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The Social Security Reform Debate John Turner AARP Public Policy Institute 10 th International Pension Seminar Tokyo November 22, 2005 The Social Security Problem In 2041, the Social Security trust fund is projected to have insufficient funds to fully pay old-age benefits.

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The social security reform debate l.jpg
The Social Security Reform Debate

John Turner

AARP Public Policy Institute

10th International Pension Seminar

Tokyo

November 22, 2005


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The Social Security Problem

  • In 2041, the Social Security trust fund is projected to have insufficient funds to fully pay old-age benefits.

  • The system will be able to pay about 75 percent of promised benefits at that point, and those benefits will be higher than the benefits paid in 2005.

    These projections were done by the actuaries of the Social Security Administration.


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The Future is Uncertain

  • Another agency of the federal government, the Congressional Budget Office, using a different approach and assumptions, projects that Social Security will have sufficient funds until 2051—for 46 years.


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A Crisis?

  • In 2051, the youngest of the baby boomers will be 86 years old.

  • This is a problem, but it is not a crisis.


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In Perspective

  • Expressed as a fraction of GDP, the shortfall of Social Security financing is 0.7% of GDP.

  • By comparison, the funding shortfall for Medicare, which is the medical care program for persons age 65 and older, is 1.4% of GDP. The problem is twice as large, but Congress is not focusing on it.


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The US Debate

1. Should Social Security be reformed by traditional changes in its benefits and financing, or should we add individual accounts?

2. If we have individual accounts,

should they be in addition to Social Security benefits or should they reduce Social Security benefits?


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A Key Issue

  • A key issue is how large should Social Security benefits be in the future.

    Conservatives tend to favor Social Security benefits being smaller than do liberals.


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Social Security Benefits

  • In 2004, the average monthly Social Security benefit was $926.

  • Based on today’s cost-of-living, that is not a lot of money.


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The Traditional Approach

  • The traditional approach to Social Security reform would be to have some combination of revenue increases and benefit cuts.


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The Payroll Tax

  • Social Security is financed by a payroll tax on earnings up to $90,000 in 2005.

  • The tax is 12.4 percent of employee pay, half paid by employers and half paid by employees.


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Increasing Revenue

  • Revenue can be increased by raising the payroll tax rate and by raising the ceiling on taxable earnings.


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International Comparison

  • By international comparisons, the Social Security payroll tax of 12.4% is low.

  • In Sweden, for example, the tax is 18.5%.


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Raising the Payroll Tax

  • No one is advocating totally solving the Social Security financing problem through raising the payroll tax.

  • For perspective, however-- if the tax were raised from 12.4% to 14.3%, that would solve the problem, according to the Social Security Administration.

  • According to the Congressional Budget Office, it would only need to be raised to 13.4%.


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Raising the Ceiling

  • One of the proposals for getting more revenue into the system is to raise the ceiling on wages taxable under the payroll tax.

  • Traditionally, the ceiling has been set so that 90% of the total wages of all workers covered by Social Security were liable for the tax.


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85%

  • Currently, only 85% of total wages of workers covered by Social Security are taxable.

  • Raising the ceiling from $90,000 in 2005 to $145,000 would bring 90% of total wages under the ceiling.


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Raising the Retirement Age

  • Currently, workers can receive Social Security benefits at age 62.

  • While no change in Social Security to help restore solvency is popular, raising the early retirement age not a popular idea.


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Arguments For

  • People are living longer and healthier

  • Jobs are less physically demanding

  • People are starting work at older ages due to more years in school


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Arguments Against

  • Some people have physically demanding jobs where it is difficult to continue working past age 62.

  • Some people are disabled and cannot work past age 62.

  • Some people are laid off and cannot find work past age 62.


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International Perspective

  • A number of nations have higher early retirement ages for Social Security

  • For example, in the United Kingdom, the early retirement age for Social Security benefits is 65 for men, and will be raised to age 65 for women in the future.


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Individual Accounts

  • Most of the current Social Security debate has been over individual accounts.

