Retirement Plans

Genuine Social Security reforms appear surprisingly likely.


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.

It's important to note that the approach embodied by the Moynihan-Kerrey plan seeks a permanent two-tier system. While 2 percent of one's income compounded over a lifetime amounts to a significant chunk of change, the savings account is designed to supplement the Social Security benefit, not replace it.

Contrast this approach with that of Sens. Gramm and Pete Domenici (R-N.M.). They have developed a two-tier plan that would allow individuals to invest three percentage points of their payroll tax in individual retirement accounts, leaving the other 9.4 percent to cover the costs of current retirees. As with the Moynihan-Kerrey plan, the government would guarantee a minimum benefit. But the goal of Gramm's plan is a fully funded system based on individually owned accounts. Over a period of 50 years, the portion of the payroll tax dedicated to private accounts would increase from 3 percent of payroll to 8.5 percent, as those already locked into the current system die. The government would always guarantee a minimum benefit no less than 120 percent of the current level. But if the economy performs at the historical average, few would have to rely on the government's safety net.

Not surprisingly, this approach is more popular in the House, where Reps. Nick Smith (R-Mich.), Mark Sanford (R-S.C.), Pete Sessions (R-Texas), and John Porter (R-Ill.) have introduced bills that would put the system on a glide path to privatization. Their plans, while falling in the same category as the Gramm-Domenici proposal, would carve out different amounts targeted for private investment, ranging from 2.8 percent in Smith's proposal to 10 percent in Porter's.

None of these plans is perfect. Daniel Mitchell of the Heritage Foundation and Ed Crane, president of the Cato Institute, criticize each of the Senate plans as too timid. Mitchell, who has studied Britain's two-tiered system, maintains that at least 5 percent of payroll must be deposited into private accounts for the system to work. Crane, who seems generally cranky with Congress, says at least 10 percent ought to go into private accounts.

A Social Security analyst from the Hill notes that the plans' numbers don't always support the sponsors' rosy claims. Moynihan's approach, after all, solves the solvency problem the old-fashioned way: by increasing taxes and lowering benefits. Gramm relies on the fictitious Social Security trust fund to solve what he calls the short-term "cash flow problem," otherwise known as transition costs.

But another way of interpreting the proposals' moderation is the seriousness with which politicians are taking the issue, now that Social Security reform is a legislative possibility, rather than just an applause line in Republican after-dinner speeches. Gramm picked the 3 percent figure after analyzing two independent variables: the lowest amount of average payroll that a 22-year-old would need to invest to be fully self-supporting at retirement and the highest amount of average payroll that would be politically feasible to fund during the transition.

Gramm is upfront that funding the transition to his system, which would be 3 percent more expensive than the status quo in the short run, would come from three sources: the budget surplus, redirection of some corporate taxes, and 71 percent of the Social Security trust fund. "No one should think [this] is a free transition," warns Gramm. "[It] is going to require cutting spending or raising taxes or incurring debt in order to do it." The bottom line for Gramm, however, is that it is worth doing even if it is necessary to raise taxes to liquidate the trust fund, since funding the current system will also require tax increases. Says Gramm, "The benefits of the transition are so big, you would want to do it even if you had to fund every penny of it by raising taxes."

The Breaux-Kolbe plan too is designed to become law rather than please activists. When asked why his plan doesn't more aggressively move Social Security to a wealth-based system, Kolbe cites the political importance of retaining a government safety net. "When I started out, I was really [leaning] much more towards the Chilean, individual savings account," he says, referring to the much revered plan enacted by Chile in the early 1980s that is entirely based on mandatory savings. "But I realized politically it wasn't going to work."

At any rate, these plans are simply blueprints of possibilities. With congressional elections in November, nothing will happen until the next Congress. President Clinton, who promises to "fix the roof while the sun is shining," will sponsor a White House conference on Social Security reform in December. In January, he promises to huddle with congressional leaders to craft a passable plan.

Is Social Security reform likely to end the injustice of the system's coerced savings or bring riches to Americans in their golden years? No. But if it allows individuals a chance to invest a portion of their payroll taxes, it will take an important step in the right direction. What is more noteworthy is how far the center has shifted. Says Kolbe, "I've heard Dick Morris say on a couple of occasions that he told Clinton a couple months ago that his legacy would be Social Security."

Once again, the crafty political consultant may have whispered in the president's ear at an opportune time. Come 1999, there may just be a bipartisan deal working its way through Congress that will actually benefit us all.

Michael W. Lynch (mlynch@reasondc.org) is Washington editor of REASON.