The History and Future of Pension Plans and Social Security

By: Richard Hurst

Contents

Introduction.................................................................................................................................................3

Defined Benefit Plans..............................................................................................................................4

Defined Contribution Plans......................................................................................................................9

Hybrid Plans...........................................................................................................................................12

Pensions and the Economic Crisis of 2008.............................................................................................14

Social Security............................................................................................................................................15

Social Security Today and Current Criticism..........................................................................................18

Projections.............................................................................................................................................20

Reform...................................................................................................................................................22

The 6.2% Solution..............................................................................................................................22

Mixed Solution...................................................................................................................................24

Arguments Against Privatization........................................................................................................25

Fully-Funded Solution........................................................................................................................26

Obama’s Plan.....................................................................................................................................27

Appendix A................................................................................................................................................28

Appendix B................................................................................................................................................29

Appendix C................................................................................................................................................32

Appendix D................................................................................................................................................33

Introduction

Before discussing in-depth where pension plans originated and where they are going in

the future, it is important to define exactly what a pension is: an arrangement to provide a

person with an income when he/she is no longer earning a regular income through

employment1. This can include disability payments, but for this paper, I will be focusing on

pension plans for retirement. Retirement pension plans are an extremely important security

net for people when they are no longer able to work, are working significantly less than they

used to, or have chosen to retire for personal reasons, because they provide money to help

people live out their days on a limited source of funding where no other money would

otherwise be coming in to their accounts. It is important to plan for retirement correctly and

early, as no one else will do it for you and the power of compound interest will be lost if you

wait until you turn 60 to actually begin saving for your retirement. Many people place their

trust in the current Social Security system, but, as I will show later, it is not a financially sound

decision and it may not even exist in the future as it does today.

1 Pensions. Wikipedia. 10 Mar. 2009 <http://en.wikipedia.org/wiki/Pension#United_States>.

Defined Benefit Plans

In 1789, the first pension plan was enacted in the American Colonies to help disabled

and enlisted men after the Revolutionary War. This plan provided half pay for any man that

was unable to earn a living and also applied to any widows of the Revolutionary War. In 1857,

the first municipal pension was offered in New York City to police officers, and in 1875,

American Express Corporation offered the first corporate pension to its workers2. This was an

important step for organizations, as it was seen as a way to entice workers to stay with one

company throughout their entire working life. If a worker knew that they would continue to

receive money even after they were able to work, the incentive to stay with that company and

help it to grow would be that much greater.

The type of company-sponsored pension plan described above is what is known as a

Defined Benefit (DB) plan, as the benefits are defined by the employer ahead of time. With this

kind of plan, an employer holds all of the risk and is responsible for managing the fund, or

finding an institution to administer it3. Companies determine the benefits of a DB plan upon

retirement for a worker by using a set formula, which typically includes various factors, such as

salary history, years of employment within the company, and the age of retirement, which is

usually set by the company4.

When these types of plans were first offered by American companies, there was no

legislation or governing body over the company’s pension plans. It was initially left to

2 Modern Pensions and Social Security: A Timeline of Historic Events. 16 Oct. 2006. Society of Actuaries. 19 Mar. 2009 <http://www.soa.org/files/pdf/027bk_rev-annual06.pdf>.3 Defined Benefit. Wikipedia.org. 10 Mar. 2009 <http://en.wikipedia.org/wiki/Defined_benefit>.4 Clark, Robert L., and Ann A. McDermed. The Choice of Pension Plans in a Changing Regulatory Environment. Washington, DC: American Enterprise Institute, 1990.

companies to ensure that there was adequate funding available for its workers for when they

retired, because as I believe, if a company defaulted on its promise, people would not want to

work for a company that lied to its workers. All of this changed though in the 1960s and 1970s.

In 1963, the automobile manufacturer Studebaker closed various plants in response to poor

sales of its automobiles and trucks5. In addition to leaving thousands of its workers

unemployed, Studebaker also terminated its underfunded Defined Benefit plan, which left

roughly 11,000 employees with no retirement income6, even though it had promised its

employees it would be there for them when they needed it.

