Important note: The following draft was prepared by staff for presentation to the members of the Commission for their review. It has been neither reviewed by nor approved by the full Commission and therefore does not necessarily reflect the official views of the President’s Commission to Strengthen Social Security.

Introduction by the Co-Chairs

From the first, Social Security was a work in progress. It remains so now. In 1939, just four years after enactment, the Administration and Congress added major provisions. FDR called for more. As he signed the 1939 Amendments he stated: "we must expect a great program of social legislation, as such as is represented in the Social Security Act, to be improved and strengthened in the light of additional experience and understanding." He urged an "active study" of future possibilities.

One such possibility – personal retirement accounts that would endow workers with a measure of wealth – has emerged as the central issue in the ongoing national debate over social insurance.

There are a number of reasons for this. The first is the most obvious, if perhaps the least commented upon: Social Security retirement benefits are no longer the bargain they once were. There is nothing sinister about this. Early retirees benefited from the fixed formula of retirement benefits. For years the Social Security Administration would distribute photographs of Ida May Fuller of Ludlow, Vermont, who having paid $24.75 in Social Security taxes lived to age 100 and collected $22,889 in benefits.

In Miss Fuller’s time there were almost 42 covered workers for each Social Security beneficiary. We are now down to 3.4 workers per beneficiary. As a result, Social Security as a retirement measure has become a poor investment. It is, even so, an essential insurance program. Widows and dependent children are very reliant on dependent benefits. For widows, widowers, singles and children, the monthly check can be a steady, stabilizing factor in life. That said, however, Social Security’ actuaries estimate that, for a single male worker born in 2000 with average earnings, the real annual return on his currently-scheduled contributions to Social Security will be only 0.86 percent. This is not what sends savers to savings banks. For workers who earn the maximum amount taxed (currently $80,400, indexed to wages) the real annual return is minus 0.72 percent.

This should come as no surprise. Demography is a kind of destiny. The founders of Social Security always assumed it would be supplemented by individual forms of savings. (In his original Message to Congress, President Roosevelt envisioned pensioners owning annuities.) In the first instance, savings took the form of housing; government subsidies were created in the 1930s, followed by the enormous influence of Veterans Administration mortgages following World War II. By 2000, two-thirds – 67.4 percent – of Americans owned their homes.

The Crash of ’29 left an indelible mark on the generation that lived through it -- and for that matter, the one that followed, such that direct investment in markets was slow in returning. But eventually it did.

Partly as a consequence of 1929, we have learned a great deal about how a modern economy works. During the Depression, the Federal government did not even calculate the unemployment rate; it was taken every ten years in the Census. Today, our economic statistics are extraordinary in range and accuracy, and since enactment of the Employment Act of 1946 economic policies have, on balance, been successful. The great swings in economic activity have been radically mitigated. In November 2001, the Dating Committee of the National Bureau of Economic Research gave out its judgment that the period of economic expansion that began in March 1991 ended in March 2001. Such a ten-year period of uninterrupted growth is something never before recorded. There will continue to be ups and downs, and all manner of risks, but in the main the modern market economy appears to have settled down to impressive long-term growth.

The post-World War II growth period was reflected, naturally enough, in the stock market. More important, a new form of investment, the mutual fund, was developed which enabled small savers to "pool" their investments over a range of stocks and bonds. As reported by the Investment Company Institute, "As of May, 2001, 93.3 million individuals, representing 52 percent of all U.S. households owned mutual funds." Further, "Nearly half of mutual fund shareholders have household financial assets below $100,000; 29 percent have less than $50,000."

The surge in mutual fund ownership began in the early 1980s. One of the more notable innovations was the development of such a fund, the Thrift Savings Plan, as part of the retirement arrangements for Federal employees. The legislation was enacted quietly by Congress and signed by President Reagan in 1986. In terms of the markets, the timing could not have been better. The results have been stunning, as the Commission learned from testimony by the Director of the Federal Retirement Thrift Investment Board, Roger Mehle. Three funds were available, in whatever combination the employee chose. A "G" Fund is invested in short-term non-marketable U.S. Treasury securities specially issued to the TSP. An "F" Fund is invested in a commercial bond index; and a "C" Fund is invested in an equity index fund. The compound rates of return for the closing decade of the last century were as follows:

Actual trading is contracted out and administrative expenses are minimal: 50 cents for every $1,000 of G Fund account balance, 70 cents for the F Fund, and 60 cents for the C Fund. (Additional funds are now being developed and offered.) As of September 2001, 86.6 percent of all Federal employees participated in the program. It is a singular success.