  • President Bush has proposed that individual accounts be introduced that would reduce Social Security benefits.



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Carve-Out Individual Accounts

  • Carve-out individual accounts are what has been proposed by President Bush.

  • They make the Social Security solvency problem worse by taking money away from Social Security.


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How They Would Work

  • For example, instead of contributing 12.4% to Social Security—

    workers would contribute 10.4% to Social Security and 2% to an individual account.


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At Retirement

  • At retirement, instead of receiving the full Social Security benefit –

    Workers would receive a smaller benefit, calculated so that if they had invested their individual accounts in government bonds the total benefit from Social Security and the individual accounts would be the same.


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The “Ownership Society”

  • President Bush has argued that this plan would expand ownership in American society

  • He argues workers would actually “own” their individual account while they do not own their Social Security benefit.


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The “Debt Society”

  • While individuals own their add-on individual accounts, their voluntary carve-out accounts are more like a loan from the government.

  • The government in effect lends to the worker the amount he or she would have contributed to Social Security. The worker repays the loan at retirement by giving back to the government some of the benefits he or she would have received.


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Why look at international experience?

  • With international experience, we aren’t solely relying on abstract analysis. We can assess the actual functioning of different types of systems.


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Why Sweden and the UK?

  • Sweden and the UK are the best examples for the United States.

  • Sweden has add-on accounts.

  • The UK has carve out accounts—they call it “contracting out.”


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Sweden - Overview

  • Starting in 2000, mandatory add-ons

  • 2.5% contributed to mandatory individual accounts

  • on top of 16% that is contributed to social security


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Lessons from Sweden

  • To reduce administrative costs--Government clearinghouse for collection of contributions and payment of benefits

  • Contributions are credited to worker’s accounts once a year to save on administrative costs—18 months after the start of the year


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Sweden

  • More than 700 investment choices—too many, most new entrants take the default fund

  • A positive feature – benefits can be taken as ¼, ½, ¾ or full benefits—facilitating partial retirement


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Problems in Sweden

  • Most participants have lost money since the system was started in 2000.

  • The default fund excludes some well-known companies, such as Coca-Cola, because of opposition to some of their policies.

  • The benefits provided are not inflation indexed, and a survivors’ benefit is optional.


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The UK

  • Since 1987, the United Kingdom (UK) has allowed employees to voluntarily withdraw from part of social security by reducing their contributions and receiving reduced benefits. Instead, employees contribute to an individual account.


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UK Overview

The main points about the UK

– a complex system

-- the only example among high-income countries of voluntary carve-out individual accounts

Japan has such a system but for defined benefit plans, not individual accounts


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UK -- Basics

  • Up to 10.5% of taxable earnings diverted into an individual account, the amount depending on the worker’s age

  • Future social security benefits are reduced


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Lessons from the UK

  • To keep down costs, contributions are credited once a year, 18 months after the start of the tax year.

  • Since the early 1990s, there has been little growth in the number of people choosing the carve out individual account, despite the growth of the labor force.


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Problems with Choice

  • The element of choice raises problems—

    Due to a lack of financial sophistication, many workers have been made worse off by taking the voluntary carve out (VCO) accounts

    The “mis-selling” scandal—12 billion pounds have been paid to the victims ($24 billion dollars)


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Problems with the Offset

  • The rebate rate paid into the private accounts for workers taking the carve out is reset every five years

  • Two large life insurance companies have recently advised their clients to not take the VCO accounts and to return fully to social security because they feel the government made a mistake in setting the level of the rebate rate


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Conclusions

  • Social Security’s financing problems can be resolved by traditional approaches, which are to raise the payroll tax and lower benefits.

  • Carve-out individual accounts would make the financing problems worse.


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Conclusions (2)

  • Sweden is a good model for relatively low- cost mandatory add-on accounts

  • It keeps costs relatively low by using a government clearinghouse and by crediting accounts only once a year.


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Conclusions (3)

  • The UK indicates problems with voluntary carve out accounts --- people are leaving the system because of problems in determining the relationship between the carve out account and the reduction in social security benefits


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