Following the Studebaker fraud and default, NBC produced a nighttime television special

in 1972 entitled “Pensions: The Broken Promise” that showed millions of Americans what can

happen with poorly funded pension plans. This special caused a significant uproar among

Americans, which government officials did not ignore. In 1974, Congress passed the Employee

Retirement Income Security Act, or ERISA, which was enacted to protect the interests of

employee Defined Benefit plan participants7. This Act included a number of provisions that

regulated the operation of a DB plan once it was established. It stated that administrators of

the plans must diversify the investments so any significant risk to the plan is minimized, and

provided fiduciary responsibilities for those who control and manage assets. The fiduciary

responsibilities ensured that organizations running the plans were doing so solely in the interest

of the participants in the plan and that any conflicts of interest must be avoided8.

5 Studebaker. Wikipedia.org. 11 Mar. 2009 <http://en.wikipedia.org/wiki/Studebaker>.6 Modern Pensions and Social Security: A Timeline of Historic Events: 2.7 Employee Retirement Income Security Act. Wikipedia.org. 11 Mar. 2009 http://en.wikipedia.org/wiki/Employee_Retirement_Income_Security_Act8 IRS. 21 Mar. 2009 <http://www.dol.gov/dol/topic/health-plans/erisa.htm>.

ERISA also created a governing body to watch over the DB plans being offered by

companies, the Pension Benefit Guaranty Corporation. The PBGC ensures payment of Defined

Benefit pension benefits, and if company claims bankruptcy, the PBGC steps in and takes over

the current plan, ensuring up to $54,000 per year as of 2009 for any plans that terminated in

20089. The PBGC currently protects roughly 44 million workers and is responsible for 631,000

retiree benefits. It is important to note that none of the money paid out to workers comes

from taxes, but rather three significant sources of income that PBGC has: insurance premiums,

assets held by the plans it takes over, and income from its current investments 10. Any company

that offers DB plans must pay a premium each year to PBGC, and it uses this money to ensure

the solvency of its funds.

ERISA also defined limits on what is known as vesting, which is one’s right to their

pensions. When a plan is fully vested that means the employee has an absolute right to the

entire amount of money currently in their account11. Two types of vesting are available to

workers: cliff vesting and gradual vesting. In cliff vesting, a worker owns 100% of his pension

benefit after participating in the plan for five years. In graded vesting, a worker owns a

percentage of the plan initially, and then it increases each year thereafter. Under ERISA, the

federal minimum for graded vesting is 20% ownership after three years, and then 20% more

each year after that. After seven years, the worker owns 100% (fully vested) of their retirement

benefits12.

9 Who We Are. Pension Benefit Guaranty Corporation. 20 Mar. 2009 < http://www.pbgc.gov/about/about.html>.10 Pension Benefit Guaranty Corporation. Wikipedia. 20 Mar. 2009 <http://en.wikipedia.org/wiki/Pension_Benefit_Guaranty_Corporation>. 11 Vesting. Wikipedia.org. 11 Mar. 2009 <http://en.wikipedia.org/wiki/Vesting#Retirement_plans>.12 Frequently Asked Questions about Pension Plans and ERISA. Department of Labor. 12 Mar. 2009 <http://www.dol.gov/ebsa/faqs/faq_compliance_pension.html>.

Given governmental interventions and legislation involved and the fact that risk is

assigned solely to the company in the Defined Benefit plan, one might think that this type of

plan is the best type of plan available. However, there are several drawbacks associated with it.

Probably the most important is the lack of control that workers have over the plan. With no

choice for investment of the funds, a potential smart investor could be missing out on a larger

return with another investment strategy. This is one of the biggest benefits emphasized by

another type of plan to be discussed later, the Defined Contribution (DC) plan. Of course, for

the average person that does not know a lot about investment strategies and does not wish to

get involved, the Defined Benefit plan is a safe bet.

Another problem with Defined Benefit plans is that most of the value of the benefit is

earned in the final years prior to retirement, in which the worker would need to stay with one

employer for most of their working life. Since most DB plans are based on a formula that

involves salary history and years of employment, the longer a worker stays with one employer,

the more money that worker will receive upon retirement13.

The last argument to be discussed here against DB plans is on behalf of companies.

Since employers that offer DB plans must follow strict guidelines set by the government and

pay a yearly premium, it is an extremely costly and administratively complex choice for

employers14. In addition to following various rules, companies (in most cases) must hire outside

firms to ensure that their fund will be solvent in the future. This process calls upon the services

13 Retirement Plan. Wikipedia.org. 10 Mar. 2009 <http://en.wikipedia.org/wiki/Retirement_plan#Defined_benefit_plans>.14 Choosing a Retirement Plan: Defined Benefit Plan. 24 Jan. 2008. Internal Revenue Service. 18 Mar. 2009 <http://www.irs.gov/retirement/article/0,,id=108950,00.html>.

of actuaries who use complex probability formulas to see how their DB fund will grow and how

much money they will need to put into the account each year thereafter15.

