ensures that workers with lower levels of retirement savings outside of Social Security would receive comparatively more in traditional benefits.

These changes would not happen suddenly. They would be gradually phased in over decades so that future retirees would have plenty of time to adjust their retirement planning. And nobody over the age of 55 today would be affected by the President's plan at all.

Benefits for All
Progressive indexation preserves the principle of social insurance for workers of every income level. All workers who are currently in Social Security would continue to pay in and continue to receive traditional retirement benefits. No one-not even the Donald Trumps and Bill Gates of the workforce-would be forced to pay into a system that provides them with nothing in return. But while the wealthy would continue to receive traditional benefits-a minor supplement, no doubt, to their investment income-in return for their taxes, their monthly benefits would not grow as fast as under current law. These savings on checks to affluent retirees would enable Social Security to pay better benefits to lower-income retirees whose need is greater.

Under current law, every worker at every income level would see his or her promised benefits cut by about 30 percent once the trust fund runs out of money in just over 35 years. Progressive indexation addresses this mismatch between revenues and payouts in a fair way that ensures our children and grandchildren will be protected from retirement poverty.

PRAs for Full Security
While progressive indexation is a prudent and fair way to adjust the growth in traditional Social Security benefits to bring the system's payments in long-term balance with its revenues, it is only one of the necessary steps for true reform. The other step is to allow younger workers-if they wish-to put part of their payroll taxes into a personal retirement account that can be invested in safe bonds and mutual funds. Workers choosing this option, the second step of President Bush's plan, could look forward to a higher return on the money in their PRAs than in traditional Social Security. When workers with a PRA retire they could choose to convert the entire account into a supplemental monthly check to enhance their traditional Social Security benefits (which would be reduced in line with the taxes they switched to the PRA) or they could use part of the PRA for that purpose and keep the rest as a nest egg for themselves and their heirs.

Because of the higher returns younger workers could expect from money placed in a PRA, as compared to the steadily declining returns on payroll taxes, they would be better off under the President's plan-despite that it would slow the growth of traditional benefits-than under a Social Security system without PRAs. Indeed, the larger the amount of payroll taxes that could be placed in a PRA, the better off workers would be. That is why President Bush's 4-percent "carve out"-which is phased in very slowly and has tight limits on total PRA contributions-should be seen as a minimum. Larger PRAs would achieve faster reform and a faster improvement in retirement income.

To see how President Bush's combination of progressive indexation and PRAs would affect you, visit the Heritage Foundation's PRA Calculator at http://www.heritage.org/pracalc

David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies, and Stuart Butler is Vice President for Domestic and Economic Policy Studies at The Heritage Foundation.

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