Social Security: The Right Fix

Last year, President Bush appointed a commission to design a Social Security reform that included voluntary individual accounts. Appointees chosen for the commission were all sympathetic to this partial-privatization approach. Before signing on, they also accepted the commission's charge of restoring long-term financial soundness without increasing payroll taxes. In December the commission presented three plans (called models). The political response has been intriguing. Congressional Republicans, evidently concerned about voter backlash, have kept their distance from the plans. House Democrats, meanwhile, have introduced bills containing the plans (which they oppose) in an attempt to force the Republicans to take a stand. Today it's hard to find a Republican who admits to supporting "privatization," and some are walking away from any form of individual accounts.

But privatization of Social Security is only sleeping, not dead. Social Security is likely to play a key role in the November elections. And if supporters of individual accounts win control of the Senate while maintaining control of the House, they might well try to enact a Social Security plan resembling a commission proposal.

Advocates of privatization often link individual accounts with the need to shore up Social Security's finances. But individual accounts would add a drain on the system. Right now Social Security is running a big surplus. Last year it took in $163 billion more than it spent, with the system investing the surplus in special U.S. Treasury bonds. The Office of the Chief Actuary of Social Security projects that over the next 75 years, the benefits written into current law will cost more than the revenues provided. The excess cost is roughly equal to 1.9 percent of taxable payroll, so raising the payroll tax rate by 1.9 percent (or 0.95 percent each on employers and employees) could cover the costs. This suggests that the long-term financing problem is real but not overwhelming.

The individual accounts in all three of the commission's models would exacerbate these financing problems, requiring additional benefit cuts, more government borrowing or increased revenues. Model One simply carves an individual account option out of the existing Social Security program. A worker could choose to invest 2 percent of taxable earnings (out of the 12.4 percent collected for Social Security) in stocks and bonds. But anyone diverting this revenue into an account would have to pay Social Security back for the money, accumulated with interest, through a reduction in traditional Social Security benefits at retirement. If a married worker died before retirement, the surviving spouse would get both the individual account and the obligation to pay back the diverted revenue out of his or her traditional benefits, and so the inheritance might be negative.

The accounts create a cash-flow problem for Social Security. The funds are diverted into individual accounts decades before traditional benefits are reduced as a result of the diversion. The Social Security Trust Fund would thus run out of money eight years earlier than it would under current law. If two-thirds of workers signed up for the accounts, the 75-year imbalance within Social Security would rise from 1.9 percent to 2.2 percent of payroll. Workers would have assets in their accounts, but Social Security would be in a deeper financial hole.

In addition to new individual accounts, Model Two cuts traditional benefits so much that if no one signed up for individual accounts, Social Security would be balanced over the next 75 years (and beyond) with no additional revenues. The plan achieves this balance by changing the determination of benefits for new retirees: Under current law, initial Social Security benefit payments increase with the ongoing growth in average real wages; under the proposal, the increase would only be with prices. Thus, Social Security would replace a steadily shrinking fraction of previous earnings. The cumulative cuts are huge and increase over time: 17 percent for a current 35-year old, 41 percent for a baby born this year.

Voluntary individual accounts would be carved out of this shrinking Social Security program. But even with these large cuts, financial problems remain. As with Model One, Social Security would have a cash-flow problem, because funds would be diverted into individual accounts well before they would be repaid through reductions in traditional Social Security benefits. But unlike Model One, the individual accounts in Model Two would be subsidized -- by charging lower interest on the revenue diverted into individual accounts than could be earned on Treasury bonds. Thus, the trust fund would receive back less than it could have earned if the funds had not been diverted. The accounts, therefore, would produce a permanent drag on the trust fund.

Notwithstanding these huge cuts in conventional Social Security relative to wages, this option would require additional money. If everyone signed up for these subsidized accounts, Social Security would need two-thirds as much general revenue to get through the next 75 years as it would if we left the program alone. Model Two thus gives us steadily shrinking traditional benefits relative to earnings while curing only one-third of the 75-year financial problem.