As stated above, DB plans can put a huge burden on companies, as they need to keep

them funded as their workers retire and begin collecting on the promises made by the

company. If a company is unable to raise income and increase its assets, it may be forced to file

for bankruptcy, at which point the PGBC would step in and take over its DB plan. In some cases,

just removing the pension obligations from a company’s balance sheets can instantly increase

the company’s value for outside investors. This strategy has been used numerous times in the

past, including US Airways, Polaroid, and Bethlehem Steel16, and has been suggested for the

troubled Detroit automakers17.

15 Retirement Plan.16 Walsh, Mary W. Whoops! There Goes Another Pension Plan. 18 Sept. 2005. The New York Times. 12 Mar. 2009 <http://www.nytimes.com/2005/09/18/business/18pensions.html?_r=1&scp=1&sq=whoops%20there%20goes%20another%20pension%20plan&st=cse>.17 Higgins, Tim. "Anxiety about GM, Chrysler bankruptcies grips retirees." 16 Apr. 2009. Freep.com. 29 Apr. 2000 <http://www.freep.com/article/20090416/BUSINESS01/904160349>.

Defined Contribution Plans

With the increase in costs associated with Defined Benefit plans, employers began to

look for cheaper alternatives for retirement plans. The Defined Contribution plan was seen as a

viable alternative that would not eat up a company’s balance sheets in the future. In a Defined

Contribution plan, the contribution is defined and set by the employer or employee and placed

into an account. The amount of money for retirement in this plan is determined by an account

balance, similar to a savings account. The employee decides where the money is placed and

how it is invested, choosing in most cases to invest in mutual funds or common stocks. In a DC

plan, the employee holds all of the risk and the employer can choose to put a percentage of the

worker’s salary into the account18. The two most popular types of DC plans today are 401(k)’s

and Individual Retirement Accounts, or IRAs.

In a 401(k) plan, any money that workers choose to divert from their paychecks (up to

$16,500 for 2009) is placed into an account, and the employee can choose where to invest19.

The investment options available to an employee depend on the administrator of the plan, but

typically include mutual funds, and the employee can choose to put a percentage of their

overall funds into many different funds (for example, 20% in a high growth fund, 30% in middle

growth fund, and 50% in a low growth fund). This diversification of funds helps to ensure that

investors do not “put all of their eggs in one basket,” and allows for significant, but not terribly

risky, growth each year.

18 Types of Retirement Plans. Department of Labor. 11 Mar. 2009 <http://www.dol.gov/dol/topic/retirement/typesofplans.htm>.19 401(k). Wikipedia.org. 10 Mar. 2009 <http://en.wikipedia.org/wiki/401(k)>.

Any money that is redirected from a worker’s paycheck is not taxed, and may actually

help to lower the worker into another income tax bracket, thereby lowering any taxes the

worker will have to pay for that year. For example, if a worker earns $40,000 each year, and

chooses to contribute $2,500 to a 401(k) plan, he/she will only have to pay taxes on $37,500.

However, once that worker begins to withdraw funds from the account, the money taken is

taxed as regular income. If a worker leaves or is fired from their job, with an active 401(k) plan,

they can choose to withdraw the money or they can rollover the current balance to another

401(k) plan at their next employer or into an IRA, which will be discussed next20.

It is important to note that a 401(k) plan cannot be started by any employee with a

paycheck, but rather, it must be sponsored directly by an employer. In some Individual

Retirement Accounts, however, any individual can choose to set up the plan, and all that is

needed is an initial investment. There are many different types of IRAs, but only the two main

types, Traditional and Roth, will be discussed in detail. For 2009, the maximum allowed

contribution under a Traditional or Roth IRA is $5,000 for ages 49 or below, and $6,000 for ages

50 or above, which can be split up between the two IRA funds21.

