While Social Security has received the most attention, recent developments emphasize the need for a comprehensive approach to pensions that expands opportunities to save for retirement and strengthens defined benefits plans. The Pension Benefit Guaranty Corporation (PBGC), which insures defined benefit pension plans, faces potential deficits of hundreds of billions of dollars that may require a government bailout. Meanwhile, while the United States has a strong defined contribution pensions system, millions of Americans work at companies that do not offer a retirement savings plan, and many who do have access to plans fail to participate. Congress should pass a unified reform that addresses all of these problems.
Three Necessary Goals
retirement income reform will have three elements. First, it must
restore Social Security's fiscal health with more realistic benefit
promises. Second, it must give every worker the opportunity to save
for retirement with both a Personal Retirement Account (PRA) in
Social Security and retirement savings programs, such as
employer-sponsored 401(k) plans. Third, it must ensure that defined
benefit plans are fully funded and able to pay the benefits that
they promise, while also reducing the chance that the PBGC will
need a taxpayer bailout.
Reform #1: Reduce the unfunded burden that today's Social Security system will impose on future generations.
Social Security has promised future generations far more in retirement benefits than its current funding sources will allow it to pay. Meeting these obligations without reforms will burden our children and grandchildren with crushing payroll taxes, sharply reducing their standard of living. In addition, because payroll taxes are essentially a levy on jobs, substantial payroll tax increases will reduce economic growth and kill jobs.
This same logic also applies to the additional general revenue funding that would be needed to pay today's promised benefits under a PRA plan. Even though this cost would be substantially lower than to the cost of paying full benefits under the current system, reformers should not repeat the mistake of trying to build political support today by pushing substantial costs onto future generations.
A sensible reform would reduce the benefits promised to younger workers to more reasonable levels while also giving them the time and tools necessary 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 imposing the burden of paying for it onto future generations.
An excellent way to accomplish this goal is progressive indexation of future retirees' benefits. This would preserve today's promised benefits for lower-income workers while gradually reducing benefit growth for upper income retirees, who are more likely to have significant other retirement savings. Other ways to accomplish this goal include gradually raising the retirement age and indexing future retirees' benefits to changes in longevity.
Reform #2: Improve younger workers' ability to save for retirement in Social Security and retirement savings programs, such as 401(k) plans.
Social Security Accounts: To have the opportunity to improve their Social Security benefits, younger workers should have the option to invest a portion of their Social Security taxes in personal accounts that they would own. 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 individual workers' PRAs, or "Social Security Part B." Workers should be able to choose whether to rely totally on Part A or to invest a portion of their retirement taxes through Part B. As shown by the experiences of over 25 countries, including the United Kingdom, Sweden, Switzerland, and Australia, PRAs can help workers to improve their retirement incomes without unreasonable risks.
At the same time, simply establishing PRAs is not sufficient. Social Security Part B should also be designed to give workers more control over how their retirement income is structured by allowing them to build nest eggs. Upon retirement, these nest eggs could be used to increase monthly income, reserved for an emergency, or left to family members. In the event that a worker dies before retirement, this nest egg would be a part of his or her estate and could be passed on to heirs.
Improving Retirement Savings: Young workers must have access to a retirement savings plan in every job they hold and begin to save as soon as they join the workforce. Future workers are almost certain to retire with smaller Social Security benefits, as a proportion to their pre-retirement earnings, than those near retirement today-an outcome that is even more likely if Congress fails to act. Today, only about half of the workforce participates in 401(k) plans or IRAs. Most of the workers who do participate are employed by large companies or have above average incomes. Those who are employed by smaller businesses or who have low to moderate incomes often save little for retirement.
Meeting this goal requires two major changes. First, existing plans need to be restructured to encourage people to participate. Second, all workers-regardless of their income level, the size of their employer, or their geographic location-must have access to retirement savings plans similar to 401(k)s.
