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Individual Accounts, Social Security Reform, and Retirement Security

Peter R. OrszagJoseph A. Pechman Senior Fellow

The Brookings InstitutionDirector, Retirement Security Project

November 18, 2004

The Brookings Institution, Washington, D.C. www.brookings.edu

Individual Accounts: An Overview• Individual accounts, such as 401(k)s

and IRAs, provide useful supplements to Social Security

• Growing body of evidence on how to boost saving in 401(k)s and IRAs

• But: Individual accounts are inappropriate for basic tier of income during retirement, disability, and other times of need.• Social Security is only source of income for 1/5

of elderly beneficiaries, 90+ of income for 1/3

The Brookings Institution, Washington, D.C. www.brookings.edu

Individual accounts within Social Security: The financing problem

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Benefit offsets

The Brookings Institution, Washington, D.C. www.brookings.edu

Even apart from financing problems, accounts don’t make sense for base income

• Social Security provides assured level of benefits protected from stock market collapses, inflation, and risk of outliving assets

• Social Security benefit formula is progressive, replacing larger share of previous earnings for lower than higher earners (social insurance)

• As pension system moves toward individuals bearing more risks, individual accounts in Social Security make even less sense

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Other problems• Administrative costs

• UK experience: More than 40 percent of account balances prior to retirement consumed by fees

• Average US mutual fund: Roughly 1.25 percent per year

• Individual account system may respond to political pressure for:• early withdrawals• no annuitizationwhich would undermine retirement security

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Bottom line on individual accounts in Social Security

• Even without transition issues, trading Social Security benefits for individual accounts is a bad deal• Individuals already bearing more risk

on top of Social Security• Political pressure to undermine

retirement security

• Financing issues are important

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Diamond and Orszag, Saving Social Security

• Restore long-term sustainable solvency• Do not destroy program in order to save it • No accounting gimmicks or magic

asterisks• No general revenue transfers, no ignoring

risks of stocks

• Combine benefit reductions and revenue increases, rather than relying solely on either• Follow precedent of 1983 Greenspan reforms

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A Progressive Reform• Protect most vulnerable: disabled

workers, young surviving children, lifetime low earners, widows

• Ask average earners to accept modest sacrifices

• Ask higher earners to play somewhat larger role in reaching long-term balance

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Bottom line: Benefits for medium earners

• Benefit reductions less substantial for lower earners and more substantial for higher earners.

• Real benefit levels continue to increase from one generation to the next because of ongoing productivity growth.

Age in 2004

Percentage change in benefits from those

under current benefit formula

Inflation-adjusted benefit at full benefit age relative to

55-year-old in 200455 0.0% 100%45 -0.6% 110%35 -4.5% 118%25 -8.6% 125%

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Bottom line: Payroll tax rate

• If 2045 increase implemented this year, $35,000 earner would pay extra $37 per month in combined employer-employee taxes

• For 25-year-old average earner, present value of additional lifetime tax is 0.3 percent of career wages

Employee rate

Combined employer-

employee rate

Note: Combined rate needed to finance

benefits under current benefit formula

2005 6.2% 12.4% 12.4%2015 6.2% 12.5% 12.4%2025 6.4% 12.7% 12.4%2035 6.6% 13.2% 12.4%2045 6.8% 13.7% 17.0%2055 7.1% 14.2% 17.7%

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Saving on top of Social Security:Existing tax preferences upside-down• Tax preferences provide larger incentives to

high-income households (in 35 percent bracket) than lower-income households

• To raise private saving, must not simply cause shifts of assets but generate additional contributions

• Studies confirm that upper-income households tend to simply shift existing savings, not save more

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What works: How to boost saving

• Make it easier to save• Automatic enrollment plans• Split tax refunds

• Increase incentive to save for low- and middle-income households• Strengthen saver’s tax credit• Reduce implicit taxes on saving (e.g., higher ed

rules)• Revenue-neutral shift from deductions to

universal credit?

• New Retirement Security Project on these issues, funded by Pew Charitable Trusts

The Brookings Institution, Washington, D.C. www.brookings.edu

Conclusions• Individual accounts do not make sense as

part of Social Security• Social Security is like a car with a flat tire.

Let’s fix the flat tire, not replace the car.• Exciting new evidence on ways to boost

saving on top of Social Security for low- and moderate-income households

• Keep an eye on the Retirement Security Project