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The Social Security reform debate: effects of financial and labor market institutions
Review of Radical Political Economics 34 (2002) 285–293
The Social Security reform debate: effects of financial and labor market institutions Douglas V. Orr∗ Department of Economics, Eastern Washington University, Cheney, WA 99004, USA
Abstract Social Security is a defined benefit (DB) pension plan. Proposals for “reforming” Social Security suggest replacing it with a defined contribution (DC) savings plan. This paper compares the financial and non-financial aspects of DB pensions and DC savings plans, and discusses how changing financial and labor markets affect the interpretation of these plans. Recent wage stagnation has strengthened the arguments for “reform,” but a return to the more historical pattern of wage growth would undermine the arguments for reform. © 2002 URPE. All rights reserved. JEL classification: H55; J32 Keywords: Social Security; Pensions
1. Introduction Both Social Security and private sector defined benefit (DB) pensions explicitly recognize that all retirement consumption occurs out of current output. These pensions were originally “pay-as-you-go” systems. Thus, Social Security payments were made out of current tax revenues, and DB payments were made out of current firm revenues. Private pension defaults led Congress to pass the Employee Retirement Income Security Act (ERISA) in 1974. ERISA required that firms set aside funds from current revenues to cover the costs of future pension payments. If the firm fails, this pre-funding ensures that funds will be available for employee retirement. Since Social Security was always modeled after private sector DB pensions, it also started partially pre-funding future pension liabilities. Unfortunately, the existence of ∗
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pre-funding helps to create the misperception that DB pensions are just an elaborate form of savings plan (Orr, 1999). Originally, Social Security was seen as part of a “three legged stool.” Social Security was to provide a minimum retirement income. The second and most important leg, private sector DB pension coverage, had been expanding rapidly, and that was expected to continue. The weakest leg was private saving. Then, as now, only the very wealthy had sufficient savings to provide for their retirement. As of 1995, two-thirds of all families had a net worth of less than $100,000 (Kennickell, Starr-McCluer, & Sunden, 1997: Table 1). For the 93 percent of all families with incomes below $100,000, the median holding of financial assets was less than $38,000. These families cannot provide for an adequate retirement based on private saving alone. In the debate over the creation of the Social Security system, policy makers were clear it is virtually impossible to base a retirement system on private savings. They explicitly recognized the social insurance nature of provision for retirement. 2. Social Security is a form of insurance—not investment We seek protection from most risks in the form of insurance. None of us view insurance the same way we view financial investments. Over a lifetime, monthly fire insurance premiums add up to a large sum of money; yet, our hope is that our house stays safe and we never get any of this money back. Thus, the desired outcome is a negative return on our money. The desired outcome of a financial investment is always positive. We buy insurance because we cannot cover the large downside risk out of our own personal income. Insurance is simply the process of pooling risk. Those with losses are helped by those without losses. The larger the risk sharing pool, the lower the individual cost of providing insurance. For retirement insurance, the logical pool is all of society. Social Security is so successful because it covers 96 percent of all U.S. workers. Retirement insurance is different in one important respect. The risk we are insuring against is longevity risk. Having a long life is something most of us look forward to; thus, we hope to collect on our retirement insurance. While this difference blurs the line between retirement insurance and investments, it does not negate that it is still a form of insurance.1 DB pensions provide insurance against longevity risk because the pension benefits continue as long as a retiree lives. Much of the confusion in the current Social Security “reform” debate arises from ignoring that pensions are a form of insurance, not a financial investment. In fact, many partisans in this debate make an effort to hide this distinction. 3. The current structure of Social Security At its creation, Social Security was structured to mimic private sector DB pensions. A DB pension provides an “annuity,” which is a promise to pay a specific benefit for the rest for the worker’s life. Social Security continues the annuity for surviving spouses. 1 Someone dying before retirement will pay premiums and not collect any benefits. Those living a long time in retirement receive payments in excess of their premiums. As in all forms of insurance, risk is pooled.
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Private sector pensions calculate the benefit using the formula B = bWf S, where b is the “benefits percentage,” usually between 1 and 2.5 percent; Wf is the “final wage” based on the last year of employment; and S is the number of years of “service” to the firm. The ratio of the benefit to the final wage is called the “replacement rate.” While Social Security is similar in structure, some features are different. First, while private sector DB pensions are funded entirely by employers, Social Security requires a “contribution” from both employers and workers. Second, the “benefits percentage” used to calculate Social Security payments is variable, and is designed to yield higher relative benefits for lower-wage workers. In the analysis that follows, only the replacement rate for the median worker is considered. A third difference is important. Unlike private DB pensions, marital status has a large impact on the Social Security benefit received. The structure of Social Security benefits has an intended and conscious bias toward “traditional” families. A single man will receive the benefit based on his own wages. A married man with an identical work history will receive that benefit plus 50 percent of that benefit for his wife. If the wife survives her husband, she will receive all of her husband’s benefit.2 A fourth difference is critical in evaluating any Social Security reform. The indexing of Social Security benefits protects retirees from inflation risk. 4. The nature of defined contribution (DC) savings plans Unlike pensions, DC savings plans are financial investments, and provide none of the insurance aspects of true pensions. For these plans, only the level of contribution to the financial investment is defined. The firm may match all or only part of the employee’s contribution. At retirement, the link between the firm and the employee is severed. The Social Security reform proposals that recommend the creation of private savings accounts do not require firms to match employee contributions (Weisbrot, 1999). Thus, the firm’s responsibility to help provide for the retirement income of its workforce is severed completely. The assets in a DC plan can be used to provide retirement income in one of two ways. First, the retiree can manage the assets, depleting them so the asset balance is zero at the time of death. However, if the retiree lives longer than expected, the assets may reach zero before death. This is longevity risk. A second mechanism is for the retiree to purchase an annuity from a private sector insurance company. 5. DB–DC “equivalence” The debate concerning pension reform has focused on evaluating the benefits of DB pensions and DC savings plans, which requires some mechanism for comparing the two systems. One common, though inadequate, method is to compare the capitalized value of the stream of 2
This paper focuses on male workers to put the proposed Social Security in the best possible light. For a detailed discussion of the ways in which women are slighted by the current system, and how they would be especially hurt by the proposed reforms, see Orr (2000).
