June 23, 1999

June 23, 1999 | Backgrounder on Social Security

Another Bold Step Forward: The Bipartisan Senate Social Security Reform Plan

The bipartisan Social Security plan spearheaded by Senators Judd Gregg (R-NH), John Breaux (D-LA), Charles Grassley (R-IA), Robert Kerrey (D-NE), Fred Thompson (R-TN), Charles Robb (D-VA), and Craig Thomas (R-WY)1 is another important step toward real reform. Like a similar plan by Representatives Jim Kolbe (R-AZ) and Charles Stenholm (D-TX) in the House,2 the Senate plan contains three crucial elements that are necessary for true reform:

  • It is bipartisan;

  • It would take steps to reduce Social Security's unfunded liability; and

  • It would allow workers to divert a portion of their existing Social Security taxes into a personal retirement account that they would own.

This last feature is extremely important because it would enable all Americans to accumulate a cash nest egg for their retirement and would improve the rate of return on their Social Security taxes. Nevertheless, the plan should be strengthened and improved in several ways during its consideration by Congress.

The bipartisan Senate proposal would divert an amount equal to 2 percent of wages from a worker's Social Security retirement taxes into a new individual retirement savings account. All workers, regardless of their age at the time the plan went into effect, would be required to participate. The accounts would be similar to those offered to federal employees under the Thrift Savings Plan, with workers offered a limited number of investment options.3 Although the accounts would be owned by the individual worker and administered by the federal government, private funds managers would make the actual investment decisions.

In addition to the amount diverted from existing Social Security taxes, workers would be allowed to save up to an additional $2,000 a year in their accounts, and contributions from lower-income workers would be matched with funds from the government. If the worker died before retirement, the full amount of the account would go into his or her estate. After retirement, any amount in the account that had not been converted into an annuity or used for other purposes could go to the worker's heirs. This is preferable to the plan offered by House Ways and Means Committee Chairman Bill Archer (R-TX) and Representative Clay Shaw (R-FL),4 under which the government would seize the whole account upon retirement and use it to pay Social Security benefits to the worker and, in certain circumstances, a spouse.

The Senate plan would gradually diversify the composition of each American's Social Security benefit to a combination of the traditional monthly payment and earnings from the individual account. As the assets in the individual account grew, the proportion coming from the traditional version would be reduced. This would be implemented by gradually changing the formula used to compute the traditional benefit. However, in all cases, workers would receive both the benefits generated from their individual account and the monthly payments from Social Security that are financed by their payroll taxes.

In addition, the Senate plan contains a number of features that would either increase the benefits for those who need them most or improve the system's cash flow. For instance, it would slightly accelerate the increase in the full retirement age to 67, which is scheduled under current law, and then index the full retirement age to changes in life expectancy. It also would calculate retirement benefits by using the income from up to 40 working years instead of just the highest 35.

The proposal would adjust the annual cost-of-living allowance (COLA), setting it at 0.5 percent below the annual increase in the Consumer Price Index (CPI). This change in the CPI would apply only to workers who were under the age of 62 at the time the bill went into effect.

At the same time, the existing earnings test, which recaptures some of the Social Security benefits from retirees who continue to work, would be repealed, and survivors benefits over time would increase to a minimum of 75 percent of the combined benefit of both spouses. The formula that sets initial retirement benefits would be adjusted to boost benefits slightly for lower-income workers.

The Senate plan also sets up a new "KidSave" program, financed from general revenues, that would partially fund future retirement benefits.

Finally, the proposal would reform the way in which the maximum income subject to Social Security taxes is set, and would transfer all of the revenue generated from taxing the retirement benefits for those earning over $34,000 annually ($44,000 for couples) to the Social Security trust fund. Currently, part of that money goes to Medicare.

IMPORTANT REFORMS IN THE BIPARTISAN SENATE PROPOSAL

The bipartisan Senate plan meets many of the necessary conditions for Social Security reform. The important reforms that it contains include the following:

  • Individual retirement savings accounts would be funded with a portion of existing Social Security taxes.
    The Senate plan would reform the existing Social Security program by redirecting an amount equal to 2 percent of income into these accounts. This is far preferable to plans that would fund these accounts from temporary budget surpluses.

  • Workers would own and benefit from their accounts.
    Instead of having the government seize all or a major portion of a worker's individual retirement savings account--as would be the case under the Archer-Shaw plan--the bipartisan Senate proposal would allow workers to receive all the benefits from their accounts. They could either receive a higher retirement income or take part of the money in cash for such things as investing in a small business or helping to pay for their children's or grandchildren's college education. If the worker died before retirement, the accounts could be left to his or her heirs.

