retirement security would be greatly improved by President George
W. Bush's plan to allow them to establish Social Security Personal
Retirement Accounts (PRAs). At the same time, workers who are 55
and older, including today's retirees, would receive every cent
that they have been promised, including annual cost-of-living
increases. Overall, the President has put forward a bold and
responsible proposal that would permanently save Social Security
and make the program a better deal for all Americans.
The Bush PRA plan
would be voluntary. PRAs would be part of the existing Social
Security system and would help to finance the retirement benefits
for younger workers. These workers would receive a retirement
benefit that is paid in part by the existing Social Security system
and in part from the money in their PRAs. The level of their
retirement benefits would not be determined solely by the amounts
in their PRAs. Instead, a benefit formula similar to the one used
today would establish a retirement benefit based on their earnings
history. The PRA could increase this amount, but the base benefit
would not drop below a certain level determined. Anyone who does
not wish to have a PRA could remain in the existing system and
receive whatever retirement benefit Social Security is able to pay
at the time that they retire.
One aspect of
reform that the President discussed in general terms is a method to
bring the retirement benefits promised to younger workers closer to
what the system will be able to pay. Admirably, the President made
clear that such a fix must be a part of reform. This could be
accomplished in many ways, ranging from changing the way that past
earnings are indexed to subtle shifts in the benefit formula
itself. Since these are controversial changes, it is not surprising
that the Bush administration wants Congress to develop a method
that it is comfortable passing. Still, the President will have to
exercise strong leadership to ensure that it is not left out of the
final legislation. Failure to change the growth of future benefits
would undermine Social Security's financial future, even with the
establishment of PRAs.
How the Bush Plan
retirees and workers age 55 and older. Workers and retirees
born before 1950 would not be affected at all. They would stay in
the current system and receive 100 percent of the benefits that
they have been promised under today's system, including annual
between 1950 and 1965. In the first year of the plan's
existence, workers born between these years would be allowed to
establish a PRA if they so wished. They would not be required to do
between 1965 and 1978.In the second year that PRAs are
available, workers born in these years would be able to establish a
PRA. Any workers born between 1950 and 1965 who have not already
established a PRA would also be able to open one.
after 1978.In the third year that PRAs are offered, workers
born after 1978 and any workers born after 1950 who have not
already established a PRA would be able to open one.
contributions. In the first year, workers would be able to
invest 4 percent of their wages in their PRA. That year, the
maximum amount that could go into the account would be $1,000. This
means that anyone making $25,000 a year or less could invest the
full 4 percent, while workers earning more than that would invest a
Starting in the
second year, the $1,000 maximum investment would climb by $100 a
year until it reaches a point when all workers could invest the
full 4 percent. This phase-in allows lower income workers who are
less likely to have significant retirement savings to make the full
investment first. At $100 a year, it would take 18 years before
workers earning today's maximum taxable income of $90,000 a year to
be able to save the full 4 percent of income.
structure.PRAs would be invested through a government-managed
central management structure similar to the Thrift Savings Plan
that is available today to government employees. The actual
investments would be handled by a professional funds manager that
would be chosen in a bidding process. This simple structure
provides the necessary infrastructure at the lowest possible cost
to the individual. The Bush Administration estimates that workers
would pay fees equal to only about 0.3 percent of the money in
their account annually. Most of those fees would go the government
agency managing the accounts. Only a small proportion would go to
the funds manager.
Investments. Workers would be limited to a few basic and
diversified investment choices. The default portfolio would likely
consist of up of 50 percent stock index funds, 30 percent corporate
bond index funds, and 20 percent government bonds. On average, this
mixture would pay about 4.6 percent after inflation annually, even
after subtracting administrative fees.
