Future Retirees at Risk

Retirement security for middle-class Americans is at risk. First, the push to privatize Social Security has diverted attention from solving the program's financing problems. Second, unchecked reliance on 401(k) plans has made employer-provided pensions less reliable. Third, the president's "ownership society" initiative has led to policy proposals that undermine pension coverage and splinter the health-care system. Finally, massive budget deficits have now made it more difficult to fix Medicare and Social Security.

Diverting the Social Security Debate

Over the 75-year period for which the Social Security system's trustees are required to plan, Social Security in its present form will fall out of balance. It will have insufficient resources to pay for the benefits it has promised. We can restore balance with moderate changes to the program's revenues, its benefits, or the returns on its accumulated assets. But the longer the decision to do so is postponed, the greater the required adjustments. Thus, the debate right now should be about how much income we want to provide to retirees through this collective savings plan, how to pay for it, and how quickly to make the necessary changes. Instead, we are arguing about the virtues of private accounts.

Private accounts are a poor replacement for Social Security. The existing program provides only modest benefits today and will provide even more modest benefits in the future. It simply makes no sense to have a portion of this basic retirement income depend on the performance of the stock market. But the harm done by the privatization proposals goes beyond the merits of the accounts.

The privatization debate has delayed any real solution to the Social Security deficit. Solving the problem requires Congress to increase taxes or reduce benefits today -- to solve a shortfall that does not arise until 2042. That is not a politically appealing option. The only way to get Congress to act is for a commission representing all points of view to provide political cover. The president's 2001 commission failed the test by requiring that any plan "include individually controlled, voluntary personal retirement accounts." By delaying action, this commitment to individual accounts exacerbates an already serious problem.

The emphasis on privatization has also diverted attention from the fact that, even under current law, Social Security benefits will replace a declining share of our earnings. For the average earner who retires at age 65, Social Security currently provides benefits equal to 41.3 percent of pre-retirement earnings, or 38.5 percent of earnings after deducting Medicare Part B premiums. But for someone retiring in 2030, Social Security benefits are projected to replace only 29.9 percent of pre-retirement wages. There are three reasons for this decline: first, the slated increase in the normal retirement age to 67, which effectively will cut the benefit paid at any given age; second, the rising cost of Medicare Part B premiums, which are automatically deducted from Social Security benefits; and third, the expanding taxation of Social Security benefits under the personal income tax.

Knowing this, how should we eliminate the 75-year deficit? Making all the adjustment on the benefit side and exempting only the disabled and those presently 55 and over from the change would require a 20-percent benefit cut -- in addition to the declines built into current law. Yet that is the policy that the Bush administration appears to support. And with all eyes focused on privatization, this choice has hardly been noticed.

The plan described in the 2004 Economic Report of the President has two components. The first would index future Social Security benefits to the growth of prices rather than wages. This would cut projected benefits by more than enough to eliminate the entire 75-year deficit. The second component introduces private accounts. Workers would be allowed to put 4 percent of their payroll tax, up to $1,000 a year, into a private account and get a smaller Social Security benefit when they retire. Because the indexing would eliminate the 75-year deficit, the private accounts are actually superfluous. In fact, they would make things worse for the government, which would have to increase its borrowing substantially for decades to accommodate them. Nonetheless, it's the proposal for private accounts that gets discussed as if it were the solution to Social Security's problems.

401(k) Plans Coming Up Short

If Social Security will be providing less in the future, will employer-sponsored pensions provide more? Probably not. In traditional pension plans, employers generally contributed the funds and bore the financial responsibility for meeting promised benefit targets. But the landscape has changed. Among those lucky enough to be covered by a pension (less than half the workforce), the portion with only a 401(k)-type plan has increased from 20 percent in 1981 to 60 percent today. Thus, 401(k)s will be the sole supplement to Social Security for the majority of future retirees with pension plans. And these plans are coming up short. The Federal Reserve's 2001 Survey of Consumer Finances reports that the typical household approaching retirement has only $55,000 in its 401(k) account, not much to support two decades in retirement.

A critical factor in explaining these low 401(k) balances is that the entire burden has shifted from the employer to the employee. The employee must decide whether or not to join the plan, how much to contribute, how to invest the assets, what to do about company stock, whether to roll over accumulations when changing jobs, and how to withdraw the money in retirement. The evidence indicates that participants make serious mistakes at every step along the way. A quarter of those eligible choose not to participate; less than 10 percent of those who do contribute the maximum. More than half fail to diversify their investments, many overinvest in company stock, and almost none rebalances his or her portfolios in response to age or market returns. Most importantly, many cash out when they change jobs, and very few annuitize at retirement.

Public policy could greatly improve the situation by setting the defaults in 401(k) plans to "best practice." Unless the individuals instruct otherwise, plans would automatically enroll all eligible participants, set their contributions at the level that maximizes whatever employer match is available, diversify and rebalance their portfolios as they age, restrict investments in company stock, automatically roll over lump-sum distributions, and pay out retirement benefits in the form of a joint-and-survivor inflation-indexed annuity.

