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Their Employees, and Their Retirement Systems

By

Cynthia L. Moore[i], Washington Counsel,

National Council on Teacher Retirement[ii]

703-243-1667 (T); cmoore@nctr.org (E)

December 11, 2000

(updated May 18, 2001)

            The Social Security System’s financial future is bleak.  Starting in 2011, the first of the 77 million baby boomers will retire.  The System’s trust fund will initially be sufficient to pay their benefits.  In about 20 years from now, however, Social Security will pay out more in benefits than it collects in payroll taxes.  By 2038, the trust fund will be depleted, and beneficiaries will receive only 75% of their promised benefits. 

Although Congress has not acted to resolve Social Security’s financial problems, the beginning of a new presidency may prompt debate.  Thus, states, local governments, their employees, and their retirement systems need to assess how possible changes to the System will affect them.  (Since I first prepared this paper, President Bush has appointed a commission to propose Social Security reform. 

A useful guide on the subject has been recently released by the General Accounting Office (GAO).  The agency looks at a variety of studies and proposals discussing the implications of Social Security reform for private pensions. [iii]  Among other issues, it examines the effects of both “traditional” and “structural” Social Security reforms (the latter encompasses individual accounts), and how private sector firms and their employees may respond to them.[iv]  It does not look at the effect on state and local governments, their employees, and their retirement systems, but, as will be discussed in the paper, the analysis is similar in some respects.

Private Sector Pension Plans

And State/Local Government Pension Plans

            Although private sector and public (e.g., state/local government) pension plans are regulated somewhat differently, their purposes and operations are similar.  Both private and public sector employers offer pension plans to their employees as a form of compensation.  The plans of both sectors are usually pre-funded (private sector defined benefit plans are usually funded through employer contributions and earnings, while in the public sector, defined benefit plans are usually financed through those two sources plus employee contributions).  Administrators of both types of plans are subject to strict laws, known as fiduciary duties, that require them to act prudently and loyally.  Workers in both sectors are eligible for a benefit if they work some requisite number of years (i.e., they vest).  Based on the foregoing similarities, NCTR decided that GAO’s analysis might be helpful in assessing how “traditional” and “structural” Social Security reforms might affect state and local governments, their employees, and their retirement systems.[v]

            This paper begins by defining “traditional” and “structural” reforms.  It then describes possible employer response to various traditional reforms, followed by possible employee response.  Finally, it handles structural reform by listing issues and discussing possible employer and employee responses.

“Traditional” Versus “Structural” Reforms

          To deal with the funding shortfall caused by the baby boomers, many reforms have been proposed.  GAO looks at two categories of them:  traditional and structural.  GAO defines reforms as “traditional” if they modify the benefit formula, reduce benefits, increase future payroll tax rates, and raise the Social Security retirement age.  It distinguishes them from “structural reforms,” in which all American workers will have an individual account into which a portion of their Social Security payroll tax will be deposited and then invested.

GAO cites several examples of traditional reform.  In 1977, the System’s finances needed to be shored up.  Congress made technical changes to the formula, reduced benefits, and increased the future payroll tax rate.  Congress’ amendments in 1983 included an acceleration of the payroll tax rate increases of 1977 and a slow rise in the normal retirement age to 67.[vi]

The 1994-1996 Advisory Council on Social Security changed the nature of the reform debate, according to GAO.  Although the Council discussed traditional reforms, it also looked at the possibility of investing a portion of the Social Security trust funds in equities markets.  Some Council members recommended that a federal entity invest part of the trust fund in a manner similar to that of state and local government pension plans.  Other members proposed establishing an individual account for each American worker, depositing a portion of the Social Security payroll tax into it, and having each worker invest it.  GAO concentrates on the latter proposal in its report.