Martha Derthick’s classic study Policy Making for Social Security begins with a quotation from Arthur Altmeyer, who was chief executive of the program from 1937 to 1953:

Social Security will always be a goal, never a finished thing because human aspirations are infinitely expandable… just as human nature is infinitely perfectible. (p. 17)

This would not quite have been the view of the Founders, who thought human nature to be anything but "infinitely perfectible." Hence checks and balances were needed to make up for the "defect of better motives." And indeed some things, notably demography, proved anything but perfectible. The Social Security tax (F.I.C.A. for Federal Insurance Contribution Act) began at two percent and has been raised more than twenty times, reaching the present 12.4 percent. This is a regressive tax that is paid on the first dollar of income by rich and poor alike. In fact, as of 1997, 79 percent of American households paid more in payroll taxes than in income taxes.

One egregious failing of the present system is its effect on minorities with shorter life spans than the white majority. For black men age 20, only some 65 percent can be expected to survive to age 65. Thus, one of every three black youths will pay for retirement benefits they will never collect. No one intends this; and with time the gap may close. But it is not closed now. And because Social Security provides no property rights to its contributors – the Supreme Court has twice so ruled – a worker could easily work forty years then die and own not a penny of the contributions he has made for retirement benefits he will never collect. There are, to be sure, survivors and dependents benefits, but many workers die before eligibility for these is established. Disability insurance was added during the Eisenhower Administration so that workers are covered during their working years. But far too many never receive any retirement benefits and leave no estate.

Similarly, the present Social Security provision can prove unjust to women, especially divorced women who too often share nothing of the benefits acquired by a previous spouse. It is time we addressed this matter. There are a number of legitimate approaches that simply need to be worked out, with the plain objective of equal treatment.

As the early administrators of Social Security anticipated – and very much hoped for – the program steadily evolved. Health insurance (Medicare) was enacted in the 1960s. By the 1990s, the time had come for Personal Retirement Accounts. (As with much else in social insurance, other nations had preceded us.) In the mode of earlier innovations, the subject was first broached in academic circles, notably by economists such as Harvard’s Martin Feldstein. In the fall of 1997, the Clinton Administration began to analyze proposals to create a system of individual retirement accounts, either as part of Social Security or outside of it. By early 1998, working groups were formed within Treasury and other departments to study issues related to such proposals.

A primary issue was how a feasible system of accounts could be administered and what would be the associated costs. In the spring of 1999 the Treasury had contracted a study by the State Street Bank entitled, "Administrative Challenges Confronting Social Security Reform." The sum of it was that the task was feasible – the Thrift Savings Accounts were already in place – and the cost modest. Accenture (formerly known as Andersen Consulting) produced similar findings. In 1998 and 1999 a range of similar measures were introduced in Congress. None were enacted, but there was now a striking new item on the national agenda.

In the course of the Republican presidential primary campaign of 2000, then Governor George W. Bush gave a major address on Social Security, proclaiming it "the single most successful government program in American history…a defining American promise." He went on to discuss Personal Retirement Accounts that would, in the words of a Democratic Senator, "take the system to its ‘logical completion.’" Then-Governor Bush envisioned a program that would "give people the security of ownership," the opportunity "to build wealth, which they will use for their own retirement and pass on to their children." He cited a range of legislators, Republican and Democrat, who shared this general view, including Senator Bob Kerrey, who had recently stated: "It’s very important, especially for those of us who have already accumulated wealth, to write laws to enable other people to accumulate it." Governor Bush then added:

In his address, then-Governor Bush insisted that "personal accounts are not a substitute for Social Security," but a supplement, a logical completion. He proposed several measures necessary to ensure the long-term fiscal viability of Social Security itself. Among them was the following:

Personal retirement accounts within Social Security could be designed and financed in a number of ways, some of which are analyzed by the Commission in detail in the pages that follow. We, the co-chairs, note here that it would be straightforward for the government to set up such accounts. This approach would establish an opportunity for all people with earnings to set up a personal retirement account, on a voluntary basis. These accounts could be financed by the individual worker voluntarily adding one percent of his pay on top of the present 6.2 percent employee share of the Social Security payroll tax. The Federal government could match the employee’s contribution with a matching one percent of salary, drawn from general revenues. The result would be retirement savings accounts for all participating American workers and their families, which might or might not interact directly with the Social Security system, depending on design choices that are discussed further in Chapter 4. The cost to the Federal government would be approximately $40 billion per year, depending on rates of participation. The magic of compound interest now commences to work its wonders.