  • Retirement benefits from Social Security would be adjusted as those from the individual accounts grew.
    All workers would continue to receive a retirement benefit from Social Security. In addition, they would receive the benefits from their individual retirement savings accounts. However, as the amount available to a worker from his or her individual account grew over time, the amount from the traditional plan would shrink.

This newest adjustment would be accomplished by using a formula that calculates the amount of monthly income that would be generated from the worker's individual account if it were invested in government bonds, subtracting that figure from the monthly benefit that would have been received from Social Security. If the worker were to invest in super-safe government bonds, the combined benefit from the individual account and Social Security would be the same as he or she would have received from Social Security. However, if the worker invested in a fund that pays a higher return, he or she could receive either a higher monthly benefit or a cash lump sum upon retirement. The combination of retirement benefits from both the individual account and Social Security would allow workers to look forward to a higher standard of living in retirement, while at the same time reducing Social Security's huge unfunded liability.

  • The rate of return on Social Security taxes would improve.
    Because workers would be able to invest their individual retirement savings accounts in stocks and bonds that pay much higher returns than the current system pays, their rate of return most probably would improve. Instead of the average annual return of about 1.2 percent a year received on Social Security taxes,5 the amount invested in the individual accounts could earn an average of 7 percent a year after inflation. Even the lowest-risk investments, such as government savings bonds, would provide a return that greatly exceeds Social Security's low returns.

  • The plan is bipartisan.
    Any reform supported by members of just one political party cannot pass Congress and be signed by the President.

CHANGES THAT WOULD IMPROVE THE PROPOSAL

The bipartisan Senate proposal is a major step toward successful reform of the Social Security program and can serve as an excellent legislative foundation upon which to build this reform. However, it is by no means perfect. It could be improved by:

  • Increasing the number of investment options.
    The bipartisan Senate plan would require workers to invest their individual retirement savings accounts through a federal agency. Although this should be one option, workers also should be able to invest their accounts through a traditional financial services provider, such as a mutual funds company, bank, credit union, or broker. Millions of Americans already have such savings plans, and it would make sense for them to be able to use them for Social Security.

  • Protecting workers from arbitrary adjustments in cost-of-living allowances (COLAs).
    Allowing Congress to adjust COLAs might make them more accurate today, but it opens the door to politically motivated changes in the future. Because the Bureau of Labor Statistics (BLS) is developing a more accurate form of the Consumer Price Index that will be completed by 2002,6 it would be better to enact a temporary 0.3 percent reduction, which is the approach taken by the Kolbe-Stenholm proposal. Moreover, if the BLS re-estimate turns out to be smaller than this 0.3 percent reduction, the difference should be refunded to workers.

  • Reviewing regularly the government match of workers' savings.
    Congress should pause before reforming one entitlement program in part by creating a new one. Even though there are good arguments for some level of government matching of additional savings for low- to moderate-income workers, this feature needs to be crafted carefully to avoid its growing into an entitlement program that later has to be reformed.

  • Dropping the proposed KidSave program.
    One of the reasons Social Security has financial problems is that Congress has attached unrelated programs to it. There may be excellent reasons to create a KidSave program. However, adding a new entitlement program that gives each newborn child a $1,000 savings account paid from general tax revenue and deposits $500 into the account in each of the following four years just makes Social Security reform more difficult.

CONCLUSION

The bipartisan Senate proposal is another step toward serious Social Security reform. It is fiscally responsible and makes many of the hard decisions that will be necessary to prevent Social Security's impending insolvency. Most important, it would allow workers of all income levels to build a nest egg for retirement and benefit more fully from the continuing growth in the American economy.

David C. John is Senior Policy Analyst for Social Security at The Heritage Foundation.


1. The plan was announced on May 20, 1999. It has not yet been introduced as legislation.

2. H.R. 1793, The 21st Century Retirement Security Act.

3. The exact number of investment options and the structure for handling investments are still being determined.

4. The Social Security Guarantee Account Plan was announced on April 28, 1999. As yet, it has not been introduced as legislation.

5. William W. Beach and Gareth G. Davis, "Social Security's Rate of Return," Heritage Foundation Center for Data Analysis Report No. 98-01, January 15, 1998.

6. On December 18, 1998, the Bureau of Labor Statistics announced that it will be updating the CPI's consumption expenditure weights effective for data released during and after January 2002.

About the Author

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies

Related Issues: Social Security