Possible Employer Response to Various Traditional Reforms

Increasing Payroll Taxes

GAO points out that in 1977 and 1983, Congress raised payroll taxes.  Some consideration has been given to an additional increase to shore up the System.  The effect on private sector employers is simple:  it raises their costs.  Employers might respond by lowering pension plan benefits, decreasing other types of compensation, such as health insurance, or even terminating plans.  The reaction will depend on the size of the entity, according to the GAO.  Because small businesses are generally more sensitive to changes in their compensation costs, payroll tax increases could make them more likely to terminate their plans, compared with larger firms.  If this result occurs, overall pension coverage might go down, intensifying the existing difference in pension coverage between large and small firms.

Higher payroll taxes will also cause state and local governments’ compensation costs to go up.  Like the private sector, the governments might attempt to reduce other types of compensation, such as health insurance, to offset the increase.[vii]  They are less likely, however, to resort to benefit reduction or plan termination because of legal and political considerations that do not exist in the private sector.

Although ERISA Section 204(g) prohibits accrued pension benefits from being cut back, it does implicitly permit private sector employers to reduce pension benefits on a prospective basis.  State and local government laws are usually not as permissive.  For example, in Alaska, pension benefits and other rights are fixed upon hiring.  Alaska Constitution, article XII, § 7.  Moreover, because of political considerations, state and local governments, even if they do have the authority, do not commonly cut back future benefit accruals of existing employees.  When they need to reduce pension costs, they create a new tier of benefits that is applicable to employees hired after a certain date and retain the older plan for existing employees.  Thus, some states, such as New York, have several tiers of benefits.  Membership in a certain tier depends on an employee’s date of hire. 

As with pension benefit reduction, state and local governments act similarly with respect to plan termination.  They tend not to eliminate plans, but enact lower benefits that apply to new employees only.

Thus, if Congress raises the Social Security payroll tax, private sector employers might resort to a wide range of solutions to offset the higher cost.  State and local governments, because of legal and political considerations, have fewer options and, if faced with increased costs, will be more likely to either cut non-pension benefits or create a new tier of lower cost pension benefits for newly hired employees.[viii]

Raising Retirement Ages

Many private sector employers use a defined benefit pension plan as a tool for workforce management.  The plan permits employers to choose when to encourage worker turnover.  Specifically, employers can induce older workers through a retirement incentive to retire, thereby hiring newer workers at lower salaries. 

If the normal or early Social Security retirement age(s) are raised, private sector employers will likely review existing early retirement incentives.  One area of impact concerns “bridge payments,” supplemental pension benefits payable until the retired employee becomes eligible for Social Security retirement at early or normal age.  With higher retirement ages, employers will incur greater bridge payments.  Some state and local governments also make bridge payments, thus the foregoing analysis will apply to them. 

Possible Employee Response to Various Traditional Reforms

          GAO looks at employees’ potential reactions to the traditional Social Security reforms of increasing payroll taxes and reducing benefit levels.  Although GAO does not discuss state and local government workers, its analysis applies equally to both private and public sector workers. 

The responses spelled out by GAO follow.

Ø      Some employees might decide to accept a reduced living standard or draw down other assets. 

Ø      Others might save more in their 401(k)s or IRAs.[ix]  This saving will funnel more capital into the equities markets and, presumably, expand the economy.

Ø      Some workers might press for an increase in the pension benefit and contribution limits under IRC Section 415 so that they could save more money on a tax-deferred basis.  Congress would have to approve the change. 

Ø      Finally, others might work more or stay in the workforce longer than they might otherwise.  If they choose the latter option, they will be less responsive to early retirement incentives.  Thus, employers will be forced to make the incentives more attractive, another higher cost.[x]

Later retirement also poses a problem not raised by GAO.  Employees in physically demanding jobs may not be able to work longer.  Examples include construction workers in the private sector and public safety employees in the public sector.  Other employees may contract debilitating conditions that impair their ability to work longer.  As a result, workers may pressure employers to amend their plans and provide for greater early retirement subsidies between the time they retire and their eligibility for Social Security.  As with some of the other responses listed, this result also raises employer costs.  As shown in endnote iv, the Social Security retirement age eligibility is increasing, and the pressure may occur regardless of whether reforms are enacted.

