Principles of Privatization of Social Security

Principles of Privatization of Social Security

August 01, 1995

The new financing method for Old Age and survivors Insurance must be based on individual investment through private sector agents in real, wealth-producing assets. OASDI must be changed over time from a defined benefit retirement plan to a defined contribution pension. The actuarial value of future benefits earned will be directly linked to two factors:

(1) The amount of employment-based earnings that is "saved" and invested by each worker in new Personal Security Accounts.

(2) The efficiency of the worker's investment choices,

Instead of providing retirement benefits through payroll tax financing of a pay-as-you-go, intergenerational social insurance program, the new system will be based on private saving, decentralized investment decisions, and market-based insurance.

The New System As Fully Implemented

Once past difficult transitional issues, the mature, privatized retirement system of the future would operate as follows:

Let's assume that workers and their employers each would still be required to "contribute" the same combined percentage of covered, wage-based earnings (12.4 percent) as under current law for the Old Age, Survivors, and Disability Insurance (OASDI) programs. (In order to shore up the DI program, the OASI share of this payroll tax ranges from 10.52 percent in 1995 and 1996, to 10.7 percent in 1997 through 1999, and finally settles at 10.6 percent beginning in 2000.)

The portion of wage income that is directed into contributions could be taxed in either of two ways. One approach would subject contributions to income tax when they were made, and then allow tax-free interest buildup and no further taxation upon accrued funds when they are withdrawn. (This would help to ease somewhat early transitional budgetary pressures on the federal Treasury.) In the alternative, if contributions are made with pre-tax dollars, federal and state income taxes would be imposed as retirement payment withdrawals were made. The latter approach would diminish opportunities for after-the-fact political reneging on promised tax advantages for such retirement saving. In any event, double taxation of saving would be eliminated in a manner consistent with future rounds of tax reform and simplification. It also would be possible, but less desirable, to distinguish between the tax treatment applied to the 50 percent share of benefit payments stemming from the employer portion of federal payroll taxes supposedly "contributed" on behalf of workers in prior years and the taxes applied to the other half share of retirement benefits due to payroll taxes imposed directly on employees (taxing only 50 percent of benefit payments after retirement).

Under a privatized retirement system, an individual worker would direct his employer to send his combined employee-employer contributions (on the same periodic basis as under current OASDI law) to the particular professionally managed investment plan that the worker has selected to handle his retirement savings. The worker should be able to choose from a wide menu of investment vehicles that could vary in aggressiveness and style. Employers could well take an active role in organizing the choices available to their workers, but they should not be the sole source of investment options. Investment plans must be able to actively compete for business, as long as they first have cleared the type of basic regulatory screening that is imposed today on the managers and custodians of mutual funds, pension plans, and other tax-advantaged retirement vehicles like IRAs and 401-Ks. Investment plan managers would mail quarterly statements to each workers, indicating the current value of their accounts.

Upon changing employment, a worker's investment account would be portable and remain under the worker's control. A new employer would be instructed to direct future combined contributions to the worker's preferred investment plan. These new contributions would be added to the funds that had already accumulated in the worker's personal security account. Workers would, of course, remain free to change investment plan managers and transfer their accumulated retirement account balances to them, after giving appropriate notice.

The worker's own individual risk preferences would guide the investment of such retirement fund balances. Paternalistic asset allocation rules and other protective risk assessment guidelines by federal regulators should be kept to a minimum.

Each individual participant in this retirement system would hold a personal property right to the accumulated value of the contributions and investment earnings in their personal security accounts. In the event that a worker died before withdrawing all or any part of his re~irement account, the balance would pass directly, in the absence of a designated survivor beneficiary, to the heirs of his estate (unlike the current OASDI system) .

Although a case could be made for eliminating any minimum age for retirement benefit withdrawals (as long as a minimum balance has already been accumulated), it would be better on balance to retain such a baseline for the personal security account portion of the reformed, privatized retirement system. Keeping the minimum retirement age (MRA) baseline would help limit the scope of political decisionmaking needed to resolve the issues of minimum benefit guarantees and maximum annuity payouts for retirees. The MRA initially would remain at the current level of 62, but it might be adjusted in concert with future increases in the normal retirement age (NRA) for those beneficiaries remaining in the transitional vestiges of the old OASDI program. In that case, it t also would then be indexed in years beyond that to reflect further increases in average longevity. However, the likely political backlash against denying previously available retirement benefits to younger retirees, some of whom might indeed find it physically difficult to work in particular occupations, is probably more trouble than the modest budget savings from such a move are worth. Actuarial reductions based on scheduled increases in the NRA already will be reducing the level of benefits available to the youngest retirees.