fund. Workers would be able to invest in a lifespan fund. This
is an investment program that automatically rebalances a workers
account as he ages. Younger workers who are far from retirement
would have most of their money invested in stock index funds. As
they get older, their investments would gradually and automatically
shift into bonds and other less volatile investments. This
means that if the stock market went down just before their
retirement, workers who invested in a lifespan fund would not see a
significant change in their PRA, as they would have only a small
amount invested in stocks at that time. Lifespan funds have been
gaining popularity in employer sponsored retirement plans, such as
401(k)s, because they automatically make the kind of portfolio
adjustments that investment professionals recommend for all workers
retirement. Retirees with a PRA would receive benefits that are
partly paid by the government and partly paid from the PRA. First,
the amount of monthly benefit would be determined with a formula
similar to the one used by Social Security today. Then, the
proportion of that monthly benefit to be paid by the government
would be determined. Social Security would calculate how large the
PRA would have been if it had only earned 3 percent annually after
inflation (the average amount earned by government bonds) and,
using an annuity calculator, convert that hypothetical lump sum
into a monthly payment. That hypothetical monthly payment would be
subtracted from the retirement benefit, and the government would
pay the rest.
For example, if
the Social Security benefit formula determined that a worker should
receive $1,200 a month and the hypothetical calculation showed that
the PRA could pay $400 a month, then the government would pay $800.
When the $800 is added to the $400 from the PRA, the $1,200 monthly
benefit is reached. But if the PRA actually earned more than 3
percent annually after inflation, then the worker would either have
money left over for a nest egg or could choose to take a higher
phased withdrawals. Workers would be required to either
annuitize enough of their PRA to produce a total monthly benefit
that is at least at the poverty level or to leave enough in their
PRA to pay a poverty-level benefit. Workers could annuitize more if
they wished and thus receive a higher monthly benefit. This feature
guarantees that workers would have at least a basic level of income
no matter what happens. The ability to choose whether to annuitize
or to leave money in the PRA increases the ability of workers of
all income levels to build a nest egg.
The Bush plan would give most workers the opportunity to build a
nest egg that could be used for emergencies or left to their
families. Unused amounts in the PRA are fully inheritable. This
means that if a worker died before reaching retirement age, his or
her PRA would remain in the family.
What Will It
Administration estimates that its PRA plan would require an
additional $664 billion over the next 10 years. This represents the
total amount of money that would go into PRAs during that time.
Assuming that this amount is borrowed, the total cost over 10 years
would be $754 billion when interest is included.
However, this only
covers the cost of establishing the accounts. It does not bring the
system into long-term balance. That can be accomplished only by
bringing the promised level of benefits closer to what the system
can afford to pay. Until Congress decides how to accomplish this
reduction in benefit growth, it will be impossible to determine the
total amount of general revenue needed to permanently preserve
Social Security. However, SSA scoring of comparable PRA plans show
that the total cost over the first 75 years is about 40 percent
less than the cost of the current system.
In terms of
long-term balance, everything is on the table, said the President,
with one exception: raising the payroll tax. This is sensible.
Raising the payroll tax would damage the economy and make Social
Security an even worse deal for workers than it already is. And by
itself, raising the tax would only push Social Security's looming
insolvency into the future, rather than solving the problem
permanently. Altogether, then, the President's proposal provides
Congress with needed flexibility while setting appropriate limits.
How to reduce
benefit growth. Under the current system's benefit formula,
workers who retire this year will receive benefits that, on
average, are about 5 percent to 7 percent higher (after inflation)
than workers with identical work histories who retired five years
ago. These increases must be reduced to save Social Security.
This growth in
benefits could be reduced using one or more of several methods.
These range from switching the indexation of past earnings when a
worker's retirement benefit is calculated from growth in real wages
to growth in inflation. Alternatives to this method might include
using an index that is halfway between the two measures or applying
the indexing change to only part of the benefit formula. In all,
there are many ways to slow the growth of benefits, and the method
chosen will determine the total amount of additional revenue needed
to save Social Security.
The Bush plan
offers younger workers an opportunity for the same retirement
security that their parents and grandparents have enjoyed. It is
far superior to the alternative, which is some combination of
massive tax increases and sharp benefit cuts.
It is a sign of
the President's seriousness and the responsibility of his proposal
that he discussed directly the need to bring future retirement
benefits into line with what the system can afford to pay. Any PRA
plan that ignores this necessary step will fall short of the
President's goal of permanently fixing Social Security.
John is Research Fellow in Social Security and Financial
Institutions in the Thomas A. Roe Institute for Economic Policy
Studies at The Heritage Foundation.