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DB pension payments to the asset value of the DC savings plan at retirement (Gustman & Steinmeier, 1995). The value of the DC savings plan is the accrued value of assets in the plan at retirement. Each month, a fraction, c, of the worker’s monthly compensation is “contributed” to the savings plan. The value of each month’s contributions grows at some interest rate, r, until retirement. Each month, the value of the DC plan increases by the return on all previous contributions plus that month’s contribution. Assuming annual wage increases at a rate of g, monthly contributions, and monthly compounding of assets, the equation used to calculate the value of the DC plan at retirement is k r k−m DCk = cWm 1 + (1) 12 m=1 where k is the number of months of service at retirement, and Wm is the income in month m. While DB benefits rise with nominal income up to retirement, the value of assets in a DC plan erodes with inflation up to retirement. Thus, real interest rates are used in Eq. (1). The equation used to calculate the capitalized (present) value of the DB pension plan is Pdb =
j
Bn (1 + d/12)n n=1
(2)
where Bn is the monthly pension benefit received, j is the number of months the person will live in retirement, and d is the annual rate of discount. This second calculation requires making several assumptions that greatly affect the comparison. The first concerns the rate of discount for future events. Robert Myers, former chief actuary for the Social Security Administration, and other pension researchers have suggested that the appropriate real rate to discount future pension benefits is 2 percent (Rejda, 1999). However, other financial analysts suggest that the appropriate discount rate is the return on available financial assets. The following analysis provides a range of discount rates. More importantly, this calculation requires making an assumption about the number of years the retiree will live beyond the retirement date. Making this assumption ignores the issue of insurance against longevity risk, which is a central benefit of DB pensions. Thus, the true value of DB plans is always underestimated relative to DC savings plans in these comparisons. This comparison ignores yet another benefit of DB pensions, insurance against investment risk. Monthly pension payments are assured under a DB pension plan, regardless of short-term variations in financial markets. The firms or government that provide these pensions pool the financial risks over a large number of employees and years. With DC savings plans, all financial risks are borne by individual employees. Individuals have no mechanism for pooling or diversifying the risk inherent in the year they happen to retire. If the duration of assets in the DC plan is 10, a one percentage point rise in interest rates will reduce retirement income by 10 percent. Schieber and Shoven (1994) have suggested that as the baby-boom generation sells their accumulated pension assets, interest rates could rise by more than five percentage points, which would reduce by half the value of the worker’s savings fund. Assuming that a DC savings plan, with assets equal to the capitalized value of the DB benefits, is somehow “equivalent” is obviously incorrect. It ignores all of the insurance aspects
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of DB pensions: insurance against longevity and investment risk. No employee would find these two options as equivalent.3 Yet this is the approach that is taken by proponents of replacing the current Social Security system with a system of private accounts. The analysis that follows allows this concept of “equivalence” to maximize the strength of the arguments for “reform.” 6. Simulation scenarios The following scenarios assume both an unmarried male worker and a married male worker, who start their covered employment at the age of 25 and work 40 years to retirement at age 65. They are expected to live 17 years in retirement, and their wives are assumed to survive their husbands by 4 years. In 1998, the median covered Social Security income was $25,000. In these scenarios this is the starting income, and monthly income increases once annually at the assumed growth rate. In 1998, the replacement rate for the median unmarried worker was 40 percent. Since wives of married workers receive a benefit equal to 50 percent of their husbands’, the overall replacement rate for the married couple is 60 percent. The benefit, Bn , used in Eq. (2) is calculated by applying these replacement rates to projected income at retirement. For example, if annual wage growth is 3.15 percent, the income at retirement would be $83,799 [W0 (1.0315)39 ]. With a 40 percent replacement rate, the annual DB benefit would be $33,520, or $2,793 per month. This value for Bn is used to calculate the capitalized value of the DB pension benefits, Pdb. The rate of contribution into a DC savings plan that will yield the same value at retirement can then be estimated. Since the rate of discount greatly affects the Pdb, rates of one, two, and three percent are used. In addition, values discounted at the assumed real rate of return on available assets are also included. The following discussion focuses only on the retirement aspects of Social Security. Thus, the rate of contribution necessary to generate an “equivalent” DC savings plan is compared to the tax rate on Old Age and Survivors Insurance (OASI) only. This rate was 5.26 percent in 1999. Many researchers suggest any analysis of tax and contribution rates should only include those contributions made by workers, since the contributions by firms are considered to be payments into the broader social insurance pool. However, proponents of privatizing the Social Security system assume payments by firms “belong” to the individual worker. Yet, in most of their privatization proposals, only the employee will be required to contribute to the new DC savings plans. Since these two views are inconsistent, the following discussion analyzes both points of view. Scenario 1 illustrates the institutional structures in place in the decade of the 1950s. During that decade, annual nominal wage growth was 4.7 percent, while real wage growth was 2.6 percent. The average annual real GDP growth rate was 4 percent. Options for relatively safe investments in financial markets were limited. As the decade started, the Dow Jones Industrials index was still below its peak of 1929, and did not return to that level until the end of 1954. 3
A central issue in every major strike in the United States during the past decade was the proposed replacement of DB pensions with “equivalent” DC savings plans. That employees were willing to strike over this issue indicates that they did not see the plans as equivalent.