Minimum benefit guarantees should be kept to a minimum. This politically determined level would probably be higher than today's SSI minimum benefit, but ideally would remain lower than today's average benefit for low-earning workers, which is a little over $6000 annually. However, since this minimum benefit would be provided only on a means-tested basis, it could be set a little higher. Direct linkage between minimum guaranteed benefit levels and the minimum wage earnings of full-time workers should be avoided, in order to dampen the dangers of unanticipated political side effects and coalition synergies. (Labor lobbyists pushing for minimum wage rate increases should not be handed an immediate tool to harness senior groups arguing for higher minimum retirement benefit guarantees.)

Under the new system, when a covered worker chooses to retire (at the minimum retirement age or later), he might be required first to withdraw sufficient funds from his personal security account to purchase a life annuity from private insurers that would provide payments equal to the minimum benefit (indexed for inflation). Any such requirement should stop well short of mandating full or extensive annuitization of personal security account balances, given the limitations of current markets for private annuities, as well as the diverse preferences of older Americans. Participating insurers might be required to offer additional survivors benefit options at this time, but their purchase would not be mandated. One possible checkpoint for determining eligibility for minimum guaranteed benefits could involve the identification of new retirees whose personal security account balances are insufficient to purchase the full amount of a minimum benefit annuity, plus a survivor's benefit. Those retirees could have their accounts supplemented (on a one-time basis) with sufficient general revenue pay for the annuity).

At the time a worker decided to retire, he could also withdraw additional portions, or all, of the remaining fund balance in his personal security account in order to purchase an annuity in a larger amount. Alternatively, he could voluntarily withdraw some or all of the remaining fund balances directly, but only after first purchasing the required minimum benefit life annuity. Or he should be allowed to purchase alternative financial instruments and investments that have the operative effect of ensuring payment of an adequate income stream at levels equal to or above those of the minimum benefit guarantee.

Transition Issues

The move from the old OASI system to a national retirement plan based on individually directed personal security accounts must directly confront difficult transition issues. We must phase out of a 100-percent defined benefit structure to a completely defined contribution structure across various generational cohorts of workers. This will require gradual integration of two separate sources of retirement benefits. Even as the benefits under the OASI structure gradually decrease, they will be replaced by investment returns on the growing sums of individual contributions devoted to personal security accounts.

The transitional financing for the hybrid retirement system of at least the next four decades must meet several simultaneous challenges. It must pay for the sunk costs of benefits promised

to current retirees. The financing system also must provide enough money to fully fund the personal security account system of the future for young adults just entering the workforce. The hardest task is to also provide hybrid financing for several cohorts of current workers (primarily those in their 50s and to a lesser extent 40s -- workers in their 30s and 20s are most likely to perceive the superior benefits for them of privatized investment through personal accounts). These workers will need sufficient funding to cover the reduced level of guaranteed OASDI benefits that they will receive during the transitional benefit structure, but they still must be able to afford the defined contributions that they will make (during the remainder of their pre-retirement working lives) toward their new personal security accounts.

The current OASI system largely operates on a pay-as-you-go basis. The new system would abandon the intergenerational float that defers financing of long-term liabilities. This poses sizeable short-term fiscal problems in the form of a double payment burden. Young and middle-aged workers will be hardpressed to simultaneouly prefund their own retirement and underwrite the benefits of current retirees through payroll taxes.

To the extent that payroll tax revenues are redirected to personal savings accounts for current and future workers, the unfunded obligations remaining under OASI must be brought back into fiscal balance by changes in spending commitments, rather than by newer and higher taxes. Payroll tax rates already have risen substantially in recent decades, and further rate hikes will only further undermine future economic growth and negate much of their proposed revenue gains. Raising the payroll tax rate another 2 percent of taxable payroll, for example, would increase the unemployment rate an additional one percent.