Achieving greater participation is fairly simple. Rather than requiring workers to fill out forms if they wish to participate in their employer's 401(k) plan, they should be automatically enrolled unless they take action to opt out. In addition, there should be a default contribution level expressed as a percentage of a worker's income, so that contributions keep pace with the growth of the worker's pay. Finally, workers' accounts should be automatically assigned an appropriate investment choice, such as a lifespan fund. Again, workers could take action to opt for other investments.
Expanding 401(k)s to smaller employers will be harder, especially where traditional financial firms have few offices, but it is just as essential. The first step is to reduce or eliminate the regulatory burdens that raise the cost of 401(k) plans and discourage employers from offering them. However, other innovative steps are also needed. These might include allowing business and professional associations to offer plans to small businesses and self-employed professionals. For instance, a pension plan covering all of the smaller retail stores in a community could be created. In addition, professional associations for nurses, architects, and social workers, as well as similar groups, could be encouraged to offer pension funds to their members just as many associations now offer insurance plans and other services.
Reform #3: Restore financial stability to defined benefit pension plans and reduce the need for a government bailout of the PBGC.
The defined benefit pensions that served workers so well for decades face the same problems that plague Social Security: shrinking numbers of workers to pay the benefits of millions of future retirees and inadequate funding because future retirees are likely to live much longer than actuaries expected when investment strategies for these plans were developed.
The retirement security of the millions of workers who are covered by defined benefit pension plans is at risk because many of those plans do not have enough money to pay all of the benefits they have promised. While the PBGC has had to take over underfunded pension plans from two airlines and most of the steel industry, worse is yet to come. Other airlines are already in trouble, and the auto industry is feeling the crush of its massive pension obligations. The end result may be a massive bailout of PBGC that costs taxpayers tens of billions of dollars. To avoid this, Congress must act quickly. It should start by considering the Administration's proposal on defined benefit pension reform.
Most of PBGC's annual income, which is used to reduce the agency's deficit, comes from a $19 per worker annual insurance premium paid by covered pension plans. The Bush Administration proposes to raise premiums-for the first time since 1991-by $11 to $30 per worker and to index the premium to the annual growth in wages. This increase, which is proportional to wage growth over the past 14 years, would take effect in FY 2006. Underfunded plans would also pay an annual risk-based premium that reflects the gap between benefit promises and funding targets. The PBGC board would set the amount of the premium based on the risk of plan failure and the need to improve the agency's finances.
While increased premiums will provide additional revenue for the agency, substantial reform of pension plan funding rules would also improve PBGC's finances. The current rules are extremely complex, and plans are evaluated with the assumption that employers will always be able to make contributions, regardless of the risk of a firm's failure. For example, Bethlehem Steel's pension plan was judged to be 84 percent funded even though it had only 45 percent of the assets needed to pay promised benefits. The PBGC was left to cover a $4.3 billion shortfall when the firm went bankrupt.
Funding rule changes proposed by the Bush Administration and House Education & the Workforce Committee Chairman John Boehner would both provide a more accurate picture of plan funding and require companies to meet their obligations. The proposed rules would also prevent companies from expanding benefit promises while their plans are severely underfunded. Combined with the additional premiums, the new funding rules would sharply reduce the need for a major taxpayer bailout of the PBGC.
The one thing that Congress should not do is to repeat the sad experience of the 1980s. Congress should not casually extend the amount of time that corporations have to fund their pension plans. While this may be justified on a case-by-case basis when there is hard evidence that a company will recover its financial health, a general rule would mean that taxpayers will have to pay more to bail out the PBGC when it runs out of money.
Because Social Security is the floor and safety net of our nation's pension system, the program must be restored to financial health without delay. Establishing a voluntary system of personal Social Security retirement accounts is an essential part of fixing Social Security. However, reforming Social Security only deals with part of the overall problem. Non-Social Security retirement income is also at risk due to problems with the defined benefit pension system and the inability of defined contribution plans to reach all workers. Congress must address the entire pension system soon if younger workers are to have the same financial stability that their parents and grandparents received. Delay in confronting any of these problems will only increase the tax burden on future workers and raise the risk that workers will be unable to meet their retirement goals.
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.