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Table 1 Contribution rate required to match capitalized value of Social Security benefits for unmarried worker Rate of discounting of future benefits
Scenario 1 Scenario 2 +Annuity admin. costs +COLA adj. costs Scenario 3 +Annuity & COLA
1%
2%
3%
r
31.2
29.4
27.2
33.2
6.80 8.36 9.72 11.8 16.9
6.28 7.75 9.01 10.9 15.6
5.81 7.13 8.29 10.1 14.4
4.40 5.41 6.29 9.09 13.0
Scenario 1: g = 4.72, r = 0.5; Scenario 2: g = 3.15, r = 7.0; Scenario 3: g = 3.15, r = 4.47; where g is the rate of growth of nominal wages and r is the real rate of return on financial assets.
Mutual funds allowing small purchases of stocks were not yet available, so workers could not hold a diversified portfolio of stock. Individuals looking for a safe financial investment were limited to short-term treasury bills, savings bonds, and passbook savings accounts. The real rate of return on these assets during this decade averaged just 0.5 percent. The first row in Tables 1 and 2 presents the contribution required to generate a DC savings plan with the same value as the Pdb of Social Security benefits the worker would receive if the 1950s institutional structures remained in place during their working life. In Table 1, if DB benefits are discounted at 2 percent, the contribution rate for an unmarried man would have to have been 29.4 percent of his income to generate the same value at retirement as his Social Security benefits. During the 1950s, the individual payroll tax rate for OASI was just 2 percent. The contribution rate necessary to generate an “equivalent” DC savings plan would have been 15 times higher. Even if the firm’s payroll tax is included, the required contribution rate needed to be 7.5 times larger than the combined tax rate. For married workers, at a 2 percent rate of discount, the required contribution rate would have needed to be 48.7 percent.
Table 2 Contribution rate required to match capitalized value of Social Security benefits for married worker Rate of discounting of future benefits 1%
2%
3%
r
Scenario 1
53.4
48.7
44.5
56.0
Scenario 2 +Annuity admin. costs +COLA adj. costs
11.6 14.3 16.6
10.6 13.0 15.2
9.71 11.9 13.9
7.08 8.73 10.2
Scenario 3 +Annuity & COLA
20.3 29.0
18.5 26.5
16.9 24.2
15.0 21.4
Scenario 1: g = 4.72, r = 0.5; Scenario 2: g = 3.15, r = 7.0; Scenario 3: g = 3.15, r = 4.47; where g is the rate of growth of nominal wages and r is the real rate of return on financial assets.
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Replacing the DB Social Security system with DC savings plans is inconceivable under these institutional conditions. Scenario 2 illustrates the institutional structures during the decade of the 1990s, which are shaping the current debate concerning the privatization of Social Security. This decade witnessed the longest period of uninterrupted growth in U.S. history. Many younger workers had never experienced a severe recession or decline in stock market values. Mutual funds accepting small denomination investments were now common. An evenly diversified portfolio of stocks and bonds grew at an average real rate of 7 percent. However, conditions in the labor market had deteriorated. The annual real GDP growth averaged just 1.8 percent. Nominal wages grew at just 3.15 percent, while real wages increased at an annual rate of just 0.7 percent. This institutional structure of high returns to financial assets and stagnant wage growth significantly changes the apparent merits of DB pensions relative to DC savings plans. Slow nominal wage growth leads to slow growth of DB pension benefits. Thus, the Pdb is reduced. As row two of Table 1 indicates, at a 2 percent discount rate and a 7 percent return on financial assets, the contribution required to generate a DC savings plan equal in value to the Pdb for an unmarried worker is 6.28 percent. This amount is higher than the individual payroll tax rate of 5.26 percent in place in 1999. However, the required contribution rate is below the combined rate of 10.52 percent. If individuals discount the future at the 7 percent return on financial assets, the value of future DB pension benefits is reduced further, and the required contribution rate is only 4.4 percent. This comparison ignores several aspects of the current system discussed above. First, if the worker only lives 17 years in retirement as is assumed in this simulation, the DC savings plan and the capitalized value of the DB benefits are equal. But, if he lives more than 17 years, his income from the DC plan will be zero, while his income from Social Security will continue. The individual could purchase an annuity to protect against this longevity risk. The average overhead expenses of annuities provided by private sector insurance firms are 23 percent, compared to the 0.7 percent overhead of the Social Security Administration (Baker, 1997). At a discount rate of 7 percent, adding this expense raises the required contribution rate to 5.41 percent, higher than the payroll tax rate. Second, Social Security indexes benefit payments for inflation. It is difficult to get indexed annuities in the private sector, and the cost of these annuities averages about 20 percent higher than non-indexed annuities (Baker, 1997). Thus, to get something more equivalent to Social Security using the DC savings plan would require a contribution rate of 6.29 percent (at 7 percent discounting) or 9.01 percent (at 2 percent discounting). With these added expenses, the DC savings plan approach would appear attractive to unmarried employees only if both employee and employer taxes are included and investment risk is ignored. Row 2 in Table 2 looks at married workers. At a discount rate of 2 percent, the required contribution rate, 10.6 percent, is about the same as the combined tax rate. But once administrative expenses and inflation protection are added, the required contribution rate greatly exceeds the combined tax rate. Even at a discount rate of 7 percent, the required contribution rate is almost equal to the combined payroll tax. Thus, even under recent institutional structures, replacing Social Security with privatized DC savings plans only benefits unmarried workers. Yet, this describes the “target audience” of the debate: young, unmarried workers who have