At one time, the prospect of several decades of "surplus" payroll tax revenues produced by the 1983 Social Security amendments offered an additional pot of money that could be redirected for down payments on privatization. However, more than one decade's worth of the OASI surpluses has already been squandered on other, additional federal spending. Projections of future OASDI surpluses have also been scaled back in the wake of lower economic growth since the late 1980s. The remaining surpluses may allow for a small step in the direction of funding personal security accounts (perhaps one percent of taxable payroll could be redirected from payroll taxes to new personal security accounts over the next ten to fifteen years), but much more revenue must be freed up to finance the double payment burden and increase the pace and scope of a privatized Social Security system.

Financing of OASI reform, then, must come from a combination of five sources:

  • Further spending reductions in the rest of the federal budget,
  • Reduced growth in future OASI benefits,
  • Increased efficiency gains through private sector investment via personal security accounts,
  • A longer transition period in moving to a full defined contribution retirement system, and
  • Reliance on additional federal borrowing within specified time limits.

The first two sources should be emphasized the most. The third source (investment efficiency) represents mostly a more optimistic outlook, but is less easily manipulable. The fourth source constitutes a less desirable, but perhaps necessary, political concession. The fifth source should be kept to as much of a minimum as possible, since it offsets greater private saving with additional public dissaving. Its greatest justification is that it helps spread the burden of transitional financing across several generations and also indirectly distributes an increased share of the gains from privatization to older cohorts of current workers

The long-term transitional financing would be very manageable under a straightforward benefit swap over time, if one left aside the issue of future unfunded claims by current retirees and older workers nearing retirement age. Claims to future defined benefits under OASI would in effect be exchanged for the right to reduce payroll taxes. The payroll taxes would then be invested for long time periods in wealth-producing assets that, on average. Such investments would conservatively yield several multiples of the "risk-free" return promised (but increasingly less likely to occur) on workers' tax contributions under the old OASI benefit structure. For new workers entering the system, and even for many younger workers whose previous payroll taxes already have been spent to finance benefits of current and previous retirees, the combination of more efficient private sector investment, plus the effect of compound interest over time, would easily exceed several times over any defined benefit claims under OASI that they would have to relinquish in exchange.

However, if OASI spending commitments to current retirees and older workers remain unchanged, and if no other federal spending patterns are adjusted downward, the task of starting and completing a full transition to a defined contribution system by relying on investment efficiency gains alone will quickly become much more difficult, if not unworkable, to complete. Therefore, one of the major hurdles to be faced involves the need to bring current OASI benefit promises back into long-term actuarial balance.

The second hurdle then becomes finding a combination of additional budget savings. The package would come from two sources:

  • Reductions in other, non-retirement areas of federal spending
  • Further benefit reductions for the later generations of workers who would claim only partial benefits under OASI and use the funds from a partial reduction in their payroll taxes to begin financing personal security accounts.

It would be very helpful, if not crucial, to get over the first hurdle before taking on the balancing act of surmounting the second one. The need to restore OASI back to long-term actuarial balance must be done in any event. (Even when this goal is accomplished, it only means that financing is covered over 75 years on an intergenerational transfer basis. There would still be no net additional prefunding over the entire time period..)

There are two major advantages to completing this task sooner rather than later. First, benefit adjustments can be phased in to a smaller degree and over a longer time period. Second, once such reductions in projected benefits are established, later generations of workers will be more eager to withdraw from the less attractive benefit deal under OASI in order to gain the higher-yielding returns available through personal security account investments. The calculus of the switch from defined benefits to defined contributions will be further tilted toward privatization.

Bringing future benefits under OASI into line with projected revenues (leaving aside the issue of privatization) essentially means slowing the real rate of growth in promised benefits. Such benefits will approximately double in real terms for average workers over the next 75 years under current benefit formulas. Although there are number of various policy options to trim benefit growth, the two best ones (to be used in combination) are further increases in the normal retirement age (NRA) and reductions in the benefit formula replacement rates for average and high-wage earners.

The NRA should be increased to 70, in gradual stages but at a more accelerated pace than the currently scheduled hike to 67, over the next three decades. As noted above, the minimum retirement age should be left alone, but full actuarial reductions (from the increased NRA baseline) would be made in the benefits of future early retirees.

Replacement rates for high-earning workers could be adjusted in several ways (adding a third bend point with a much lower replacement rate of about 10 percent, trimming the growth of the second AIME bracket covered by the 32 percent replacement rate, and/or switching from wage indexing to price indexing of benefit formula bend points).