To illustrate what a participant might anticipate from setting aside one percent of his or her pay, matched with the government’s one percent, we can forecast the situation of a "scaled medium earner" entering the workforce at age 21 and retiring at age 65 in the year 2052. Assume a portfolio choice – there should be choices – roughly that of the current Thrift Savings Plan: 50 percent corporate equity, 30 percent corporate bonds, and 20 percent U.S. Treasury bonds. Real yields are assumed to be 6.5 percent for equities, 3.5 percent for corporate bonds, and 3 percent for Treasury bonds. Also assume that this worker pays 0.3 percent of his account assets for annual administrative costs. At retirement, she or he will have an expected portfolio worth $523,000 ($101,000 in constant 2001 dollars). A two-earner family could easily have an expected net "cash" worth of $1 million.

As the Commission’s interim report has shown, Social Security is in need of an overhaul. The system is not sustainable as currently structured. The final report demonstrates that there are several different approaches that national policymakers could take to address the problem, and we hope the pages that follow will provide sufficient analysis and suggestion to prompt a reasoned debate concerning how best to strengthen Social Security.

In the accompanying report, the Commission recommends that there be a period of discussion, lasting for at least one year, before legislative action is taken to strengthen and restore sustainability to Social Security. Regardless of how policymakers come to terms with the underlying sustainability issues, however, one thing is clear to us: the time to include personal accounts in such action > has, indeed, arrived. The details of such accounts are negotiable, but their > need is clear. The time for our elected officials to begin that discussion, informed by the findings in this report, is now.

Daniel Patrick Moynihan, Richard D. Parsons

Co-Chairs

December 11, 2001

Findings:

The Commission agrees that while there are multiple paths to fiscal sustainability that are consistent with the President’s principles for Social Security reform, we have chosen to include three reform models in the report that improve the fiscal sustainability of the current system, are costed honestly, and are preferable to the current Social Security system.

Under the current system, the benefits to future retirees are scheduled to grow significantly above the benefits received by today’s retirees, even after adjusting for inflation, and the cost of paying these benefits will significantly exceed the amount of payroll taxes collected. To bring the Social Security system to a path of fiscal sustainability—an essential task for any legitimate reform plan--there are differing approaches. The Commission believes that no matter which approach is taken, personal accounts can enhance benefits expected by future participants in the Social Security system.

• The Commission has developed three alternative models for Social Security reform involving personal accounts. Under all three reform plans, future retirees can expect to receive benefits that are at least as high as those received by today’s retirees (inflation adjusted).

• All three models include a voluntary personal retirement account that would permit participants to build substantial wealth and receive higher expected benefits than those paid to today’s retirees. Thus, all of the plans would enhance workers’ control over their retirement benefits with accounts that they own and can use to produce retirement income, or pass on to others in the form of an inheritance.

• Because the Commissioners believe that the benefits currently paid to low-wage workers are too low, we have included a provision in two of the three plans that would enhance the existing Social Security system’s progressivity by significantly increasing benefits for low-income workers above what the system currently pays. This provision will raise even more of our low-income elderly – most of whom are women – out of poverty. Two of the three models also boost survivor benefits for below-average income widows and widowers.

• The Commission has set a goal of moving the Social Security system toward a fiscally sustainable course that reduces pressure on the remainder of the federal budget and can respond to economic and demographic changes in the future. The three reform models outlined here are therefore transparently scored in terms of plan provisions, effects on workers’ expected costs and benefits, and effects on Trust Fund operations as well as the unified federal budget. We also identify clearly how large the personal account assets may be expected to grow as the system evolves.

• All three of the models improve the fiscal sustainability of the program, though some move farther than others. All three require a transition investment from general revenues to strengthen Social Security, but all three reduce the long-term need for general revenue as compared to the current, unsustainable, system. In all three plans, the system’s cash flow needs are met so that the benefits promised by each plan can be paid as retirees need them.

