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January 25, 1997

SS Advisory Council Summary

By Cynthia L. Moore Washington Counsel
National Council on Teacher Retirement

The inability of Social Security to meet the financial strain of the Baby Boomers' retirement is attracting attention. The Advisory Council on Social Security issued its report on January 6 that proposes a wide range of options to shore up the system. The most talked about portion of the report centers on the possible investment of Social Security assets in the equities market. It also proposes mandatory social security coverage of newly hired state and local workers after 1997. The Council is composed of 13 members and worked two and one-half years to come up with their recommendations. The Council's mandate did not include making recommendations about Medicare, which is also suffering a financial crisis. A summary of the report appears at the end of this commentary.

NCTR does not have a position on the investment of Social Security assets in the equity market. It does advocate, however, that any coverage of state and local employees by Social Security be through a voluntary agreement between the state and the federal government, which includes a referendum of the affected workers.

Too Many Boomers; Not Enough Money

By way of background, Social Security has been run largely on a pay-as-you-go basis and has not changed markedly since its establishment in 1935. Social Security benefits are financed from current payroll taxes. Any excess revenue from payroll taxes is spent on other government programs. The government puts IOU's into the Social Security trust fund, in the form of non-marketable special issue U.S. government securities, to represent what it owes the trust fund.

Concern about Social Security financing is not new. In 1983, Congress modified the pay-as-you-go financing by adding a pre-funding mechanism in anticipation of the Baby Boomers.

The Social Security trust fund is currently running a surplus and is expected to continue to do so over the near-term. The annual surplus in 1995 was $59.7 billion and is estimated to rise to nearly $100 billion annually around the turn of the century.

The surplus will rapidly decline when the baby boom generation retires during 2010 and 2030. By 2013, payments to Social Security recipients will exceed the revenue from payroll taxes that are used to finance the trust fund. The trust fund will run out of money in 2030, 30 years earlier than projected when Congress passed the 1983 amendments.

As the Baby Boomers begin to retire, there will be a greater proportion of elderly in the U.S. than in any previous generation. There are approximately 24 million people over the age of 70 alive in the U.S. today. By 2030, that number will double to 48 million.

To put it into percentages, today approximately 13% of the U.S. population is over 65. By 2030, that percentage will increase to over 20%.

Making the issue more serious is the increasing longevity of Americans. The creators of Social Security were shrewd about their choice of normal retirement age. They chose 65, even though at that time the average life expectancy was only 61. Today, average life expectancy is 76. By 2030, it is expected to approach 80 years of age.

Not only are people living longer, but fewer workers are available to pay the payroll taxes to support Social Security. In the 1950's, there were about 8 working-age Americans for every person over 65 years of age. Today, there are fewer than 5 working-age Americans for every person over 65. By 2030, there will be just 2 working-age Americans for each person over 65.

Thus, the financial situation combined with the demographic data makes the future of Social Security grim indeed.

Summary of Council's Recommendations of Interest to NCTR Members

Mandatory Social Security Covered Proposed

To illustrate the difficulty of their task, Council members have split into three groups on how to shore up Social Security's finances. Ironically for states and localities, one of the few issues of agreement is mandatory Social Security coverage of state and local government employees. The Council members propose coverage of any such employees not currently covered by Social Security who are hired after 1997. Here are the arguments they put forth:

• all Americans have an obligation to participate in Social Security, since an effective program helps to reduce public costs for relief and assistance, which, in turn, means lower general taxes;
  
  
• a high proportion of state and local government employees are already covered by Social Security (since the 1980's, all new hires in the federal government are covered by Social Security);
  
  
• in light of several Supreme Court decisions dealing with federal/state relationships in the area of labor law, it is now generally thought that there is no constitutional barrier to compulsory coverage;
  
  
• the issue of covering the last sizable group of workers not under Social Security is an issue of fairness; and
  
  
• a high proportion of state and local government employees will get Social Security benefits anyway. (Report pp. 19-20)

Their last argument overshadows the others because it is based on what many believe is the sole reason for proposing mandatory coverage: money. They say that mandatory coverage saves money over both the short and long term. "[C]ontributions will be received for many years before the benefit payments must be made . . . Including all state and local government workers hired after 1997 saves 0.22% of taxable payroll, 10% of the present long-term actuarial deficit." (Report, p. 20)

In a footnote, the report notes that three of the 13 Council members oppose mandatory coverage because of the financial burden that would be placed on workers and employers who are already contributing to other public pension systems. Data compiled by OPPOSE, a group opposed to mandatory coverage, backs up this conclusion. Such coverage would annually cost states and localities nearly a $1 billion a year. An equal cost would fall on employees, for a total of $2 billion per year.

