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by Cindie Moore, NCTR Washington Counsel

August 23, 1998

The General Accounting Office (GAO), in an August 18 report to the Chairman of the Subcommittee on Social Security of the House Ways and Means Committee (GAO/HEHS-98 196), analyzes the implications of extending mandatory Social Security coverage to employees of state and local governments. The report builds upon initial findings that the GAO submitted during testimony that was presented to the subcommittee in late May of this year and in response to a formal request for information from the subcommittee's Chairman, Rep. Jim Bunning (R-KY). Contact me for a copy of the report or the earlier testimony. You may also find the report on the internet at www.gao.gov.

Specifically, the GAO was asked to examine:

• the implications of mandatory coverage for the Social Security program;
  
  
• the implications of mandatory coverage for public employers and employees and existing public pension plans;
  
  
• and the potential legal and administrative problems associated with implementing mandatory coverage.

General Findings

In its report, the GAO finds that extending mandatory coverage to all newly hired state and local government employees would reduce the long term (75 year) actuarial deficit in the existing program by roughly 10 percent and would extend the trust funds' solvency by two additional years. Mandatory coverage would also "broaden participation in an important program and simplify program administration," in GAO's view.

The effect of mandatory coverage on public employers, employees, and pension plans would depend on the reaction of the individual governments to the costs and benefits of Social Security coverage. For example, those states and localities that elect to maintain benefit levels for new employees that are consistent with their current retirement plan would experience increased costs. Offsetting these costs, according to the GAO, is the fact that these employees would benefit from additional Social Security protections. On the other hand, in cases where level retirement spending is required, a state or locality may need to reduce some retirement benefits for the newly hired employees.

With respect to the constitutionality of the issue, the GAO contends that challenges to mandatory coverage are likely to be defeated. Administrative challenges would be presented to state and local governments and therefore the GAO suggests that up to a four year time period could be granted to allow the governments to design and implement pension plans that are coordinated with Social Security.

Method of Analysis

GAO researchers examined Social Security Administration (SSA) estimates concerning the increase in taxable payroll and Social Security revenues and expenditures attributed to extending mandatory coverage to newly hired state and local government employees. GAO staff also reviewed documents provided by the Internal Revenue Service (IRS) and held discussions with IRS staff. Additionally, the costs of pension benefits, investment practices, and actuarial valuation methods and assumptions were surveyed via data collected by the Bureau of Labor Statistics (BLS), the Public Pension Coordinating Counsel (PPCC), and the Society of Actuaries. Likewise, discussions were held with actuaries at the Office of Personnel Management (OPM), the Pension Benefit Guaranty Corporation (PBGC), the American Academy of Actuaries, and in private practice.

Further, a 1980 study by the Universal Social Security Coverage Study Group ("1980 Study"), prepared by the Secretary of the Department of Health, Education and Welfare (now the Department of Health and Human Services) was reviewed and analyzed. Interviews with state and local government employer, employee, and pension plan representatives in the seven states that account for over 75 percent of the noncovered payroll (California, Colorado, Illinois, Louisiana, Massachusetts, Ohio, Texas) were also conducted.

Current case law and relevant articles were reviewed in order to draw conclusions about the legality of mandating Social Security coverage.

Implications of Mandatory Coverage for the Social Security Program

For the 75 year period beginning January 1, 1998 , GAO using SSA's analysis indicates that extending mandatory coverage to all newly hired state and local government employees (assuming that mandatory coverage would be effective beginning January 1, 2000) would reduce the program's long term deficit from 2.19 percent of payroll to 1.97 percent of payroll, or 10 percent. The result would extend the trust funds' solvency from 2032 to 2034. The SSA assumes that payroll tax collections for new employees would accelerate early in the 75 year period, while the benefits for those employees would not accelerate until later. Specifically, GAO points out that:

"Annual revenues from payroll taxes collected from the newly covered employees and their employers are expected to exceed expenditures for benefits to those employees until 2050. In that year, however, revenues resulting from an extension of mandatory coverage, including interest on cumulative surplus revenues, are projected to exceed expenditures on those employees by over 300 percent." (Page 9)

The GAO report also cites as beneficial the elimination of the need to administer and enforce special rules for today's noncovered population. Specifically the report identifies the Windfall Elimination Provision (WEP) and the Government Pension Offset (GPO) as two mechanisms that are employed today to reduce the chance that a worker with a period of noncovered employment is deemed to qualify for higher Social Security benefits due to his/her appearance as a low income wage earner (WEP) or for additional benefits as a nonworking spouse (GPO). Because the SSA has difficulty in determining whether an applicant should be subject to WEP or GPO, overpayments result. Extending Social Security coverage to all state and local government employees would eliminate the costs associated with maintaining the WEP and GPO programs.

In addition, the SSA contends that those not contributing to the system typically receive the benefits either from periods of covered employment or as a dependent of a covered worker. Requiring today's noncovered population to participate in the Social Security system would address issues of fairness.