In a Traditional IRA, contributions are tax deductible and upon withdrawal, the

distributions are taxed as normal income, similar to a 401(k) plan. In order to be eligible for a

Traditional IRA, single investors must make less than $53,000 for full contribution or $63,000

for a partial contribution if covered by a retirement plan at work22. If married, investors must

make less than $85,000 for a full contribution or $105,000 for a partial contribution, which

20 401(k).21 Individual Retirement Arrangements: Publication 590. 30 Jan. 2009. Internal Revenue Service. 24 Apr. 2009 <http://www.irs.gov/pub/irs-pdf/p590.pdf>.22 Individual Retirement Arrangements: Publication 590 15.

again only applies to those that are covered by a retirement plan at work. If no retirement plan

is offered at work, then there is no eligibility limit on income for the given year23.

A Roth IRA is different from a Traditional IRA in that contributions are not tax-

deductible, and most withdrawals made are tax-free. This is seen as the biggest benefit of a

Roth IRA, as the money can be withdrawn at any time because taxes have already been paid on

the income. Also, if an investor thinks that investments made will be a large sum in the future,

they can reduce the amount of possible taxes paid in the future by choosing a Roth IRA. Like

the Traditional IRA, there are income eligibility limits for the Roth IRA. If single, investors must

make less than $101,000 to qualify for a full contribution or $116,000 for a partial contribution.

If married, investors must make less than $159,000 for a full contribution or $169,000 for a

partial contribution24.

The benefits gained through DC plans can outweigh the possible gains in a Defined

Benefit plan, as the investor can choose how risky the portfolio should be in the future. But,

with an increased level of risk, comes the possibility that the portfolio might be worth less

down the line. It is important to consult a Financial Planner or other specialist to get sound

advice on future retirement needs with a DC plan, as the investor is solely responsible, and

there is no governing body that will step up to assist financial calamity, like in a DB plan.

23 Individual Retirement Arrangements: Publication 590 16.24 Individual Retirement Arrangements: Publication 590 58.

Hybrid Plans

Another type of retirement plan available to companies and workers combines the

benefits of Defined Benefit and Defined Contribution plans, and as such, is called a Hybrid Plan.

The Cash Balance plan is the most popular type of Hybrid Plan currently available. This plan is

like a DB plan in that it has a similar tax and legal structure, is insured by the PBGC, and the risk

is borne by the employer. It is like a DC plan in that the benefit is expressed in terms of an

account balance, and is “usually paid as [a] cash balance upon termination of employment”25.

In a Cash Balance plan, “a participant's account is credited each year with a ‘pay credit’ (such as

5 percent of compensation from his or her employer) and an ‘interest credit’ (either a fixed rate

or a variable rate that is linked to an index such as the one-year treasury bill rate)”26. This type

of plan is good for employees that switch jobs often, as the balance can be left in the current

plan or rolled over into an IRA or their next employer’s plan27.

In Appendix A, which looks at how a hypothetical Cash Balance plan can perform over

time versus a Defined Benefit plan, it is noticeable that in the first 25 years of employment the

Cash Balance plan outperforms the accrual rate of a DB plan, owing to the fact that a DB plan

does not become very lucrative until the retirement age is reached. In this way, a Cash Balance

plan is seen as a more enticing investment strategy for workers, as they do not have to stay

25 Pension. Wikipedia.org. 20 Mar. 2009 <http://en.wikipedia.org/wiki/Pension#Hybrid_and_cash_balance_plans>.26 Retirement Plans, Benefits & Savings. U.S. Department of Labor. 1 Mar. 2009 <http://www.dol.gov/dol/topic/retirement/typesofplans.htm>.27 Private Pensions: Information on Cash Balance Pension Plans. Oct. 2005: 17. United States Government Accountability Office. 18 Mar. 2009 <http://www.gao.gov/new.items/d0642.pdf>.9 Elliott, Kenneth R., and James H. Moore, Jr. Cash Balance Pension Plans: The New Wave. Summer 2000. Bureau of Labor Statistics. 18 Mar. 2009 <http://www.bls.gov/opub/cwc/archive/summer2000art1.pdf>.

with one company throughout their working life, but can move from company to company, and

likewise take their retirement benefits with them.

Pensions and the Economic Crisis of 2008

With the severe economic downturn that was experienced in 2008, many investment

portfolios were severely dampened, including pension funds. This was not limited to one type

of pension plan, but all. With Defined Benefit plans, many companies did not receive the

typical return on investments (and in fact, many lost money), and now are facing serious

shortfalls for 2009. Because of government enforcement of DB plans, companies must have a

certain amount of money available to keep their funds solvent, but cannot because of the

combination of lost investment and lost revenue with cutbacks in consumer spending and

confidence.