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yet to experience a recession, and who are not yet thinking about how long they might live in retirement. The Social Security “reform” debate usually focuses on the “intermediate” forecast of the trustees of the Social Security Administration. This forecast assumes an average real GDP growth rate over the next 75 years of just 1.7 percent (Social Security Administration Trustees, 2000). No 20-year period to date has seen U.S. GDP grow this slowly, including any period during the Great Depression. This forecast has real wages stagnating for the next 75 years, so nominal wages grow at 3.15 percent. Despite this pessimistic forecast for the real economy, the trustees assume the stock market will continue to provide the same 7 percent annual real return it has for the past 35 years. The return on stocks reflects both profit income in the form of dividends and the appreciation of stock prices, which reflect the capitalized value of future earnings. If relative income shares going to wages and profits stay the same, profit income can only increase at the same rate as GDP growth. The historically unprecedented returns on stocks during the late 1980s and 1990s resulted from an also historically unprecedented change in the relative shares of profit and earnings incomes. From 1980 to 1999, the earnings share of national income fell from 73.5 to 70.5 percent, while the profit share rose by 2 percentage points, which drove up stock returns. This rise is unsustainable. As Baker (1997) demonstrates, at a real GDP growth rate of 1.7 percent, for stocks to continue to provide a 7 percent return, real wages would have to be reduced by 37.4 percent by 2035 and 82.2 percent by 2055. Since household consumption based on earnings represents about 65 percent of all spending, an 82.2 percent reduction in wage income would reduce GDP by at least 53 percent. This contradicts the trustees’ assumptions about GDP growth rates. Baker estimates the real rate of return that is possible under the trustees’ assumptions concerning the real economy. If the relative earnings and profit shares remain at their 1997 levels, the annual return on stocks over the trustees’ 75-year forecast can be no more than 4.47 percent. Scenario 3 reflects the stagnant but stable wages the trustees forecast and Baker’s estimates of returns on stocks.4 In Table 1, at a 2 percent discount rate, the contribution rate required to generate a DC savings plan “equivalent” to the Social Security benefits is 10.9 percent, higher than the current combined tax rate. Once allowance is made for insurance against inflation and administrative costs, the required rate of contribution is 5 percentage points above the combined tax rate. At a 4.47 percent discount rate, replacing Social Security with private savings plans is barely equivalent for unmarried workers who ignore the insurance aspects of DB pensions. Even ignoring the insurance aspects of the current system, Table 2 indicates married couples would be made worse off changing to a system of DC savings plans. 7. Conclusions The debate about replacing the current Social Security system with a system of private savings plans would not have started without the changes in financial and labor market 4 This scenario assumes that employees put all of their assets into the stock market as the proposed reforms require.
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institutions that occurred during the late 1980s and 1990s which generated unsustainable returns on financial assets. The proposed system of private accounts is a barely viable alternative to the current Social Security system only for unmarried workers, and only if real earnings continue to stagnate. If the rates of growth of real wages and real GDP were to return to their historical rates, the proposed system of private savings accounts would be incapable of providing the same retirement income as the current Social Security system. References Baker, D. (1997). Saving social security with stocks: The promises don’t add up. New York: The Twentieth Century Fund. Gustman, A. L., & Steinmeier T. L. (1995). Pension incentive and job mobility. Kalamazoo, MI: W.E. Upjohn Institute for Employment Research. Kennickell, A. B., Starr-McCluer, M., & Sunden, A. E. (1997). Family finances in the U.S.: Recent evidence from the survey of consumer finances. Federal Reserve Bulletin, 83, 1–24. Orr, D. V. (1999). Why defined contribution savings plans are not real pensions. Under review by Journal of Economic Issues. Orr, D. V. (2000). The erosion of women’s retirement security: Social security and private pension reform (Working Paper). Rejda, G. E. (1999). Social insurance and economic security. Upper Saddle River, NJ: Prentice-Hall. Schieber S. J., & Shoven, J. B. (1994). The consequences of population aging on private pension fund saving and asset markets (Working Paper No. 4665). Cambridge, MA: National Bureau of Economic Research. Social Security Administration Trustees. (2000). Annual report of the board of trustees, federal old-age and survivors insurance and disability trust funds, 2000. Washington, DC: U.S. Government Printing Office. Weisbrot M. (1999). Unequal sacrifice: The impact of changes proposed by the advisory council on social security. Washington, DC: The Preamble Center for Public Policy.