Therefore the GAO report concurs with the 1994-1996 Social Security Advisory Council as to the beneficial aspects of mandating coverage of state and local government employees.

Effect of Mandatory Coverage for Public Employers and Employees and Effect on Public Pension Plans

From the employer standpoint, adjustments in pension plan designs would likely be necessary to integrate newly hired employees into the Social Security system. The GAO theorizes that three options are possible, each posing separate and distinct issues:

• First, states and localities could maintain similar total retirement benefits for all employees, both current and newly hired. New hires would receive pension benefits at retirement, which, when combined with Social Security benefits, would approximate the pension benefits of current employees. The option would increase total benefit costs, but add benefits for newly hired employees;
  
  
• Second, states and localities could look to changes that other plans have employed to coordinate Social Security benefits and respond in a like manner. In other words, they could provide benefits for new hires similar to benefits of employees now covered by Social Security. As with the first option, this one would likely result in increased benefit costs to the employer and increased benefits for the newly hired employees; and
  
  
• Third, state and localities could maintain level benefit costs. This option would necessitate a reduction in benefits from the government's plan for many newly hired employees, though the employees would have the benefit of participating in the Social Security system.

First Option. Studies which include the 1980 Study and recent ones undertaken by actuaries in Colorado, Illinois and Ohio, indicate that the increased costs could be roughly 7 percent of new-employee payroll in order to maintain similar retirement benefits for all employees. The 1980 study group assumed that most new hires would have salary replacement percentages in their first year of retirement that would be comparable to the salary replacement percentages to current employees. The study concluded that since Social Security benefits are weighted in favor of families and low income wage earners and because such benefits are fully indexed for inflation, while many retirement plans provide limited cost of living protections, total lifetime benefits for some new hires would be greater than those of current employees. The cost associated with designing benefit formulas that explicitly integrate pension and Social Security benefits would be large in the public sector where only about 4 percent of full-time employees participate in integrated plans.

Second Option. GAO looked at the 1980 Study to conclude to that providing newly hired employees with benefits similar to those provided to current employees that are covered by Social Security would likely result in a cost increase of between 3 and 11 percent of payroll. Also the present value of lifetime benefits for the new hires would be greater than the value of benefits of current noncovered employees. GAO reached this conclusion using BLS data. The data show that public pension plans replace about 65 percent of the final average salary of noncovered employees retiring with 30 years of service and only about 53 percent of a covered employees final average salary. Thus, the percentage of salary that is replaced by retirement income is smaller for covered employees who retire before they become Social Security eligible. Once Social Security benefits begin, however, the covered employees have higher salary replacement rates.

Third Option. If states and localities decide to maintain level spending for retirement, they might need to reduce pension benefits under public pension plans for many employees. For example, a June 1997 actuarial evaluation of an Ohio pension plan examined the impact on benefits of mandating Social Security coverage for all employees, assuming no increase in total retirement costs. The study concluded that level spending could be maintained if:

• service retirement benefits were reduced (for example, salary replacement rates for employees retiring with 30 years of service would be reduced from 60.3 percent to 44.1 percent);
  
  
• retiree health benefits were eliminated for both current and future employees; and
  
  
• the funding period of the plan's unfunded accrued liability was extended from 27 years to 40 years.

Because the Social Security system did not historically cover state and local government employees, plan administrators argue that the forced change in the state or local pension plans could result in reduced contributions to the plan, which in turn would affect the long-term financing of the government's plan. The report points out that some plan representatives are concerned that efforts to provide adequate retirement income benefits for new hires would affect the employer's willingness or ability to continue amortizing its current unfunded accrued liabilities which could pose a problem in states that already have large unfunded liabilities.

Legal and Administrative Issues In Implementing Mandatory Coverage

While the GAO suggests that the mandatory coverage could elicit a lawsuit, it contends that recent Supreme Court cases have affirmed the authority of the federal government to raise taxes that affect the states and to impose federal requirements governing the relationship between states and their employees. Thus, the mandatory coverage of state and local government employees is likely to be upheld. When considering cases cited by plan representatives as upholding state sovereignty, GAO contends such cases are generally distinguishable from the situation presented by mandatory Social Security coverage.

The three year time period needed by the federal government to enact changes which dictated that all newly hired federal employees participate in the Social Security program coupled with the results of the 1980 Study cited above brought GAO to the conclusion that four years would be required to implement mandatory Social Security coverage. Administrative considerations involve the redesign of pension formulas, and the need to legislate changes, adjust budgets, and disseminate information to employers and employees. In addition, because state constitutional provisions or statutes in some instances might prevent employers from reducing retirement benefits of an employee once he/she has been hired, it might be administratively infeasible to modify a public pension plan in that regard unless those states first enacted legislation to distinguish between current and future employees. The fact that some state legislatures do not meet annually, provides an additional reason for the need for a lengthy time period.