With Defined Contribution plans, many retired or near-retirement individuals lost a lot

of money in their 401(k)’s, IRAs, and other types of plans. In fact, the funding of the Top 100

pension sponsors fell by $303 billion in 2008, falling from an $86 billion surplus at the end of

200728, a significant decrease for people that are dependent upon their funds in retirement. A

recent number for pension fund assets could not be found, but in 1990, pension funds owned

40% of common stock, accounting for over $2.4 trillion in assets29, which has most likely only

increase in the past decade.

28 2008 Disclosures of Funding, Discount Rates, Asset Allocations and Contributions. Apr. 2009. Watson Wyatt Worldwide. 20 Apr. 2009 <http://www.watsonwyatt.com/us/pubs/insider/showarticle.asp?ArticleID=20764>.29 Kleiner, Art. Garbage Magazine 1 May 1991: 56. 25 Apr. 2009 <http://www.well.com/~art/exxon.html>.

Social Security

In the mid-1880s the United States began shifting from an agricultural society to an

industrialized one, where a person’s economic security was tied to his ability to maintain a job

and be a wage earner. During this shift, families increasingly moved to large cities where most

of the jobs were located, and in 1930, 56% of Americans lived in cities, up from 28% in 1890.

The year 1920 was an important historical year for America, in which “for the first time in [the]

nation’s history, more people were living in cities than on farms”30. This trend towards

urbanization also aided in replacing the societal norm of the extended family with that of a

nuclear family. When families moved away from rural communities, they typically did not do so

with their entire family. Economic security was greater with an extended family because “when

a family member became too old or infirm to work, the other family members assumed

responsibility for their support”31.

The last significant change to affect the financial security of Americans was a rapid and

increased availability of sanitation and health care. From the 1900s to the 1930s, the life span

of the average American increased by ten years, which “was the most rapid increase in life

spans in recorded human history. The result was a rapid growth in the number of aged

persons, to 7.8 million by 1935”32. With this increase in lifespan and the importance of being a

wage earner to ensure financial security, serious pressures were building against the older

30 Historical Background and Development of Social Security. Ed. Larry DeWitt. Mar. 2003. Social Security Administration. 20 Apr. 2009 <http://www.ssa.gov/history/briefhistory3.html>.31 Ibid.32 Ibid.

generations in the United States, with one more immediate disaster soon to come: the Great

Depression.

Following the Stock Market Crash of 1929, unemployment exceeded 25%, wages paid to

adult workers went from $50 billion in 1929 to $30 billion in 1932, two million adult men were

homeless, “and the majority of elderly lived in a state of dependency”33. These severe

circumstances in America led many individuals to call for a radical change to social programs for

the poor, and many began to organize to let the government know that they wanted a change.

The Share Our Wealth program, led by Louisiana Governor Huey Long, called upon the

government to redistribute the wealth of the rich to the poor. With 7.7 million supporters, the

program also wanted the federal government to guarantee an annual income of $5,000 to

every family, limit private fortunes to $50 million and annual incomes to $1 million, and offer

anyone over age 60 a pension34.

The Townsend Movement was started by Francis Townsend, a 66 year old unemployed

doctor in Long Beach, California. Townsend could not find any work, and without savings or

prospects, he became “the self-proclaimed champion of the cause of the elderly”, calling for

passage of his Townsend Plan. Townsend wanted the government to provide a pension of $200

a month to every citizen over 60, which would be funded by a 2% sales tax. This movement had

2.2 million members.

Another movement was pushed by Father Charles Coughlin, a weekly radio preacher.

He frequently talked about social programs and called on the government to implement them.

With 35-40 million listeners each week, “Father Coughlin had a greater share of the weekly

33 Ibid.34 Historical Background and Development of Social Security.

broadcast audience than Howard Stern, Rush Limbaugh, Paul Harvey and Larry King

combined”35. These three large movements, in addition to many other smaller ones across the

country, forced the government to listen and heed the country’s wishes, and on August 15,

1935, as part of the New Deal, President Franklin Roosevelt signed the Social Security Act into

law. This act provided old age assistance, unemployment assistance, aid to dependent children,

and state grants to provide medical care36. This was a very significant step in providing aid to

older Americans.