To date, however, little has been done to make 401(k) plans work better. Not even the issue of overinvestment in company stock has received the attention it ought to, given that 20 percent of 401(k) assets -- 40 percent of assets in large plans -- are invested in company stock. The spectacular failures of Enron, Polaroid, and Global Crossing should have driven home the downside of this risky practice, as large numbers of workers lost their jobs and retirement savings at the same time.

Undermining Pension and Health Systems

Instead of bolstering pension and health-care protections for middle-class Americans, the Bush administration's commitment to an ownership society has led it to propose policy changes that will undermine existing programs. On the pension side, the president's 2005 budget introduces a set of new tax-preferred accounts, including the Retirement Savings Account and the Lifetime Savings Account, which would operate something like supercharged Roth IRAs. A couple with two children could put as much as $30,000 per year into these accounts -- before putting a single dollar into a 401(k) plan -- and the money could grow and be withdrawn tax-free.

One rationale for these proposals is to circumvent current limits on IRA and 401(k) accounts and thus increase savings. But whose savings? Middle-class families can't save $30,000 per year because they earn only slightly more than that. And regular people are simply not constrained by the current rules. Only 5 percent contribute the maximum to their IRAs and only 8 percent to their 401(k)s. The only people who would gain from the higher limits are the wealthy.

For middle-class families, the new accounts would more likely lead to a reduction in pension coverage. Under current law, the owners of small- and medium-sized businesses can enjoy the valuable tax advantages of qualified pension plans only if they comply with the nondiscrimination rules and provide benefits to the rank and file. With the proposed savings accounts, most business owners would be able to save just as much money and reap equivalent tax advantages for themselves without incurring obligations to anyone else. As a result, they would be less likely to establish pensions for their employees.

In the area of health benefits, the ownership-society ideal has produced health savings accounts. A provision of the Medicare prescription-drug law passed in 2003 allows individuals and their employers to put a total of $2,600 ($5,150 for a family) of pre-tax dollars into such accounts. Although this part of the legislation has received little attention, it could have a sweeping impact on the American health-care system.

The danger is that health savings accounts could undermine the pooling of risks that are central to the existing employer-sponsored system. If given the choice, the healthy and the wealthy will tend to opt for a medical savings account plus a comparatively cheap catastrophic health-insurance policy. (The healthy think they are unlikely to get sick and the wealthy are well-heeled enough to cover the higher deductibles of a catastrophic policy.) This would leave the old comprehensive health plans with a growing proportion of poor and sickly members and sharply higher costs. If the premiums for these plans were to rise much as a result, employers might well decide to offer only catastrophic coverage and let their employees rely on individual savings accounts to cover most of their health-care bills. And if ordinary families are unable to save as much in their health accounts as they end up needing? The system would offer no provision for them.

The tax treatment of the health savings accounts is extraordinary. Tax preference accounts such as IRAs exempt either contributions or withdrawals from tax. But in the new health savings accounts, both contributions and withdrawals are exempt, so long as the money is used for health-care purposes. To further spur the use of health savings accounts, President Bush proposed in his State of the Union address that premiums for catastrophic policies be fully tax deductible.

Wealthy people could gain greatly from such tax provisions. But the more attractive we make individual health and retirement accounts for the rich, the more likely they are to harm middle-class workers and their families by undermining the pension and health-insurance systems on which so many ordinary people rely.

Gutting the Federal Budget

Even more threatening than these legislative proposals has been the gutting of the federal budget. When President Bush took office, the Congressional Budget Office (CBO) reported a 10-year surplus of $5.6 trillion for the period of 2002-11. The CBO now projects a $1.9 trillion deficit over the period of 2005-14. Neutral observers such as the Concord Coalition, which is not constrained by the CBO's mechanical rules for calculating a baseline budget, see a 2005-14 deficit of $5.3 trillion.

What turned the budget world upside down? Some factors were unforeseeable. The CBO's economic assumptions turned out to be too optimistic; the office did not forecast the recession that was only a few months off when it made its original projections. The budget model, based on patterns observed during the bubble of the 1990s, overpredicted revenues. The events of September 11 resulted in large expenditures for defense and homeland security.

But the main reason for the swing from surplus to deficit was tax cuts. These cuts have substantially reduced government revenues and could bring about even larger reductions in the future if the president succeeds in having them made permanent. The Center for Budget and Policy Priorities estimates that over the next 75 years, the long-term cost of retaining the tax cuts will amount to between 2.3 percent and 2.7 percent of the gross domestic product. This exceeds the combined 75-year deficit in the Social Security (0.73 percent of the GDP) and Medicare (1.11 percent of the GDP) programs. In other words, President Bush is giving away the money that could solve the Social Security and Medicare financing problems. Nothing could be more harmful to the future security of middle-class workers.

Social Security, private pensions, and our employer-sponsored health-insurance system have been extremely successful programs. Because of them, being old in America no longer means being poor. But this success is about to be reversed. Enthusiasm for replacing our existing social-insurance systems with personal savings accounts and a gutted federal budget threatens to make old age and poverty once again synonymous for much of the American middle class.