The Social Security reform debate: effects of financial and labor market institutions Douglas V. Orr∗ Department of Economics, Eastern Washington University, Cheney, WA 99004, USA
Abstract Social Security is a defined benefit (DB) pension plan. Proposals for “reforming” Social Security suggest replacing it with a defined contribution (DC) savings plan. This paper compares the financial and non-financial aspects of DB pensions and DC savings plans, and discusses how changing financial and labor markets affect the interpretation of these plans. Recent wage stagnation has strengthened the arguments for “reform,” but a return to the more historical pattern of wage growth would undermine the arguments for reform. © 2002 URPE. All rights reserved. JEL classification: H55; J32 Keywords: Social Security; Pensions
1. Introduction Both Social Security and private sector defined benefit (DB) pensions explicitly recognize that all retirement consumption occurs out of current output. These pensions were originally “pay-as-you-go” systems. Thus, Social Security payments were made out of current tax revenues, and DB payments were made out of current firm revenues. Private pension defaults led Congress to pass the Employee Retirement Income Security Act (ERISA) in 1974. ERISA required that firms set aside funds from current revenues to cover the costs of future pension payments. If the firm fails, this pre-funding ensures that funds will be available for employee retirement. Since Social Security was always modeled after private sector DB pensions, it also started partially pre-funding future pension liabilities. Unfortunately, the existence of ∗
Tel.: +1-509-359-2424. E-mail address: [email protected] (D.V. Orr).
0486-6134/02/$ – see front matter © 2002 URPE. All rights reserved. PII: S 0 4 8 6 - 6 1 3 4 ( 0 2 ) 0 0 1 6 9 - 9
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D.V. Orr / Review of Radical Political Economics 34 (2002) 285–293
pre-funding helps to create the misperception that DB pensions are just an elaborate form of savings plan (Orr, 1999). Originally, Social Security was seen as part of a “three legged stool.” Social Security was to provide a minimum retirement income. The second and most important leg, private sector DB pension coverage, had been expanding rapidly, and that was expected to continue. The weakest leg was private saving. Then, as now, only the very wealthy had sufficient savings to provide for their retirement. As of 1995, two-thirds of all families had a net worth of less than $100,000 (Kennickell, Starr-McCluer, & Sunden, 1997: Table 1). For the 93 percent of all families with incomes below $100,000, the median holding of financial assets was less than $38,000. These families cannot provide for an adequate retirement based on private saving alone. In the debate over the creation of the Social Security system, policy makers were clear it is virtually impossible to base a retirement system on private savings. They explicitly recognized the social insurance nature of provision for retirement. 2. Social Security is a form of insurance—not investment We seek protection from most risks in the form of insurance. None of us view insurance the same way we view financial investments. Over a lifetime, monthly fire insurance premiums add up to a large sum of money; yet, our hope is that our house stays safe and we never get any of this money back. Thus, the desired outcome is a negative return on our money. The desired outcome of a financial investment is always positive. We buy insurance because we cannot cover the large downside risk out of our own personal income. Insurance is simply the process of pooling risk. Those with losses are helped by those without losses. The larger the risk sharing pool, the lower the individual cost of providing insurance. For retirement insurance, the logical pool is all of society. Social Security is so successful because it covers 96 percent of all U.S. workers. Retirement insurance is different in one important respect. The risk we are insuring against is longevity risk. Having a long life is something most of us look forward to; thus, we hope to collect on our retirement insurance. While this difference blurs the line between retirement insurance and investments, it does not negate that it is still a form of insurance.1 DB pensions provide insurance against longevity risk because the pension benefits continue as long as a retiree lives. Much of the confusion in the current Social Security “reform” debate arises from ignoring that pensions are a form of insurance, not a financial investment. In fact, many partisans in this debate make an effort to hide this distinction. 3. The current structure of Social Security At its creation, Social Security was structured to mimic private sector DB pensions. A DB pension provides an “annuity,” which is a promise to pay a specific benefit for the rest for the worker’s life. Social Security continues the annuity for surviving spouses. 1 Someone dying before retirement will pay premiums and not collect any benefits. Those living a long time in retirement receive payments in excess of their premiums. As in all forms of insurance, risk is pooled.
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Private sector pensions calculate the benefit using the formula B = bWf S, where b is the “benefits percentage,” usually between 1 and 2.5 percent; Wf is the “final wage” based on the last year of employment; and S is the number of years of “service” to the firm. The ratio of the benefit to the final wage is called the “replacement rate.” While Social Security is similar in structure, some features are different. First, while private sector DB pensions are funded entirely by employers, Social Security requires a “contribution” from both employers and workers. Second, the “benefits percentage” used to calculate Social Security payments is variable, and is designed to yield higher relative benefits for lower-wage workers. In the analysis that follows, only the replacement rate for the median worker is considered. A third difference is important. Unlike private DB pensions, marital status has a large impact on the Social Security benefit received. The structure of Social Security benefits has an intended and conscious bias toward “traditional” families. A single man will receive the benefit based on his own wages. A married man with an identical work history will receive that benefit plus 50 percent of that benefit for his wife. If the wife survives her husband, she will receive all of her husband’s benefit.2 A fourth difference is critical in evaluating any Social Security reform. The indexing of Social Security benefits protects retirees from inflation risk. 4. The nature of defined contribution (DC) savings plans Unlike pensions, DC savings plans are financial investments, and provide none of the insurance aspects of true pensions. For these plans, only the level of contribution to the financial investment is defined. The firm may match all or only part of the employee’s contribution. At retirement, the link between the firm and the employee is severed. The Social Security reform proposals that recommend the creation of private savings accounts do not require firms to match employee contributions (Weisbrot, 1999). Thus, the firm’s responsibility to help provide for the retirement income of its workforce is severed completely. The assets in a DC plan can be used to provide retirement income in one of two ways. First, the retiree can manage the assets, depleting them so the asset balance is zero at the time of death. However, if the retiree lives longer than expected, the assets may reach zero before death. This is longevity risk. A second mechanism is for the retiree to purchase an annuity from a private sector insurance company. 5. DB–DC “equivalence” The debate concerning pension reform has focused on evaluating the benefits of DB pensions and DC savings plans, which requires some mechanism for comparing the two systems. One common, though inadequate, method is to compare the capitalized value of the stream of 2
This paper focuses on male workers to put the proposed Social Security in the best possible light. For a detailed discussion of the ways in which women are slighted by the current system, and how they would be especially hurt by the proposed reforms, see Orr (2000).