35 Ibid.36 Ibid

Social Security Today and Current Criticism

Today, Social Security provides benefits to 51 million Americans37, and in 2008, it paid

out $625 billion in benefits and collected $805 billion, for a surplus of $180 billion 38. Income tax

is not used to fund Social Security, but rather, a 12.4% tax is deducted from the wages of

employees, called a FICA (Federal Insurance Contributions Act) tax, in which 6.2% is taken from

employees and 6.2% from employers. The money that is collected from taxes is immediately

paid out to Americans over 65, and any money that is left over is put into a Trust Fund 39, and as

of the end of 2008, the Trust Fund was valued at over $2.4 trillion40. When revenues are

greater than expenses, as they have been for the past 26 years, the excess is invested in US

Treasury Securities, which indirectly finances the government’s deficit spending41. This could

lead to a severe problem if benefits need to be paid out of the Trust Fund and is thought by

some to not make a lot of fiscal sense, as the U.S. taxpayer is responsible for repaying these

bonds42.

Social Security has also been criticized for discriminating against the poor and

minorities. Any families that make over $108,000 do not have to pay FICA tax after that limit.

Also, the rich tend to have better access to health care and insurance, and tend to live longer

than poorer Americans. The major complaint then is that poorer families pay a large share of

37 Social Security (United States). Wikipedia.org. 21 Apr. 2009 <http://en.wikipedia.org/wiki/Social_Security_(United_States)>.38 Social Security Trust Funds. 29 Jan. 2009. Social Security Administration. 20 Apr. 2009 <http://www.ssa.gov/OACT/STATS/table4a3.html>.39 Social Security (United States).40 Social Security Trust Funds.41 Social Security (United States).42 Tanner, Michael. Editorial. “The 6.2 Percent Solution: A Plan For Reforming Social Security.” The CATO Institute (2004): 2. 20 Apr. 2008 < http://www.socialsecurity.org/pubs/ssps/ssp32.pdf>.

their income into something that they do not get to see upon retirement, and most of the

money goes to richer families that tend to not rely on Social Security43.

43 Tanner: 4.

Projections

Social Security projections typically go out 75 years, because most workers enter into

the workforce at 20 or 25, and few tend to live beyond 95 or 100. The Social Security

Administration (SSA) looks at three different models to predict future needs: the CBOLT

(Congressional Budget Office Long-Term) model, the TL Model (developed by Shripad

Tuljapurkar and Ron Lee, formerly of the Retirement Research Center), and the OCACT (Office

of the Chief Actuary of the Social Security Administration) model. The SSA looks at three

different stochastic models in order to get different views into how Social Security will look in

future years. Despite using models that use different formulae, they still “deliver broadly

consistent results”44. The OCACT model for projecting the financial future uses

“three alternative sets of deterministic projections. The intermediate (Alternative II)

projections are intended to reflect the best estimates of future experience. The low-cost

(Alternative I) and high-cost (Alternative III) projections are based on more optimistic

and more pessimistic assumptions about the future, respectively. The three alternatives

indicate a possible range for future experience. The stochastic model also relies on the

assumptions underlying the intermediate (Alternative II) projections”45.

According at the OCACT model (Appendix B), by roughly 2018 (Alternative II projection) annual

costs will start exceeding benefits, and by 2042, the fund will be completely exhausted. This is

nothing new, however, as this type of forecast has happened in the past. In 1954, it was said

that Social Security would be exhausted by 1995. In 1970, it was again said that the fund would

44 Burdick, Clark, and Joyce Manchester. Stochastic Models of the Social Security Trust Funds. Mar. 2003. Social Security Administration. 20 Apr. 2009 <http://www.ssa.gov/policy/docs/rsnotes/rsn2003-01.html>.45 Ibid.

be exhausted by 2040, and in the 1980s, it was to be exhausted in one year 46. These past

projections should not be taken lightly though, as the typical reaction to these reports was a tax

increase or benefit decrease.

46 Hines, Jr., James R., and Timothy Taylor. "Shortfalls In The Long Run: Predictions About the Social Security Trust Fund." The Journal of Economic Perspectives 19 (2005): 6.

Reform

In his 2001 inaugural address, President George W. Bush told the country that Social

Security reform would be a top priority. In February of that same year, in his first address to

Congress, Bush said that he would appoint a Presidential Commission to address the reform.

This Commission was to uphold three important features that the President was looking for: 1.)

It must preserve the benefits of current retirees, 2.) It must return Social Security to sound

footing, and 3.) It must offer personal savings accounts to younger workers47. Bush was not

able to make any changes to the current system, as his plan for privatization of the Social

Security system did not garner enough votes.