Issues Arising Under Structural Reform

Individual accounts are already part of U.S. pension policy in the form of IRAs, 401(k) plans, 403(b) tax-sheltered annuities, 457 deferred compensation plans, and similar savings vehicles.  While the idea of individual accounts is easily understood by analogy to existing vehicles, the establishment of individual accounts will be very complex.  GAO highlights a few of the issues.

Magnitude of Accounts’ Financing.  What amount or percentage of the payroll tax will be paid into the account?  Proposals differ, but some suggest 2%.

Nature of Financing.  Is the payment into the account a “carve-out” or an “add-on”?  Under a “carve-out,” the current level of payroll tax rates are maintained, but a portion of it (e.g., 2%) is paid into the account.  An “add-on” supplements the Social Security System and increases overall contributions to it.

Administration.  Will workers be allowed to maintain their accounts outside of the Social Security System or will some government institution set up the accounts, administer them, and channel the contributions to money managers?  In effect, GAO is asking what role employers, private and public, alike will play in individual accounts 

Scope.  Will participation in individual accounts be mandatory or voluntary?  Stated another way, will workers be required to participate in individual accounts, or will they merely have the option?

Possible Employer Response to Structural Reforms

The foregoing issues do not effect employers equally (although all of the issues are of concern to private and public sector employers alike).  Two of the issues will create higher costs:  1) if structural reform consists of an “add-on,” it will increase payroll expenses; and 2) if employers must carry out much of the administration of the new accounts, they will need to set up new systems that will also entail costs.  The other issues will have the opposite affect.  Under a “carve-out,” the amount being funneled into the private accounts comes from the existing payroll tax, thus, no additional costs are required.  By the same token, if a federal governmental entity is responsible for handling the accounts, thereby relieving employers of administrative responsibilities, costs will not significantly rise.

If an add-on is approved, employers will likely react in the same way as they will under the traditional reforms.  Private sector employers will lower pension plan benefits, decrease other types of compensation, such as health insurance, or even terminate plans.  State and local governments, on the other hand, will cut non-pension benefits or establish a tier of lower cost pension benefits for newly hired employees.

More problematic for employers is the administration of the accounts.  Although GAO does not detail what such administration will entail, the following activities are possible:  collecting the applicable portion of payroll tax for each employee, depositing the portion into each employee’s account, deciding the types of investments available to employees and who the providers will be, supplying information to employees about the investments, and sending the money to the appropriate provider as directed by the employee.  These activities will not only raise overall costs, but they will require employers to set up new procedures.  The cost and new procedures will apply equally to both private and public sector employers. 

Cost will not be an issue in the mandatory versus voluntary account issue.  GAO points out that mandatory accounts provide a degree of certainty about the structure of Social Security.  Thus, employers will more easily be able to respond to the reforms.  Voluntary accounts will be similar to existing retirement savings vehicles such as IRAs, and it will be far more difficult for employers to factor in how and whether they should change their pension plans to respond to them. 

Possible Employee Response to Structural Reforms

GAO points out that because individual account balances depend on investment returns, they will increase the level of uncertainty about the amount of a worker’s retirement income.  In response, employees might demand pension plans that provide income security, such as annuity-type products or defined benefit plans.  Moreover, if the accounts earn investment returns lower than historical trends, both employers and workers will have to make adjustments.  Workers might pressure employers to increase benefits to make up the shortfall, a point not raised by GAO.  Of course, if individual accounts earn higher rates of return than current Social Security beneficiaries receive, they might, as GAO points out, lower workers’ need to adjust to reduced benefit levels (e.g., under the “traditional” reform category).  Both private and public sector workers will encounter these affects.

Conclusion

The debate on Social Security reform will require policymakers to reach difficult decisions.  The options presented by GAO pose, at minimum, uncertainty, and also possibly, significant burdens to private sector employers and employees.  As pointed out in this paper, similar uncertainty and possible burdens might affect public sector employers and employees.  Policymakers need to remain mindful of these concerns as they work toward a solution.