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DB pension payments to the asset value of the DC savings plan at retirement (Gustman & Steinmeier, 1995). The value of the DC savings plan is the accrued value of assets in the plan at retirement. Each month, a fraction, c, of the worker’s monthly compensation is “contributed” to the savings plan. The value of each month’s contributions grows at some interest rate, r, until retirement. Each month, the value of the DC plan increases by the return on all previous contributions plus that month’s contribution. Assuming annual wage increases at a rate of g, monthly contributions, and monthly compounding of assets, the equation used to calculate the value of the DC plan at retirement is k r k−m DCk = cWm 1 + (1) 12 m=1 where k is the number of months of service at retirement, and Wm is the income in month m. While DB benefits rise with nominal income up to retirement, the value of assets in a DC plan erodes with inflation up to retirement. Thus, real interest rates are used in Eq. (1). The equation used to calculate the capitalized (present) value of the DB pension plan is Pdb =
j
Bn (1 + d/12)n n=1
(2)
where Bn is the monthly pension benefit received, j is the number of months the person will live in retirement, and d is the annual rate of discount. This second calculation requires making several assumptions that greatly affect the comparison. The first concerns the rate of discount for future events. Robert Myers, former chief actuary for the Social Security Administration, and other pension researchers have suggested that the appropriate real rate to discount future pension benefits is 2 percent (Rejda, 1999). However, other financial analysts suggest that the appropriate discount rate is the return on available financial assets. The following analysis provides a range of discount rates. More importantly, this calculation requires making an assumption about the number of years the retiree will live beyond the retirement date. Making this assumption ignores the issue of insurance against longevity risk, which is a central benefit of DB pensions. Thus, the true value of DB plans is always underestimated relative to DC savings plans in these comparisons. This comparison ignores yet another benefit of DB pensions, insurance against investment risk. Monthly pension payments are assured under a DB pension plan, regardless of short-term variations in financial markets. The firms or government that provide these pensions pool the financial risks over a large number of employees and years. With DC savings plans, all financial risks are borne by individual employees. Individuals have no mechanism for pooling or diversifying the risk inherent in the year they happen to retire. If the duration of assets in the DC plan is 10, a one percentage point rise in interest rates will reduce retirement income by 10 percent. Schieber and Shoven (1994) have suggested that as the baby-boom generation sells their accumulated pension assets, interest rates could rise by more than five percentage points, which would reduce by half the value of the worker’s savings fund. Assuming that a DC savings plan, with assets equal to the capitalized value of the DB benefits, is somehow “equivalent” is obviously incorrect. It ignores all of the insurance aspects
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of DB pensions: insurance against longevity and investment risk. No employee would find these two options as equivalent.3 Yet this is the approach that is taken by proponents of replacing the current Social Security system with a system of private accounts. The analysis that follows allows this concept of “equivalence” to maximize the strength of the arguments for “reform.” 6. Simulation scenarios The following scenarios assume both an unmarried male worker and a married male worker, who start their covered employment at the age of 25 and work 40 years to retirement at age 65. They are expected to live 17 years in retirement, and their wives are assumed to survive their husbands by 4 years. In 1998, the median covered Social Security income was $25,000. In these scenarios this is the starting income, and monthly income increases once annually at the assumed growth rate. In 1998, the replacement rate for the median unmarried worker was 40 percent. Since wives of married workers receive a benefit equal to 50 percent of their husbands’, the overall replacement rate for the married couple is 60 percent. The benefit, Bn , used in Eq. (2) is calculated by applying these replacement rates to projected income at retirement. For example, if annual wage growth is 3.15 percent, the income at retirement would be $83,799 [W0 (1.0315)39 ]. With a 40 percent replacement rate, the annual DB benefit would be $33,520, or $2,793 per month. This value for Bn is used to calculate the capitalized value of the DB pension benefits, Pdb. The rate of contribution into a DC savings plan that will yield the same value at retirement can then be estimated. Since the rate of discount greatly affects the Pdb, rates of one, two, and three percent are used. In addition, values discounted at the assumed real rate of return on available assets are also included. The following discussion focuses only on the retirement aspects of Social Security. Thus, the rate of contribution necessary to generate an “equivalent” DC savings plan is compared to the tax rate on Old Age and Survivors Insurance (OASI) only. This rate was 5.26 percent in 1999. Many researchers suggest any analysis of tax and contribution rates should only include those contributions made by workers, since the contributions by firms are considered to be payments into the broader social insurance pool. However, proponents of privatizing the Social Security system assume payments by firms “belong” to the individual worker. Yet, in most of their privatization proposals, only the employee will be required to contribute to the new DC savings plans. Since these two views are inconsistent, the following discussion analyzes both points of view. Scenario 1 illustrates the institutional structures in place in the decade of the 1950s. During that decade, annual nominal wage growth was 4.7 percent, while real wage growth was 2.6 percent. The average annual real GDP growth rate was 4 percent. Options for relatively safe investments in financial markets were limited. As the decade started, the Dow Jones Industrials index was still below its peak of 1929, and did not return to that level until the end of 1954. 3
A central issue in every major strike in the United States during the past decade was the proposed replacement of DB pensions with “equivalent” DC savings plans. That employees were willing to strike over this issue indicates that they did not see the plans as equivalent.