If the current Social Security system is kept the way it is, either taxes will need to be

increased (to 14.5% in 2030, 15.4% in 2050, and 16.6% in 2075) or benefits will need to be

decreased (by up to 1/3)48. It is for this reason that a number of solutions have been proposed

so that these drastic measures do not need to be taken. The following sections will present a

number of these proposals, which include privatization, semi-privatization, and a fully-funded

solution, closing with Obama’s ideas for reform.

The 6.2% Solution

The 6.2% solution has been proposed by Michael Tanner at the Cato Institute, a non-

partisan organization based in Washington, DC49. This solution proposes diverting half of the

payroll tax (6.2%) to individually owned, privately invested accounts, while using the remaining

47 Historical Background and Development of Social Security.48 Feldstein, Martin. "Structural Reform of Social Security." The Journal of Economic Perspectives 19 (2005): 33-55.49 Cato Institute. Wikipedia.org. 21 Apr. 2009 < http://en.wikipedia.org/wiki/Cato_Institute>.

6.2% to pay for transition costs and fund disability and survivor’s benefits. The invested money

would have a default option (for those that are not familiar with investing) of 60% stocks and

40% bonds, but smarter investors could choose another option plan. Upon retirement, one

could choose to purchase an annuity, have a programmed withdrawal option, or a combination

of an annuity and a lump sum50. It would also give people the option to choose not to invest in

the accounts, and instead keep their money in the current system.

Tanner believes that the current Social Security system displaces private, fully-funded

alternatives, which results in “a large net loss of national savings, which reduces capital

investment, wages, national income, and economic growth”. Instead, he believes that

“[s]hifting to a private system, with hundreds of billions of dollars invested in individual

accounts each year, would likely produce a large net increase in national savings … [t]hat would

increase national investment, productivity, wages, jobs, and economic growth”. If part of a

worker’s direct compensation was tied to future earnings, Tanner believes that it would

stimulate more output and employment in the present51.

Tanner also believes that minorities would benefit greatly from this type of investment

as it would pay greater benefits. Also, with the current Social Security system, workers that pay

into the Fund but die before being able to collect are not able to pass on their funds to any

survivors. With a privatized account, the remaining benefits could be passed onto heirs or next

of kin, helping the family break out of the cycle of poverty through redistribution of wealth52.

The last benefit that privatization would provide is a greater return on investment than

the current system. The current system offers a low, below-market rate of return, which “is

50 Tanner: 1-8.51 Tanner: 4.52 Tanner: 5.

expected to be less than 2% for most of today’s workers”53 (Appendix C). In 1997, Martin

Feldstein, a Harvard economist, “estimated that if all Social Security payroll taxes were privately

invested, that investment would provide a net benefit of from $10 trillion to $20 trillion in

present value”54. This tends to be the biggest advantage promulgated by supporters of

privatization: the power of the free market.

Mixed Solution

The Mixed Solution was proposed by Martin Feldstein, who was noted above. Feldstein

served as Chairman of the Council of Economic Advisors from 1982 to 1984 and served as Chief

Economic Advisor to Ronald Reagan. He has also been a member of the Group of Thirty (G30)

and served as the president of the National Bureau of Economic Research, a non-profit

organization that studies the science of economics. Also, he served as a senior member of the

board of AIG Financial Products55.

The Mixed Solution is very similar to the 6.2% Solution, except that it combines the

current Social Security system with privatization. With this system there would be a period of

transition, in which individual out-of-pocket contributions would be made to personal accounts.

When the system would be fully phased in, 9.1% would go to the current Social Security system

and would account for 60% of the current benefits. The remaining 1.5% would go to a private

account only if an individual put up 1.5% of their own income into the account. This way there

53 Tanner: 3.54 Tanner: 4.55 Martin Feldstein. Wikipedia.org. 21 Apr. 2009 < http://en.wikipedia.org/wiki/Martin_Feldstein>.

would be an incentive for citizens to invest in their future. This 3% would then account for 40%

of the current benefits56.

With this Mixed Solution, the 40% that is invested in private accounts would be put in a

combination of a broad equity mutual fund index (60%) and a corporate bond fund (40%). At

retirement, the investor would have the option of a lump sum or an annuity.

