May 2, 2005

May 2, 2005 | WebMemo on Social Security

How the President's Plan Benefits Younger Workers

Last Thursday night, President George W. Bush finally presented his full Social Security plan. The President outlined a new method for calculating benefits that will improve the Social Security system's solvency. Many critics have been quick to focus on the pain from necessary benefit adjustments that lead to solvency. But like taking a sip of lemonade before you've had a chance to stir in the sugar, critics' puckered responses to the President's plan leave out the sweetener: personal retirement accounts (PRAs). Add personal accounts into the mix, and younger workers have the chance to enjoy more comfortable retirements than under the current system.  

 

Today's Social Security

For younger workers, today's Social Security system is broken. Younger workers will get a worse deal from Social Security than their parents and grandparents because Social Security cannot afford to pay the same generous benefits to today's younger workers that it did to previous generations.

 

For example, consider the case ofa 25-year-old worker, earning $27,500 today, who is expected to retire in 2047. That year, under current law, he would receive only about 75 percent of the benefits that Social Security now promises to pay. If Congress continues to do nothing, the benefits would continue to decline over the years of his retirement. Chart 1 shows that he would receive a smaller proportion of the promised benefits from Social Security every year of retirement. Even as the cost of living rises, his Social Security check could actually shrink.

 

Under the current system, this worker would receive a $1,664 monthly check from Social Security at retirement. That is what today's Social Security can afford to pay.

 

Though Social Security's looming insolvency is responsible for this state of affairs, raising taxes or cutting benefits alone isn't the answer. Any fix for Social Security that replicates 1983's "permanent fix" reform package-which cut benefits and raised taxes-would just make Social Security a worse deal for younger Americans than it already is. Tax increases combined with benefit cuts would force younger Americans to pay more into the system while getting less out of it. Social Security needs reform, but passing its costs on to younger workers is not a fair was to achieve solvency.

 

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A Fairer Alternative

The President's plan is a fairer alternative than just raising taxes or cutting benefits. Critics have focused on how the President's plan would change the benefits formula, but they tend to overlook that it would restructure how a retiree receives benefits. Under the President's plan, retirees would receive their benefits from two sources-think of them as Part A and Part B.

 

Part A is the traditional Social Security benefit, which is the sole component of the current system. While the President's plan would slow the growth of younger workers' traditional Social Security benefits, a worker's personal retirement account-that is, Part B-would also contribute to his or her monthly benefits. Younger workers would be most affected by the change in traditional benefits, but they would also benefit the most from their PRAs thanks to the power of compound interest. The earlier an investment is made, the more time it has to grow and compound its earlier gains to create even larger later ones. The power of compounding and time is why financial planners advise their clients to invest early in their careers for retirement, so that their money can work harder for them.

 

Under the President's plan, the 25-year-old worker discussed above would receive traditional Social Security benefits-Part A-of $1,216, about three-quarters of the benefit under the current system. He would also have a PRA balance of $162,965 at retirement. By using some or all of that account to purchase an annuity-Part B of the total monthly benefit-a retiree could achieve higher benefits than are possible under today's Social Security. A retiree could also, if he or she chooses, keep part of the PRA as a nest egg, something that is not possible under today's Social Security.

 

If our example retiree used his entire PRA to purchase an annuity, the annuity would provide a Part B payment of about $1,131 each month, for a total monthly benefit-Part A and B together-of $2,347. That is $683 more per month than today's Social Security can afford to pay. Even taking into account that the President's plan would slow the growth of traditional benefits to make the system solvent, this typical worker would still do better under the President's plan than under today's Social Security.

 

Many retirees will want to leave a nest egg in their accounts that they can use during retirement, as they see fit, or pass on to their children or grandchildren. Today's Social Security does not give workers the choice to create a nest egg at retirement. If our example retiree uses only part of his PRA to purchase an annuity that provides a Part B payment of $808 each month, he would be left with a nest egg of $43,615 in his PRA. If he chooses not to spend this money during retirement, it would remain in his account, continuing to compound, and eventually grow to a sizeable nest egg for his children or grandchildren. Taking together Part A and Part B benefits, he would receive a total benefit of $2,044 each month. In terms of monthly benefits, he would be slightly better off than under the current system, but his heirs would enjoy a nest egg-a small jump-start on life-that he could not have created under the current system.

 

Conclusion

President Bush's plan to reform Social Security would bring the system to solvency, but it does more than that, too. The President's plan also would help retirees achieve greater benefits than are possible under today's Social Security and let them build up and pass on nest eggs to their children and grandchildren, which most lower- and middle-income households cannot afford to do today.

 

But critics of the President's plan-especially in the time since he announced his approach to traditional benefits-too often overlook the Part B side of his proposal. While the President's plan would slow the growth of Social Security's traditional benefits for most workers, a retiree would also enjoy a new Part B income stream from his PRA. Especially for younger workers, personal accounts are the spoonful of sugar that makes the medicine go down. This is why personal accounts are an integral part of any plan to bring Social Security to solvency. Critics who focus solely on benefit adjustments and ignore PRAs are taking a dishonest tack and add little to this discussion.

 

Rea S. Hederman, Jr., is Manager of Operations and a Senior Policy Analyst in the Center for Data Analysis at The Heritage Foundation.

About the Author

Rea S. Hederman, Jr. Director, Center for Data Analysis and Lazof Family Fellow
Center for Data Analysis

Related Issues: Social Security