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Table 1 Contribution rate required to match capitalized value of Social Security benefits for unmarried worker Rate of discounting of future benefits
Scenario 1 Scenario 2 +Annuity admin. costs +COLA adj. costs Scenario 3 +Annuity & COLA
1%
2%
3%
r
31.2
29.4
27.2
33.2
6.80 8.36 9.72 11.8 16.9
6.28 7.75 9.01 10.9 15.6
5.81 7.13 8.29 10.1 14.4
4.40 5.41 6.29 9.09 13.0
Scenario 1: g = 4.72, r = 0.5; Scenario 2: g = 3.15, r = 7.0; Scenario 3: g = 3.15, r = 4.47; where g is the rate of growth of nominal wages and r is the real rate of return on financial assets.
Mutual funds allowing small purchases of stocks were not yet available, so workers could not hold a diversified portfolio of stock. Individuals looking for a safe financial investment were limited to short-term treasury bills, savings bonds, and passbook savings accounts. The real rate of return on these assets during this decade averaged just 0.5 percent. The first row in Tables 1 and 2 presents the contribution required to generate a DC savings plan with the same value as the Pdb of Social Security benefits the worker would receive if the 1950s institutional structures remained in place during their working life. In Table 1, if DB benefits are discounted at 2 percent, the contribution rate for an unmarried man would have to have been 29.4 percent of his income to generate the same value at retirement as his Social Security benefits. During the 1950s, the individual payroll tax rate for OASI was just 2 percent. The contribution rate necessary to generate an “equivalent” DC savings plan would have been 15 times higher. Even if the firm’s payroll tax is included, the required contribution rate needed to be 7.5 times larger than the combined tax rate. For married workers, at a 2 percent rate of discount, the required contribution rate would have needed to be 48.7 percent.
Table 2 Contribution rate required to match capitalized value of Social Security benefits for married worker Rate of discounting of future benefits 1%
2%
3%
r
Scenario 1
53.4
48.7
44.5
56.0
Scenario 2 +Annuity admin. costs +COLA adj. costs
11.6 14.3 16.6
10.6 13.0 15.2
9.71 11.9 13.9
7.08 8.73 10.2
Scenario 3 +Annuity & COLA
20.3 29.0
18.5 26.5
16.9 24.2
15.0 21.4
Scenario 1: g = 4.72, r = 0.5; Scenario 2: g = 3.15, r = 7.0; Scenario 3: g = 3.15, r = 4.47; where g is the rate of growth of nominal wages and r is the real rate of return on financial assets.
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Replacing the DB Social Security system with DC savings plans is inconceivable under these institutional conditions. Scenario 2 illustrates the institutional structures during the decade of the 1990s, which are shaping the current debate concerning the privatization of Social Security. This decade witnessed the longest period of uninterrupted growth in U.S. history. Many younger workers had never experienced a severe recession or decline in stock market values. Mutual funds accepting small denomination investments were now common. An evenly diversified portfolio of stocks and bonds grew at an average real rate of 7 percent. However, conditions in the labor market had deteriorated. The annual real GDP growth averaged just 1.8 percent. Nominal wages grew at just 3.15 percent, while real wages increased at an annual rate of just 0.7 percent. This institutional structure of high returns to financial assets and stagnant wage growth significantly changes the apparent merits of DB pensions relative to DC savings plans. Slow nominal wage growth leads to slow growth of DB pension benefits. Thus, the Pdb is reduced. As row two of Table 1 indicates, at a 2 percent discount rate and a 7 percent return on financial assets, the contribution required to generate a DC savings plan equal in value to the Pdb for an unmarried worker is 6.28 percent. This amount is higher than the individual payroll tax rate of 5.26 percent in place in 1999. However, the required contribution rate is below the combined rate of 10.52 percent. If individuals discount the future at the 7 percent return on financial assets, the value of future DB pension benefits is reduced further, and the required contribution rate is only 4.4 percent. This comparison ignores several aspects of the current system discussed above. First, if the worker only lives 17 years in retirement as is assumed in this simulation, the DC savings plan and the capitalized value of the DB benefits are equal. But, if he lives more than 17 years, his income from the DC plan will be zero, while his income from Social Security will continue. The individual could purchase an annuity to protect against this longevity risk. The average overhead expenses of annuities provided by private sector insurance firms are 23 percent, compared to the 0.7 percent overhead of the Social Security Administration (Baker, 1997). At a discount rate of 7 percent, adding this expense raises the required contribution rate to 5.41 percent, higher than the payroll tax rate. Second, Social Security indexes benefit payments for inflation. It is difficult to get indexed annuities in the private sector, and the cost of these annuities averages about 20 percent higher than non-indexed annuities (Baker, 1997). Thus, to get something more equivalent to Social Security using the DC savings plan would require a contribution rate of 6.29 percent (at 7 percent discounting) or 9.01 percent (at 2 percent discounting). With these added expenses, the DC savings plan approach would appear attractive to unmarried employees only if both employee and employer taxes are included and investment risk is ignored. Row 2 in Table 2 looks at married workers. At a discount rate of 2 percent, the required contribution rate, 10.6 percent, is about the same as the combined tax rate. But once administrative expenses and inflation protection are added, the required contribution rate greatly exceeds the combined tax rate. Even at a discount rate of 7 percent, the required contribution rate is almost equal to the combined payroll tax. Thus, even under recent institutional structures, replacing Social Security with privatized DC savings plans only benefits unmarried workers. Yet, this describes the “target audience” of the debate: young, unmarried workers who have