Arguments Against Privatization

Many supporters of Social Security privatization use other countries as models, and

suggest that since their program is doing so well, then there is no reason why it should not also

be used in the United States. Chile, one of the first countries to move to a private security

system, is usually hailed as the poster child of privatization. However, the benefits gained

through the program were actually much smaller than anticipated, because commissions and

administrative costs took up large shares of the accounts57. Here in the U.S., “[m] any workers’

accounts would be so small that they would be of no interest to profit-making firms … and the

cost of administering so many small accounts would overwhelm and benefits to be gained from

the stock market”58.

If up to 4% of the current payroll tax was diverted to private accounts, it would

significantly shorten the length until the Trust Fund was completely empty (Appendix D). This

would add $1 trillion in new federal debt in its first decade of implementation, $3.5 trillion in

the following decade, and trillions more thereafter”59. In addition, “the odds are against

56 Feldstein: 5-7.57 Anrig, Greg, and Bernard Wasow. Twelve Reasons Why Privatizing Social Security Is A Bad Idea. Publication. New York: The Century Foundation, 2005: 8.58 Anrig, Greg, et al.: 11-12.59 Anrig, Greg, et al.: 7.

individuals investing successfully” as the average person does not know much about stocks or

investment strategies. An SEC report found that “only 14 percent knew the difference between

a growth stock and an income stock, … 38 percent understood that when interest rates rise,

bond prices go down, [and] [a]lmost half of all investors believed incorrectly that diversification

guarantees that their portfolios will not suffer if the market drops”60. If the financial retirement

net of Social Security were put in the hands of unwise investors, chances are that there would

in fact be no net when the time came.

Fully-Funded Solution

The Fully-Funded solution was proposed by an MIT team in 1999, consisting of Franco

Modigliani, a professor of Economics, Arun Muralidhar, a Ph.D. graduate, and Marialuisa

Ceprini. This solution combines the benefits of a Defined Benefit plan with that of a Defined

Contribution plan. All funds would be pooled together and invested in a highly diversified

portfolio that was managed by the U.S. government (DB), and each participant would have their

own account, with contributions coming from their own taxed dollars (DC). With the

government controlling the fund, it could fix the rate in advance, and quickly swap the return of

the portfolio against a real rate of return. If the markets went down significantly, the

government could absorb and spread out the loss among everyone, thereby mitigating

significant risk to the funds61.

60 Anrig, Greg, et al.: 9.61 Modigliani, Franco, Marialuisa Ceprini, and Arun S. Muralidhar. A Solution to the Social Security Crisis: From an MIT Team. Nov. 1999. Massachusetts Institute of Technology: 1-13. 20 Apr. 2009 <http://dspace.mit.edu/bitstream/handle/1721.1/2740/SWP-4051-42747675.pdf?sequence=1>.

The transition to this type of system would not be overnight, but would instead start

simple by investing small amounts, perhaps with only surplus funds initially. The MIT team

expected that this transition would take roughly 60 years. They believe that this Fully-Funded

system is superior to the present system, because currently the required contributions are very

susceptible to small and very possible changes, such as productivity and age62.

Obama’s Plan

President Obama has stated that he is strictly opposed to raising the age of retirement, cutting

benefits, and any type of privatization of Social Security63, moving along party lines (as Democrats are

typically for the current system, while Republicans prefer privatization64). He instead supports higher

taxes on the rich, and has stated that he wishes to impose a 2-4% tax increase (1-2% employee and 1-2%

employer contributions) on those making over $250,00065. He also wishes to encourage private

retirement savings by proposing a government program that would match 50% of the first $1,000 in

savings for families that earn less than $75,000. It is important to note, that as of the publication of this

paper, none of the above changes have yet be enacted.

62 Modigliani, et al.: 13-20.63 Seniors & Social Security. Organizing For America. 21 Apr. 2009 <http://origin.barackobama.com/issues/seniors/>.64 Social Security debate (United States). Wikipedia.org. 21 Apr. 2009 < http://en.wikipedia.org/wiki/Social_Security_debate_(United_States)>.65 Seniors & Social Security.

Appendix A

66 Elliott, Kenneth R., et al.: 5.

Appendix B

OCACT Stochastic Model

67 Burdick, Clark, and Joyce Manchester.

TL Model

68 Burdick, Clark, and Joyce Manchester.

CBOLT Model

69 Burdick, Clark, and Joyce Manchester.

Appendix C

70 Tanner, Michael.

Appendix D

71 Anrig, Greg, and Bernard Wasow.