Even after OASI is brought back to long-term actuarial balance, further spending reductions must be made to provide the fiscal leeway for the full transition to a defined contribution system. Further reductions in promised OASI benefits would help to some degree, but they would fail to deliver the short-term savings needed to ease the remaining double payment burden. The most valuable source of savings would come from the rest of the expenditure side of the federal budget. Working Americans would in effect be making a clearcut business decision. They could trade off the limited benefits of the most marginal areas of public spending, in exchange for the much higher-yielding returns available on private investments in their personal security accounts. Given conservative assumptions about investment returns and holding periods, it would take a budget spending reduction of about 1 percent of GDP to cover a reduction in payroll tax rates of about 2 percent. The fiscal proposal to workers would be: You can invest more of your money in personal security accounts, instead of paying more payroll taxes, if you support additional reductions in federal spending.

To the extent that reductions in federal spending alone are not large enough to cover all or most of the double payment fiscal gap, three alternatives remain.

Deeper cuts can be made in the promised rate of growth in OASI benefit levels for middle-aged workers who are willing to pay an "exit penalty" in order to accelerate their own transition to a defined contribution system. Instead of simply unwinding benefits from the current replacement rate formula (treating diverted payroll taxes as an proportionate reduction in wages credited under the OASI benefit formula), such benefit reductions could be tilted in either of two more progressive directions. The benefit offsets could treat the reduced payroll taxes for an exiting worker as if they came from reduced wage earnings credits at the top end of the AIME replacement rate formula. This would provide less of a benefit reduction. But while the reduction would be neutral for high-earners, it would be more favorable for lower-earning workers. On the other hand, a higher replacement rate penalty (above the normal 15 percent rate after the second bend point) could be used. This would not discourage lower-earning workers from exiting OASI as rapidly and as fully (as long as the penalty rate remained below 32 percent -- the current intermediate replacement rate after the first bend point). It would, however, selectively penalize the higher-earning workers (currently affected on the margin by the 15 percent replacement rate) who felt they could still come out ahead under a personal security account system.

Another method of benefit cuts, for middle-aged workers caught midway in the transition from a defined benefit program to a defined contribution system, would be to arbitrarily write off all or a portion of future OASI benefits according to generational cohort. For example, workers currently in their 20s would forfeit any OASI claims. Workers in their 30s would have their OASI benefits reduced 50 percent. Workers in their 40s -25 percent. Workers in their 50s -- 10 percent. Using a meat cleaver approach would cause a few unwieldy notch problems, but a more graduated set of reductions would increase administrative complexity.

Phasing in the transition to full funding of personal security accounts for younger workers (perhaps in graduated steps of 2 percent of taxable payroll every five years) would buy a little time and relieve short-term fiscal pressure.

The remaining, least desirable stop gap to temporarily fill the double payment hole would be to increase federal borrowing and guarantee the future, readjusted OASI claims of current workers with Treasury bonds. The bonds would be placed in the personal security accounts of individual beneficiaries, but short-term cash flow pressure could be relieved by structuring the bonds as zero-coupon obligations with staggered maturities based on the projected retirement ages of individual workers.

Remaining Items

The Disability Insurance program also needs major restructuring, but it should be kept separate from the new retirement system. The current amount of payroll tax revenue dedicated to the DI program should be rearranged within a system that begins either to require younger workers to purchase private disability insurance, or provide a means-tested, general revenue safety net for disabled workers. Rules for determining continuing eligiblity under the DI program need to be tightened, but that has proven politically and legally difficult in the past. More incentives for returning to work and getting off the disability rolls are needed. Parallels to welfare reform are clear.

Taxation of social security benefits, at a minimum, should be revised to decoupll:_~ it from the thresholds of other income (in return for a smaller portion of benefits beig subject to tax). Ideally, it should be completely repealed (in return for a reduction in replacement rates for higher-earning workers).

The earnings penalty on older workers who receive OASI benefits should be repealed, or at least reduced by raising its earnings thresholds.

No changes in cost-of-living adjustment guarantees, apart from technical cleaning up of the CPI calculation.

Absolutely no federal government investment (or indirect guidance of investment) of newly-freed OASI reserves.