PEPPRA Advocated

Surprisingly, the Council recommended that certain provisions of ERISA should apply to state and local government plans. These include disclosure, fiduciary standards, and spousal protection, i.e., pre- and post-retirement survivor annuities and qualified domestic relations orders, (which are currently contained in the governing laws of most state and local government plans, thus making the proposal unnecessary). The Council did not recommend extending the minimum funding standards, "particularly in light of the effects of its recommendations to cover all new state and local government hires under Social Security." (Report, pp. 23-24) The Council failed to provide an explicit connection between ERISA-style regulation of state and local plans and the Social Security funding crisis. The recommendation appears in a section of the report called "Policies regarding Other Retirement Income."

Investment in the Equities Markets Promoted

The most controversial proposals by Council members are the so-called "privatization" proposals. These proposals would require the investment of some Social Security trust fund money in the equities markets in order to tap into the higher rates of return available. The goal is to provide an additional means to finance the program.

All of the 3 schools of thought in the Council appear to support the investment of assets in the Social Security trust fund in the equities markets. The difference is how they would accomplish it.

Option 1. Six Council members support the "Maintain Benefits Plan." Under it, Social Security would invest a portion of its assets in private equity funds after a period of study and evaluation. If implemented, the amount would rise gradually so that in 2014 about 40% of the assets would be invested.

Trust fund investment in equities would be overseen by an investment policy board nominated by the President and confirmed by the Senate. The board would be subject to legislated fiduciary standards mandating that trust fund investment is solely for the economic benefit of Social Security participants, and not for other economic, social, or political objectives. The board would have two major responsibilities: (1) selecting among alternative passive market indexes, and (2) conducting a competitive bidding process to select the equity index portfolio managers. It would also monitor portfolio and investment manager performance. The Council members who support this option discussed, but did not reach agreement on how to neutralize the effect of Social Security holding on stockholder voting on company policy.

The proponents of Option 1 seek to reassure the public about their intentions. They say that; "[t]he sole purpose of Social Security's investment in equities is to secure a higher return than can be obtained from the present practice of investing all funds in government bonds. Otherwise, the Social Security structure would be little changed." (Report, pp. 25-27)

Option 2. Two Council members support the "Individual Account (IA) Plan," which would create mandatory individual accounts as a supplement to Social Security benefits. The individual accounts would be funded by worker contributions equal to 1.6% of earnings, in addition to the current Social Security payroll tax. Workers would have a narrow range of investment options available in which to invest the money. It appears (but is not entirely clear) that the federal government would hold and/or manage the money. Nor is the report completely clear about how the rest of the Social Security trust fund money would be invested, but implies that it would be the same as under the current system, i.e., in government bonds. Workers would draw the amount in the IA as an annuity. (Report pp. 28-29)

Option 3. The remaining five Council members support the "Personal Security (PSA) account." Under it, Social Security would move gradually to a 2-tier system. The Tier 1 would provide a flat monthly benefit equal to about $410 (in 1996 dollars) for full career workers. It would be financed by 7.4% of the total 12.4% Social Security payroll tax. The report does not explain how assets in Tier 1 would be treated, but the assumption is that they would be invested in the same manner as under the current program, i.e., invested in government bonds.

Tier 2 assets would be invested in a personal savings account (PSA). The assets for the accounts would come from the 5% of the employee contributions to the payroll tax. Unlike Option 2, the accounts would be owned and managed by workers and investment options would be less restricted. Regulations would be established to ensure the PSAs were invested in financial instruments widely available in the financial markets and that they were held for retirement purposes. Workers would not be required to annuitize their accumulations at retirement, as under Option 2.

Because Option 3 represents the most far-reaching change, its advocates propose a phase in. Retirees and workers age 55 and above in 1998 would not participate in PSAs. Workers age 25 to 54 would receive a combination of the Tier 1 benefit, their accumulated benefit under the existing system, and the Tier 2 amount, i.e., the amount in their PSAs. Workers under age 25 would be transferred to the 2-tiered system.

Issues Raised by the Proposed Investment in the Equities Markets

General Issues Relating to Market Investment

• How should Social Security investments be structured to prevent undue federal government influence in the private market? Some analysts predict that companies whose stocks are selected by Social Security will receive an investment boost not available to other companies. This may give the federal government substantial influence over the companies' financial well-being. Others have said that trust fund monies be invested in index funds only, which might avoid undue influence (as recommended by the Council members supporting Option 1).
  
  
• How should Social Security deal with the risk inherent with the higher returns from the equity markets? The Social Security trust fund is currently invested in U.S. government securities, which are viewed as a safe investment. If Social Security moves a portion of the trust fund money from these government securities into the private market, some commentators worry about market volatility that does not currently exist under the current method of investing in government bonds. To mitigate the effect, limited investment choices have been suggested.
  
