No Easy Way Out

Fixing Social Security can't be painless.

John Attarian from the July 1996 issue

"In years past, you could hold a hearing like this in a bowling alley at 3 a.m.," observed Sen. Alan Simpson (R-Wyo.) on March 25, when a Senate subcommittee heard testimony from members of the Advisory Council on Social Security. The 13-member advisory council is the latest incarnation of a committee that has been appointed by every administration since FDR. Usually its reports do not receive much notice. But the current advisory council, appointed in 1994 by Secretary of Health and Human Services Donna Shalala, has been considering dramatic changes in the Social Security system, including various forms of privatization. Its report, which was scheduled to be released in April, has been anxiously awaited, with politicians and journalists trying to predict the recommendations of the deeply divided panel. Meanwhile, the House Public Pension Reform Caucus, co-chaired by Reps. Jim Kolbe (R-Ariz.) and Charles Stenholm (D-Tex.), has attracted about 40 members from both parties since it was formed last August. As Simpson noted at another Social Security hearing in March, "People are talking about this issue as never before."

That's because they are finally starting to recognize that, without fundamental reform, the Social Security system will start to collapse in the second decade of the next century, as the baby boom generation retires. A number of reformers have proposed ways to avoid the crash (see "Retirement Plans," March). So far, however, these plans have not received close scrutiny. Given Social Security's importance in our national life and in the retirement calculations of millions, and the pain that its bankruptcy would inflict, the temptation to escape into utopian quackery is enormous. For the sake of all concerned, it must be resisted, lest we embrace some clever but unsound scheme promising Americans their fantasy: a painless ending in which no hard choices are made, no one gives up anything, and everybody is happy.

A case in point is National Development Council Chairman Sam Beard's proposal to divide Social Security's payroll tax into two tiers, one to pay current retirees' benefits, the other to be invested in individual investment and retirement accounts (IRAs). Beard has been promoting his scheme assiduously, in Policy Review, in The Wall Street Journal, and in his book Restoring Hope in America: The Social Security Solution, recently published by the Institute for Contemporary Studies. Beard's book exhorts readers to join a citizens' campaign for his plan; it even offers "talking points" to help them. Republican presidential candidate Steve Forbes similarly proposed putting part of payroll taxes into IRAs or 401(k) plans. Certain to be prominent in the Social Security reform debate, Beard's plan is a good candidate for a hard look. It doesn't pass muster.

In his book Beard claims that his plan can "turn every hard-working American into a millionaire" via "a radically redesigned Social Security system." By century's end, more than 100 million Americans will be earning at least $10,000 annually. "Allow them to set aside their Social Security payments into personal investment and retirement accounts--and they will become millionaires."

Beard would "begin by keeping our promises to current retirees," using Tier 1 of the payroll tax. "Most of your Social Security taxes will be pledged to pay the Social Security of existing retirees." For Beard deems Social Security "a sacred contract" and intends to pay current retirees all benefits "as promised under the existing system," i.e., mandated by present law.

One's remaining payroll taxes would go into Tier 2 for IRAs. "Will it require paying higher taxes? No." Anyone who paid at least $500 in payroll taxes could participate. Drawn from payroll taxes and voluntary savings, Tier 2 contributions would be capped at $3,000 a year. The first $500 in payroll taxes would go automatically into Tier 2, matched by payroll taxes paid by your employer, up to a total of $1,560 in taxes. Workers earning $12,580 or more could have set-asides of $1,560, $2,500, or $3,000. To increase your set-aside to $2,500, you would add $628 in savings, matched by another $314 in taxes. To hit the $3,000 maximum, $1,500 in payroll taxes would be matched by $1,500 in savings.

This money would grow into huge nest eggs: "If you earn $12,580 or more per year, you can amass a capital pool of $1,291,433 with $30 per week set aside from your taxes." How? "The magic of compound interest": 8 percent interest generates that sum in 45 years; $2,005,799 in 50. Since the return on the Standard & Poor 500 stock index during the past 70 years has averaged 10.2 percent, Beard argues, a rate of 8 percent is not farfetched.

Besides saving Social Security, Beard's scheme to create "100 million millionaires" serves another agenda: to "democratize capital ownership" à la Louis Kelso, father of Employee Stock Ownership Plans (ESOPs). Most wealth, Kelso argued, is produced by capital. "The magic of compound interest" would enable workers to become rich and obtain a second income: payments from their capital. Furthermore, this "mind-boggling" additional wealth--100 million millionaires means a $100 trillion capital pool--would have "unprecedented" potential to stimulate economic growth. A tempting prospect indeed.

Unfortunately, Beard's plan is untenable. Use payroll taxes to simultaneously keep all of Social Security's promises to current retirees and create "100 million millionaires"-- without tax increases? It can't be done.

Before we adopt any two-tier scheme, the first thing to ask is this: Assuming we're going to pay current retirees full benefits under present law, how much of the payroll tax must be retained to do so? This question is the crux of the matter, since its answer determines the scheme's possibilities. Yet Beard nowhere asks, much less answers, it. Indeed, he doesn't even seem to realize that it needs asking.

A handy way to answer the question is to consider the recent performance of the payroll tax. In recent years its revenues have been not only paying benefits but creating trust fund surpluses. From 1985 to 1995, the surplus of payroll tax revenue over benefit payments averaged 9.6 percent of revenue. So in an average year, 90.4 percent of revenue went to pay benefits, leaving 9.6 percent for the trust funds. This generates a rough proxy for the Tier 1/Tier 2 split that a commitment to pay current retirees full present-law benefits would dictate. Honoring that commitment requires (rounding to simplify things) 90 percent of payroll taxes, leaving only 10 percent for Tier 2. But this means that if we insist on paying current retirees full benefits, most Social Security taxpayers would have virtually nothing left for their IRAs--nowhere near enough to create a million-dollar nest egg in 45 years.

A $10,000-a-year worker putting 90 percent of his $1,240 combined employer- employee payroll tax into Tier 1 would have only $124 a year, or $2.38 a week, left for Tier 2. After 45 years at 8 percent, this would grow to just $102,652.

Higher-income taxpayers won't hit the cool million, either. At $61,200, Social Security's maximum taxable income, a 90/10 split of the $7,589 payroll tax leaves only $14.60 a week to invest, which would generate only $628,067. Not even the highest- income taxpayers, then, would be able to have "$20-$30 a week set aside from your taxes"--not while paying full present-law benefits. Becoming a millionaire would require adding far more voluntary savings than Beard contemplates.

Besides, these are only nominal-dollar nest eggs. By Beard's own admission, adjusted for 4 percent annual inflation, $1,291,433 becomes $229,935; $1,026,524 shrinks to $182,769. Our $10,000-a-year worker's $102,652 thus becomes $18,277.

Not only does Beard ignore the issue of how much payroll tax would be needed to pay benefits, but his plan counts payroll taxes twice. He says "most" payroll taxes would go into Tier 1 to pay current retirees' benefits. But his book's examples of capital accumulation from money "set aside from your taxes" on incomes up to $12,580 assume that the entire tax goes into Tier 2. And he consistently writes as if all of everyone's payroll taxes would be invested: "Allow them to set aside their Social Security payments...and they will become millionaires"; "the 12.4 percent payroll taxes compounded...will grow very substantially in personal savings and investment accounts"; "if they could set their current tax payments aside...".