• All three of the models are expected to increase national saving, though some more than others.

• The Commission concludes that building substantial wealth in personal accounts can be and should be a viable component of strengthening Social Security. We commend our three models to the Members of Congress and to the American public in order to enrich national understanding of the opportunities for moving forward.

President’s Principles

The President directed the Commission to propose Social Security reform plans that will strengthen Social Security and increase its fiscally sustainability, while meeting several principles:

Understanding the "Benchmarks"

In analyzing any plan for reforming Social Security, it is important to be clear about the benchmarks for comparison. Benchmarks could include:

• Currently scheduled benefits from the existing system, which cannot be paid by existing payroll tax revenues ("scheduled benefits").
• Benefits that are payable given in the existing tax revenues ("payable benefits").
• Benefits currently paid to retirees ("currently paid benefits").

All of these benchmarks are legitimate, but they are significantly different. For example, comparing benefits under a reform plan to "promised benefits" is an unfair comparison because currently promised benefits are not payable. Without adding more revenue to the system, a more appropriate comparison would be to "payable benefits."

Three Reform Models

The three models for Social Security reform devised by the Commission demonstrate how alternative formulations for personal accounts can contribute to a strengthened Social Security system.

Reform model 1 establishes a voluntary personal account option but does not specify other changes in Social Security’s benefit and revenue structure to achieve full long-term sustainability.

• Workers can voluntarily redirect 2% of their payroll taxes to a personal account.
• In exchange, traditional Social Security benefits are offset by the worker’s personal account contributions compounded at an interest rate of 3.5% above inflation.
• No other changes are made to traditional Social Security.
• Expected benefits to workers rise while cash deficit of Social Security falls at end of valuation period.
• Workers, retirees and taxpayers continue to face uncertainty because a large financing gap remains that requires future benefit cuts or substantial new revenues.
• Additional revenues are needed to keep the trust fund solvent starting in mid-2030’s.

Reform Model 2 enables all future retirees to receive a Social Security benefit that is at least as great as today’s retirees, inflation adjusted, and, in addition, increases the Social Security benefits paid to low-income workers. Model 2 establishes a voluntary personal account, without raising taxes or requiring additional worker contributions, it achieves solvency and it balances Social Security revenues and costs.

• Workers can voluntarily redirect 4% of their payroll taxes up to $1000 (wage indexed) to a personal account.
• No additional contribution from the worker would be required.
• Workers who opt for personal accounts can reasonably expect to receive a combined benefit greater than benefits paid to current retirees and also greater than the future benefits payable under the current system.
• The plan makes the system more progressive, since additional protections against poverty are provided for low-income workers and survivors.
• Expected benefits payable to a medium earner electing a retirement account would be 59% above benefits currently paid to today’s retirees by 2052. At the end of the 75-year valuation period, the personal account system would hold $2 trillion (in today’s dollars), much of which would be new saving, an accomplishment that would not need increased taxes or increased worker contributions over the long term.
• Solvency will be achieved by price indexing instead of wage indexing initial benefits, beginning in 2009.

• Temporary transfers from general revenue would be needed to keep the Trust Fund solvent from 2025-2054. Furthermore, this model achieves a positive system cash flow during the 75-year valuation period under all participation rates.

Reform Model 3 establishes a voluntary personal account option that enables workers to reach or exceed current-law scheduled benefits and wage replacement ratios, by adding new sources of revenue and by slowing benefit growth less than price indexing.

• Workers who opt for personal accounts can reasonably expect to receive total social security benefits (including their PRA) that exceed scheduled benefit levels and current replacement rates.
• Personal accounts are created by a match of part of the payroll tax – 2.5% up to $1000 annually – for any worker who contributes an additional 1% of wages subject to Social Security payroll taxes.
• The add-on is partially subsidized for workers in a progressive manner by a refundable tax credit (33% up to a $100 maximum).
• Solvency is restored to the traditional social security system by:

• flattening out the benefit formula (reducing the third factor from 15 to 10%).

• New sources of dedicated revenue are added.
• Transition burden is reduced by charging a 2.5% benefit offset, making additional contributions to the personal account.
• Progressivity is enhanced and poverty reduced by providing a minimum benefit for low earners and an improved survivors’ benefit.
• Additional temporary transfers from general revenues are needed to keep the trust fund solvent from 2028-2057.

Specifications of Commission Reform Models