  
• If Social Security has to sell off assets invested in the equity markets when the Baby Boomers retire (because Social Security benefit payouts from the trust fund will exceed payroll taxes), what will happen to the markets? Some commentators are concerned that these withdrawals could substantially depress market prices and reduce the trust fund's income. It could also reduce investment returns for other players in the market, such as state and local government retirement funds. In addition, the Social Security trust fund could suffer capital losses if its investments had been purchased when market prices were artificially high.

Issues Involving IAs and PSAs

• What should be done to guarantee the investment success of the PSAs or IAs? To avoid problems, some analysts say that the funds in the accounts should be administered by professional investment managers with a restricted choice of investments. Other analysts say that the government should set up FDIC-style insurance on the principal in the account up to a certain amount, although, in general, account owners would make the basic investment decisions and would have to accept some degree of risk. If the market turned down just as Baby Boomers retired, the government might be forced to make whole their PSA or IA accounts.
  
  
• Would administrative costs rise with the private accounts? The administrative costs of the existing Social Security program are very low -- less than 1% of outgo. Some analysts question whether private sector investment managers could match this because they incur such costs as marketing, which Social Security doesn't have. They assert that the higher costs would reduce the expected higher investment returns and ultimately affect the level of benefits available from individual accounts. Other commentators believe that the higher investment returns will be sufficient to cover these higher costs.
  
  
• Do Americans want to shoulder the responsibility and risks for their own retirement income security, which is a fundamental change in Social Security's philosophy? The present Social Security system operates something like a defined benefit plan in that a person's benefit is based on a formula. Under a PSA or an IA, investment risk shifts to the individual. This transfer of risk could have significant impact on the success of IAs and PSAs. Some analysts say that individuals can't absorb the amount of risk as the Social Security program, especially during periods when market values drop sharply. Individuals are less able to ride out periods of poor market performance for both financial and psychological reasons. Other commentators argue that employees in private sector pension plans are increasingly accustomed to managing their investment through their participation in 401(k) plans.

Issues Common to All Proposed Investment Programs

• Because the current Social Security surplus finances other government activity, will shifting a portion of the reserves to the equities markets deprive the government of needed revenue? The federal government might be forced to borrow more funds from the public, according to some analysts. Increased government borrowing could crowd private investment out of the market, and lead to higher interest rates. Others believe that Social Security investment could offset the money leaving the market to finance government debt, leaving net stock market investment unchanged. If the government was unable to raise sufficient funds from the public, it could reduce spending or raise taxes. Either of these solutions could raise significant political problems. Most analysts believe that any program would have to be phased in to avoid any of these results.
  
  
• Will there be sufficient investment opportunities in the market to absorb the large amount of money from both the trust fund assets and the individual accounts and still maintain high rates of return? Some commentators argue that the new capital will result in more opportunity for high-yield investments. Others are concerned, however, that if productive capacity does not increase, the new capital could push up market prices without leading to economic growth.

Other Proposals Advanced

Other proposals being advocated by some, though not all of the Council members, include: -raising the retirement age more rapidly;

• changing the taxation of benefits;
  
  
• slowing benefit increases;
  
  
• extending the benefit computation period from 35 to 38 years; and
  
  
• increasing payroll taxes.

Conclusion

Congress will likely hold hearing on the issue, but few elected officials are anxious to take on this hot button issue. An exception is Senator Bob Kerrey (D-NE) who is a long-time supporter of Social Security investment in the markets. He has called for rapid action on the concept.

1994-96 ADVISORY COUNCIL ON SOCIAL SECURITY (SSAC)

The SSAC released its report on January 6, 1997 about the restructuring of Social Security, including the investment of Social Security trust fund assets in the equities markets. The members failed to reach a consensus; instead, each member supported one of three options. The following information, distributed by the Social Security Administration, summarizes each option.

Brief Description of Each Option

Maintain Benefits (MB) Option: Traditional Social Security program with a portion of trust fund assets invested by the Social Security Administration in passively-managed indexed stock funds.

Individual Account (IA) Option: Traditional Social Security program with some benefit reduction and an additional mandatory employee contribution to fund individual retirement accounts.

Personal Security Account (PSA) Option: Two-tiered Social Security program: a flat benefit (Tier I) supplemented with individual account (Tier II) funded by redirecting 5 percentage points of payroll tax.

Financing

MB: Combined employer/employee OASDI tax rate (currently 12.4% of payroll) increased by 1.6% of payroll in 2045.

IA: OASDI tax rate held at 12.4% of payroll. New IA funded with additional employee contribution of 1.6% of payroll deposited in individual account beginning in 1998.

