Retirement Plans

Genuine Social Security reforms appear surprisingly likely.

Michael W. Lynch from the August/September 1998 issue

In 1992, presidential candidate Bill Clinton, needing to shed the liberal baggage that then accompanied Democrats on national campaigns, promised to "end welfare as we know it" if elected. In 1996, after President Clinton twice vetoed bills that would have done so, Dick Morris whispered in his ear, and the president signed a bill that ended Aid to Families with Dependent Children.

Cut to January 1998. The president's Lewinsky period begins. Facing a hostile press and Congress, President Clinton needed to come up with a zinger or two for his State of the Union address. With his favorite subject--children--temporarily off the table, Clinton shifted his attention to the other end of the age spectrum. Pre-empting Republican dreams of tax cuts, the president promised to use "every penny of any [budget] surplus" to "save Social Security."

Whether Clinton meant it at the time isn't important. Political leaders often set forces in motion they cannot control. And just as Clinton's pre-presidential promise eased the way for welfare reform, his State of the Union speech may mark the beginning of the end for the unsustainable Ponzi scheme known as Social Security.

It is far from a sure thing, but the political planets are in alignment for real reform in 1999: Congressional Republicans have long wanted to reform the system; polls show the public understands something must change for Social Security to remain intact; the budget surplus is accumulating to cover some of the short-term costs that any reform will generate; and high-profile Democrats such as Sens. Daniel Patrick Moynihan (N.Y.) and John Breaux (La.) are joining Republicans in offering serious reform plans.

One reason action is likely is that Washington's policy makers--and many Americans--already know what's wrong with the system: It's a raw deal on the verge of long-term insolvency. They also know what needs to be done to fix it: Transform the system from an intergenerational transfer program to one that is based on invested wealth.

Social Security, as currently structured, faces the twin problems of insolvency and poor rate of return. According to the latest Social Security Trustees report, by 2013 Social Security will begin to pay out more each year than it collects in taxes. At that point, the system's obligations will put pressure on the general budget, as the cash-flow shortfall will have to be made up by some combination of spending cuts, tax increases, or debt finance.

Even as its solvency slips away, Social Security promises to provide Americans currently compelled to contribute to it an extremely poor rate of return. Calculations by the Heritage Foundation show that an average two-income family with 30-year-old parents can expect a dismal 1.2 percent return from the 10.7 percent of its income devoted to Social Security's retirement benefit.

Here's the rub: Under the current pay-as-it-goes structure, the problems of solvency and rate of return cannot be simultaneously addressed. Everyone knows how to increase the system's solvency: Implement a politically unpalatable combination of increased taxes and reduced benefits. But to do this would make Social Security an even rawer deal for those toiling to pay its taxes. Doing the reverse--reducing taxes and raising benefits--would increase the rate of return. But the system's solvency would slip away.

The only way out of this bind is to make the system's assets work harder. And the only way to make the system's assets work harder is for it to actually accumulate assets. As Sen. Phil Gramm (R-Texas) quipped at a Heritage Foundation luncheon, "You cannot set up a wealth-based system without wealth." There are many ways for the Social Security system to begin to rely on wealth, some better than others, some downright dangerous, and all requiring legislative change.

There are three general approaches to fund the system with real assets. One is to maintain the structure of the current system but have its administrators supplement the investment in government bonds with private securities. This is the preference of old-guard liberals such as Henry Aaron of the Brookings Institution. Writes Aaron: "If Congress wants to assure Social Security beneficiaries the same high returns on Social Security reserves that private securities yield, it need only instruct the managers of the trust funds to invest Security reserves in passively managed index funds containing private stocks and bonds."

The perils of this approach are obvious. The risks of letting the federal government own a chunk of corporate America outweigh any return on the investments.

The other two approaches fall under the heading of "two-tiered" systems, meaning that the basic government benefit would be accompanied by a private account. One two-tiered approach would maintain the primacy of the government benefit, while allowing individuals to supplement it with individually owned accounts. Another approach would put the system on the path to more complete privatization, structuring the accounts in such a way that over time the portion of benefits coming from private savings would replace the government benefit for all but the poorest Americans. At present, a consensus in Washington seems to be emerging around some sort of two-tiered approach, a remarkable shift from the days in which any structural change to Social Security was deemed a political impossibility.

Perhaps nothing marks the shift of the center more than the Social Security Solvency Act of 1998, introduced by Sens. Moynihan and Bob Kerrey (D-Neb.). In a speech delivered at Harvard's John F. Kennedy School of Government in March, Moynihan spoke of America's movement away from "government programs--`the nanny state'--towards individual enterprise, self-reliance, free markets." Explaining how a longtime social policy liberal could advocate a reform plan that included a private investment component, Moynihan reminded the audience that "the mother's pension of the progressive era, incorporated into the 1935 legislation, had vanished with scarcely a word of protest." Moynihan asked: "Will the old age pensions and survivors benefits disappear as well? What might once have seemed inconceivable is now somewhere between possible and probable."

The key to Moynihan's plan is that it would privatize a portion of Social Security with the hope of saving the entire system from privatization. The Moynihan-Kerrey plan, which is similar to a bipartisan and bicameral plan offered by Sens. Breaux and Judd Gregg (R-N.H.) and Reps. Jim Kolbe (R-Ariz.) and Charles Stenholm (D-Texas), addresses the system's solvency by increasing taxes and reducing benefits. Tax increases include broadening the amount of earnings on which Social Security taxes are paid, increasing the payroll tax after 2024, taxing Social Security benefits like ordinary pensions, and forcing all newly hired state and local employees into the system. Among the chosen benefit reductions are increasing the retirement age and reducing future cost-of-living adjustments.

The plan addresses the rate of return by cutting the payroll tax by two percentage points immediately and allowing individuals to invest the money in private accounts. The Breaux-Kolbe plan differs from the Moynihan-Kerrey proposal most significantly in that the supplemental accounts are mandatory.