From the March 2005 issue of Investment Advisor • Subscribe!

March 1, 2005

The Social Security Scrum

Numerous proposals are being floated to reform the system

President Bush declared last month in his State of the Union address that reforming Social Security using personal savings accounts is one of his top priorities. Soon after his speech, Bush took to the road to rally support for his plan. Members of Congress, too, began introducing bills late last year and early this year suggesting ways to revitalize the ailing federal system.

Many lawmakers' proposals embrace the use of private accounts. But, like Bush, lawmakers admit the accounts are only part of the solution. How much it will cost to fund the accounts, and where the money will come from, are the bigger questions. Bush has said he would borrow $2 trillion over 10 years to pay for the transition to private accounts, and not raise payroll taxes. Critics say diverting such a large sum of money from Social Security will cause the federal system to go bust many years before it's projected to, which is in 2042, according to the trustees of the Social Security trust funds. Proposals on Capitol Hill would require smaller dollar amounts to fund the accounts. For instance, Rep. Paul Ryan's (R-WI) bill, The Social Security Personal Savings Guarantee and Prosperity Act of 2004 (H.R. 4851), calls for $575 billion in transition financing over 16 years.

Congressional proposals also differ on how they would get the money to fund the accounts--via an increase in payroll taxes or borrowing from the Treasury Department--and on whether setting up a personal account would be voluntary or mandatory. President Bush wants to make the program voluntary. But a bipartisan bill sponsored by Rep. Jim Kolbe (R-AZ) and Allen Boyd (D-FL), the Bipartisan Retirement Security Act of 2005 (H.R. 440), would require mandatory participation in private accounts. Kolbe said during a recent conference on Social Security held by the Cato Institute, a non-profit public policy research foundation in Washington, that Britain switched to a mandatory private accounts system after its voluntary program failed.

Dallas Salisbury, president of the Employee Benefit Research Institute (EBRI) in Washington, says a voluntary program funded through a carve-out--an increase in payroll taxes--"makes it quite difficult to have a large proportion of people come out better." Salisbury says that "on a run-the-numbers basis, proposals that are an add-on to Social Security and are mandatory create a much higher probability that individuals would be better off in retirement."

Florida Republican Congressman Clay Shaw's bill, H.R. 750, which was introduced February 10, would create an add-on whereby the money would come directly out of the "Treasury and be invested in accounts [managed] by well-known investment houses," he told attendees at the Cato conference. Senator Lindsey Graham (R-SC), however, told conference attendees that he's working on legislation that would take a portion of payroll taxes to fund the accounts. He's also in favor of reducing the 12.4% Social Security tax rate, and increasing the current $90,000 wage threshold that is subject to payroll taxes. "We have to stop borrowing money for every problem that comes to town," Graham said.

The Kolbe-Boyd bill would also create a carve-out whereby 3% of a taxpayer's first $10,000 in earnings would be diverted into a Thrift Savings account--the retirement account for federal employees that includes a mix of conservative stocks and bonds. Once the taxpayer's account reached $7,500, then it would drop to 2%. A person "could then move it into an SEC-approved fund," Kolbe said. Taxpayers "can shift accounts to other investments as they age, and these accounts can be passed on" to their heirs, he said.

It's fair to say that the members of Congress who have introduced bills to remedy the Social Security mess agree that personal accounts will help turn Americans into savers. Rep. Ryan told conference attendees that personal accounts are a great "equalizer of wealth" because "everyone becomes an owner." Michael Tanner, Director of the Cato Institute Project on Social Security Choice, said that the last time personal accounts were floated was in 1983. "The market is up 800% since then, so imagine how much better off people would have been" if the accounts were created then.

Things Have Changed

Social Security's plight is due to its pay-as-you-go funding scheme; there are now far fewer workers to support the benefits of existing retirees and American birth rates have declined. Today, there are only three workers per retiree; back when President Franklin Roosevelt created the system in the 1930s, the ratio was 43 workers per retiree.

Members of Congress also agree that fixing Social Security must be done now. Come 2008, which is right around the corner, the first set of baby boomers retire and the surpluses in the Social Security fund begin to dwindle. "If we don't solve this problem [with Social Security] before the baby boomers slip into retirement, it's over," warned Senator Lindsey Graham.

But Congress faces tough obstacles ahead: hashing over their differences and winning bipartisan support for any proposals. "The first challenge that Congress is going to face is deciding what their objectives are," in reforming Social Security, says Salisbury of EBRI. "When you then match up the proposals against a set of objectives, it helps you do the screening." He adds: "Some of the proposals are based on the objective of not reducing Social Security benefits, and in fact creating the potential of individuals having more than the existing system. Those are not the objectives that the President has put forth."

Everyone--including Democrats and Republican members of Congress who are on the fence--is waiting to see the approach President Bush takes on reducing Social Security benefits, Salisbury says. The Administration floated the idea of indexing Social Security benefits based on the consumer price index (CPI), instead of on changes in wage rates, which critics say would cut back dramatically on benefits. Sen. Lindsey Graham argued that Social Security benefits should be based on wage growth for low- and moderate-income workers, and on CPI for high wage earners.

If the Bush personal accounts are approved, they would be available to taxpayers born after 1950 and would become available in 2009. Workers 55 years or older would see no change in their Social Security benefits. Under many of the Congressional proposals, those people participating in personal accounts would get credit for what they've already contributed to Social Security.

Another sticking point with Bush's proposal is that "the prospect of significant numbers of Americans being able to achieve in excess of a 3% real rate of return in order to do better with the personal accounts would appear to be relatively low," Salisbury says. Why? Just look at Americans' savings and investing patterns. EBRI has "had a database since 1986 on how people invest in 401(k) plans, and a large proportion of participants invest more conservatively by choice than the assumptions being used by the administration." EBRI plans to release a new analysis in early March, he says, which shows that "if you take individuals not yet born so that you assume they were in this new system on a lifetime basis, less than 20% of them would be better off in the existing system."

From a budgetary standpoint, Douglas Holtz-Eakin, director of the Congressional Budget Office (CBO), told Congress on February 9 that Social Security is the single largest program of the federal government. This fiscal year, Holtz-Eakin told Congress, outlays for Social Security are expected to top $500 billion and account for 23% of total federal spending (excluding interest). The CBO projects that money devoted to Social Security will grow from 4.2% of gross domestic product (GDP) in 2005 to 6.5% in 2050, he said. While that growth is significant, "it pales in comparison" with the projected growth in Medicare and Medicaid, he said.

Indeed, Holtz-Eakin, along with the Congressmen who spoke at the Cato Institute's conference, said reforming Social Security is a piece of cake compared to fixing Medicare. The shortfall in Social Security and Medicare combined is $73.8 trillion, Thomas Saving, a member of the Social Security Board of Trustees, told conference attendees. Medicare faces about a $67 trillion shortfall. By 2042, $375 billion will have to be transferred from the Treasury to pay Social Security benefits, Saving said, "which will swamp the budget."

Holtz-Eakin told Congress that the Social Security surplus will reach about $100 billion in 2007. But, he said, by 2025 that surplus is projected to become a $100 billion (in 2005 dollars) deficit. "That $200 billion swing will create significant challenges for the budget as a whole," he said.

Social Security's demand on the budget "will take place simultaneously with--and be eclipsed by--the demand generated by Medicare and Medicaid," Holtz-Eakin said. Federal spending on Medicare and Medicaid, he said, will triple by 2050 to 12% of GDP. "Although Social Security will place demands on the federal budget, those demands will coincide with much greater demands from Medicare and Medicaid," he said.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@ia-mag.com.

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