PSA: 5 percentage points of payroll tax shifted from OASDI to PSA. Additional tax of 1.52% of payroll from 1998-2069 to finance transition. Transition also financed by borrowing from Treasury, paid back with the 1.52% tax in later years.

Investment of New Individual Accounts

MB: N/A

IA: IA defined contribution accounts held by the government but the worker selects the investment from constrained investment choices.

PSA: PSA defined contribution accounts would be privately held; workers would have wide discretion on investments.

Benefit Formula

MB: The Primary Insurance Amount (PIA) formula would remain the same as current law.

IA: PIA formula factors would be modified (phased in over 1998-2030). Low earners would receive 8% less; average earners 17% less; maximum earners, 22% less. IA proceeds would be based on investment performance. Proceeds would not be available before retirement and when paid must be converted to a single or joint indexed annuity.

PSA: Tier 1: flat benefit for retired workers under 55 in 1998 ($410/month in 1996, wage indexed thereafter; reduced and prorated if between 25 and 35 years of earnings). Past service credits, wage indexed to year of eligibility, for those age 25-54 in 1998. For disabled workers and young survivors: benefit amount is reduced over time (e.g., reduced by 30% by 2038). Tier II: proceeds based on investment performance. Proceeds would not be available before retirement.

Benefit Computation Period

MB: The computation period would be increased from 35 to 38 years, phased in over the 1997-1999 period. (Average benefit reduction 3%).

IA: Same as MB Plan.

PSA: Computation period would increase slowly to 38 years as Early Eligibility Age (EEA) rises to 65; but shift in wage indexing point (as EEA rises) would roughly offset it.

Investment of OASDI Trust Fund Assets

MB: After a period of study, serious consideration would be given to investing 40% of OASDI trust fund assets in stocks. Analysis in report assumes investment starts in 2000; reaches 40% in 2014.

IA: No change. All assets invested in U.S. Treasury bonds.

PSA: No change. All assets invested in U.S. Treasury bonds.

Retirement Age

MB: Normal Retirement Age (NRA): same as current law. Early Eligibility Age (EEA): Retain at age 62.

IA: NRA: Increased to age 67 by 2011 (2 mo/1 yr starting with individuals age 62 in 2000). Indexed to life expectancy thereafter -- increases at 1 mo/2 yr. Retirement age would reach 68 for workers reaching age 62 in 2035 and continue to rise. EEA: Retain at age 62.

PSA: NRA: Same as IA Plan EEA: Increases at same pace as NRA, increasing to 65 for individuals reaching age 62 in 2035. The EEA would not increase above age 65.

Taxation of Benefits

MB: Beginning in 1998, all benefits in excess of employee contributions would be made subject to income taxation (i.e., same manner prescribed for private and government defined benefit pension plans). Phase out $25,000/$32,000 thresholds beginning in 1998 (fully phased out by 2007).

IA: Same as MB Plan for OASDI benefits. The plan has two options for the tax treatment of proceeds from the IA: Include all proceeds in taxable income at time of withdrawal if contributions were tax deductible; or Make withdrawals tax free if contributions were made with after tax funds.

PSA: Beginning in 1998, OASDI benefits would be subject to tax as follows: 50% of DI and young survivor benefits taxable, 100% of Tier 1 benefit and 50% of past service credits taxable, 50% of benefits to those over 54 in 1998 would be taxable. Phase out $25,000/$32,000 thresholds over the 1998-2007 period. PSA withdrawals would be tax free because contributions would be made with after-tax funds.

Redirect Tax on Benefits

MB: Redirect benefit taxation revenue from the HI to the OASDI trust funds (over the 2010- 1019 period).

IA: No change from present law.

PSA: Discontinue revenue transfer to HI program effective 1998.

Spousal Benefits

MB: Retain current spouse's benefit at 50% of worker's Primary Insurance Amount (PIA).

IA: Phase down spouse's benefit to 33% of worker's PIA.

PSA: Rate for spouse's benefit remains at 50%, but of the lower flat benefit; reduce rate to 33% of worker's PIA for spouse of disabled worker.

Survivor Benefits

MB: Retain current survivor benefit (100% of deceased worker's PIA or own PIA whichever is higher).

IA: Survivor benefit of 100% of deceased spouse's PIA, own PIA or 75% of couple's combined basic benefit, whichever is higher (phased in 1998-2037). Plus proceeds from IA. PSA Same as IA plan for Tier I benefits. Tier II: Survivor inherits the PSA. Cost of Living Adjustment (COLA) MB Assume that CPI changes by BLS will result in 0.21 lower COLA by 12/97. IA Same as MB Plan.

PSA: Same as MB Plan.

Retirement Earnings Test

MB: No change.

IA: No change.

PSA: Retirement earnings test eliminated at NRA.