The Heritage Foundation

Executive Summary #1811 on Social Security

November 17, 2004

November 17, 2004 | Executive Summary on Social Security

Executive Summary: How to Fix Social Security



There are only three real solutions to Social Secu­rity's rapidly approaching fiscal problems: raise taxes, reduce spending, or make the current payroll taxes work harder by investing them through some form of personal retirement account (PRA).

Establishing PRAs is the only solution that will also give future retirees the opportunity to receive an improved standard of living in retirement. These accounts would give them more control over how to structure their income and allow them to build a nest egg that could be used for emergen­cies during retirement, used to start a business, or left to their families. However, establishing PRAs will be complex and-as experience from other countries shows-will require careful planning.

To set up a workable PRA system, Congress needs to:

  • Create an account structure that uses a por­tion of existing payroll taxes and allows workers of all income levels an opportunity to build family nest eggs. PRAs would be vol­untary and would not affect current retirees in any way. Workers would own their Social Security PRAs, which would be funded by directing a portion of their Social Security retirement taxes into their PRAs. About 5 per­cent of income would be best, but the directed portion should not be less than 2 percent or more than 10 percent. The larger the account, the more likely that it could pay for all or a substantial portion of workers' retirement ben­efits without requiring more than a token amount of funding through the existing gov­ernment-paid system.
  • Create a simple, low-cost administrative structure for the accounts that uses the cur­rent payroll tax system and professional investment managers. Probably the simplest and cheapest structure would be the existing payroll tax system. Rather that having the gov­ernment invest PRA money, the agency over­seeing the accounts should contract out fund management to professional fund managers.
  • Create a carefully controlled set of invest­ment options that includes an appropriate default option. Initially, workers would be allowed to put their PRA contributions into any one of three balanced and diversified mixes of stock index funds, government bonds, and similar pension-grade investments. The default fund for workers who do not make a choice would be a lifestyle fund in which the asset mix changes with the age of the worker. Younger workers would be invested fairly heavily in stock index funds; but as they age, their funds would automatically gradually shift toward a portfolio that includes a substantial proportion of bonds and other fixed-interest investments. This would allow workers who are far from retirement to grow with the econ­omy while older workers would lock in that growth with a portfolio made up predomi­nantly of lower-risk investments.
  • Adjust Social Security benefits to a more sustainable level for future generations. Despite promises from both the left and the right to pay promised benefits in full, this is simply not realistic. While current retirees and those close to retirement should receive every cent that they are due, future benefit promises must be scaled back to more realistic levels.
  • Create a realistic plan for paying the gen­eral revenue cost of establishing a PRA sys­tem. The necessary money will have to come from some combination of four sources: bor­rowing additional money, collecting more gen­eral revenue and other taxes, reducing other government spending, and reducing Social Security benefits more than is required under current law or in the reform plans. While some Representatives and Senators will be tempted to cover Social Security's deficits with higher taxes, this is the wrong approach. The necessary amounts are so large that such a tax increase would consume enough resources to harm the economy.
  • Create a system that allows workers flexi­bility in structuring their retirement bene­fits while ensuring that they receive an adequate monthly benefit. To protect both the retiree and the taxpayer, a PRA plan should require all retirees to use some of their PRAs to purchase annuities that would guarantee at least a minimal level of income for life, includ­ing an adjustment for inflation. This would protect taxpayers from retirees who would oth­erwise spend their entire PRAs, expecting some form of government handout to meet their monthly expenses.

Any plan to fix Social Security should:

  • Improve the retirement income of future retirees without reducing the benefits of current retirees or those close to retirement. Social Security reform should not reduce the benefits of today's retirees or those close to retirement.
  • Add voluntary PRAs that include a savings/ nest egg component to the current system. In the future, Social Security retirement bene­fits should come from both the current govern­ment-paid program, which would become Social Security Part A, and from the individual worker's PRA, which would be known as Social Security Part B.
  • Reduce the unfunded burden that today's Social Security system will impose on future generations. A sensible reform would reduce the benefits promised to younger work­ers to more affordable levels while also allow­ing them the opportunity to make up the difference through investment earnings. Con­tinuing to promise those who are a long way from retirement more than Social Security can realistically deliver only makes the system unstable by pushing the burden of paying for it onto future generations.

Conclusion. It is not fair either to force senior citizens into poverty because of low Social Security benefits or to beggar their children and grandchil­dren by requiring them to pay for unrealistic promises. Establishing Social Security PRAs is the only way to avoid both of these extremes.

Because PRAs would earn higher returns than the current system can afford to pay, they could preserve retirement benefits at a sustainable level and reduce the unfunded promises imposed on future generations. However, PRAs are not a magic bullet. To work properly, a PRA system must be carefully structured and administered. The system must neither promise more than it can reasonably be expected to deliver in benefits nor attempt to hide its true cost through budget tricks.

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

About the Author

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

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