The commission does not have a single word to say about where government should get the money, which totals more than $2 trillion. It was one thing for President Clinton to propose using projected surpluses for transfers to Social Security rather than for a tax cut. But it is very different for President Bush to call for large transfers to finance individual accounts after pushing for and signing a large tax cut -- primarily for the well-off -- that leaves a large deficit even before the baby boomers start retiring. What is likely to happen to traditional benefits when the money isn't there? Future retirees would have their individual accounts (less the cost of repaying their debts). But how would Social Security pay benefits to the already retired?

Model Two also cuts benefits for the disabled and for children of workers who die. A worker starting disability benefits in 2030 would receive benefits one-fifth below scheduled levels.

The third commission model bases some of its benefit cuts on life expectancy. In principle, adjusting the system in anticipation of longer lives is a good idea. Social Security benefits and Social Security taxable earnings already change each year depending on the growth of prices and wages. A sound approach would be to have automatic adjustments in both benefits and revenues that depend on the growth of life expectancy.

But while Model Three has an automatic adjustment for longer lives through reductions in benefits, it does not include any automatic increases in taxes. A more sensible approach would be to adjust both taxes and benefits for longer lives. Then the cost of longer lives would be spread out over a worker's entire lifetime, not just during the retirement years.

Beyond relying too much on benefit cuts in its automatic adjustments, Model Three has two financing holes. It proposes to cover one-third of the current actuarial deficit by new dedicated revenues but doesn't recommend any source for this revenue. The commission's report says that some members favored increasing the level of earnings subject to the Social Security payroll tax for part of this revenue flow. But the commission was unable to make such a recommendation because the president had ruled it out in advance.

Model Three's proposed individual accounts, like those of Model Two, are subsidized. As with Model Two, the accounts also create a cash-flow problem, so Model Three needs to draw on general revenue. And the more workers who choose to participate, the more money is needed. Again, the commission has no recommendation for a source for this money.

While cutting benefits in general, the commission also bolsters benefits for two groups: retiring workers (with at least 20 years of earnings and low benefits) and low-benefit surviving spouses. The latter reform has been studied and is sensible; the former has not yet been carefully evaluated. In any case, these modest progressive changes hardly offset the many flaws in the commission's general approach.

By diverting revenue into individual accounts, all three commission plans take money from Social Security that it cannot afford to provide. This diversion creates a financial hole that makes a difficult but manageable problem into a politically unmanageable one. Two of the three plans cut benefits far too much.

Social Security reform is dead this year, but it will surely be a major topic of debate in 2003. Individual accounts could be good policy if they were supplements to Social Security rather than a drain on it. Any compromise reform should also be absolutely clear about a source for the additional money, rather than make vague references to general revenues despite projected budget deficits. Relying on future general revenues that may not be there is leaving a time bomb ticking in Social Security finances.

Instead of a nominally bipartisan commission made up of members whose views were all of a piece, we could benefit from a new commission that reflects the range of views in Congress and in the country. That kind of a commission might actually provide a financially sound remedy that would enjoy broad political support. For example, the 1983 Greenspan Commission included people such as Robert Ball working with congressional leaders, especially Democratic House Speaker Tip O'Neill, and with the Reagan White House. That commission was truly bipartisan, and it produced reforms that kept Social Security solvent for decades.

For a commission to have the room to find a compromise, those running for office this November should not declare their opposition to all benefit cuts or to all tax increases in the future. Addressing Social Security's modest long-term deficit is likely to require both additional revenue and modest benefit reductions in the future. Everyone needs to recognize that the diversion of revenues from Social Security into individual accounts makes the Social Security financing problem worse, requiring larger reductions in traditional benefits than are needed otherwise. This November's election will likely determine whether we get political posturing and acrimony over Social Security, or real solutions.