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yet to experience a recession, and who are not yet thinking about how long they might live in retirement. The Social Security “reform” debate usually focuses on the “intermediate” forecast of the trustees of the Social Security Administration. This forecast assumes an average real GDP growth rate over the next 75 years of just 1.7 percent (Social Security Administration Trustees, 2000). No 20-year period to date has seen U.S. GDP grow this slowly, including any period during the Great Depression. This forecast has real wages stagnating for the next 75 years, so nominal wages grow at 3.15 percent. Despite this pessimistic forecast for the real economy, the trustees assume the stock market will continue to provide the same 7 percent annual real return it has for the past 35 years. The return on stocks reflects both profit income in the form of dividends and the appreciation of stock prices, which reflect the capitalized value of future earnings. If relative income shares going to wages and profits stay the same, profit income can only increase at the same rate as GDP growth. The historically unprecedented returns on stocks during the late 1980s and 1990s resulted from an also historically unprecedented change in the relative shares of profit and earnings incomes. From 1980 to 1999, the earnings share of national income fell from 73.5 to 70.5 percent, while the profit share rose by 2 percentage points, which drove up stock returns. This rise is unsustainable. As Baker (1997) demonstrates, at a real GDP growth rate of 1.7 percent, for stocks to continue to provide a 7 percent return, real wages would have to be reduced by 37.4 percent by 2035 and 82.2 percent by 2055. Since household consumption based on earnings represents about 65 percent of all spending, an 82.2 percent reduction in wage income would reduce GDP by at least 53 percent. This contradicts the trustees’ assumptions about GDP growth rates. Baker estimates the real rate of return that is possible under the trustees’ assumptions concerning the real economy. If the relative earnings and profit shares remain at their 1997 levels, the annual return on stocks over the trustees’ 75-year forecast can be no more than 4.47 percent. Scenario 3 reflects the stagnant but stable wages the trustees forecast and Baker’s estimates of returns on stocks.4 In Table 1, at a 2 percent discount rate, the contribution rate required to generate a DC savings plan “equivalent” to the Social Security benefits is 10.9 percent, higher than the current combined tax rate. Once allowance is made for insurance against inflation and administrative costs, the required rate of contribution is 5 percentage points above the combined tax rate. At a 4.47 percent discount rate, replacing Social Security with private savings plans is barely equivalent for unmarried workers who ignore the insurance aspects of DB pensions. Even ignoring the insurance aspects of the current system, Table 2 indicates married couples would be made worse off changing to a system of DC savings plans. 7. Conclusions The debate about replacing the current Social Security system with a system of private savings plans would not have started without the changes in financial and labor market 4 This scenario assumes that employees put all of their assets into the stock market as the proposed reforms require.
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institutions that occurred during the late 1980s and 1990s which generated unsustainable returns on financial assets. The proposed system of private accounts is a barely viable alternative to the current Social Security system only for unmarried workers, and only if real earnings continue to stagnate. If the rates of growth of real wages and real GDP were to return to their historical rates, the proposed system of private savings accounts would be incapable of providing the same retirement income as the current Social Security system. References Baker, D. (1997). Saving social security with stocks: The promises don’t add up. New York: The Twentieth Century Fund. Gustman, A. L., & Steinmeier T. L. (1995). Pension incentive and job mobility. Kalamazoo, MI: W.E. Upjohn Institute for Employment Research. Kennickell, A. B., Starr-McCluer, M., & Sunden, A. E. (1997). Family finances in the U.S.: Recent evidence from the survey of consumer finances. Federal Reserve Bulletin, 83, 1–24. Orr, D. V. (1999). Why defined contribution savings plans are not real pensions. Under review by Journal of Economic Issues. Orr, D. V. (2000). The erosion of women’s retirement security: Social security and private pension reform (Working Paper). Rejda, G. E. (1999). Social insurance and economic security. Upper Saddle River, NJ: Prentice-Hall. Schieber S. J., & Shoven, J. B. (1994). The consequences of population aging on private pension fund saving and asset markets (Working Paper No. 4665). Cambridge, MA: National Bureau of Economic Research. Social Security Administration Trustees. (2000). Annual report of the board of trustees, federal old-age and survivors insurance and disability trust funds, 2000. Washington, DC: U.S. Government Printing Office. Weisbrot M. (1999). Unequal sacrifice: The impact of changes proposed by the advisory council on social security. Washington, DC: The Preamble Center for Public Policy.