Mr. Chairman, my testimony this morning addresses two aspects of strengthening retirement security: why it is critical to preserve Social Security’s core insurance features while reforming the program to eliminate its long-term deficit; and how we can expand retirement saving on top of Social Security.
Saving Social Security without destroying it
Social Security is one of America’s most successful government programs. It has helped millions of Americans avoid poverty in old age, upon becoming disabled, or after the death of a family wage earner.
Social Security’s success as a social insurance program is attributable to several basic features of the system. It provides participants with a well-defined, assured basic income that is protected against inflation, the risk of outliving one’s assets, and financial market fluctuations. It is progressive, providing larger annual benefits (relative to previous wages) for lower earners than for higher earners. And it provides families with insurance against the disability or death of a wage earner, in addition to retirement benefits.
Although we can and should boost retirement saving on top of Social Security, we must not forget that for the majority of the population, Social Security provides the key layer of financial security during particular times of need. One-fifth of elderly beneficiaries receive all their income from Social Security, and nearly two-thirds receive the majority of their income from Social Security. The average Social Security benefit amounts to slightly more than $10,000 a year, and 20 percent of beneficiaries receive $7,000 a year or less.
Social Security faces a long-term deficit. Restoring long-term financial balance to Social Security is therefore necessary, but it is not necessary to destroy the program in order to save it. One particularly contentious issue involves whether part of Social Security should be replaced with individual accounts. In my view, such an approach would be unwise both because of the
financing issues it entails and because individual accounts are not likely to provide an adequate replacement for the crucial protections offered by the current system:
Diverting Social Security revenue into individual accounts creates a substantial financing problem. The revenue diversion by itself worsens Social Security’s financial standing. To avoid this, individual accounts must be linked in some way to a reduction in traditional benefits sufficient to offset the cost of the diverted revenue. Even then, however, the flow of revenue into the individual accounts would precede by many years (if not decades) the offsetting reductions in traditional benefits.
Despite whatever ivory-tower proponents might like to believe, it is unlikely that real-world individual accounts would require that benefits keep pace with inflation, last as long as the beneficiaries are alive, or protect surviving spouses as well as the current system. There would also likely be intense political pressure to allow withdrawals prior to retirement, which would undermine the role of the accounts in providing retirement security. Furthermore, the assets in the accounts are subject to financial market risks. As a result, individual accounts are simply inappropriate for the basic tier of income during retirement, disability, and other times of need. Especially as the private retirement system on top of Social Security shifts from a defined benefit to a defined contribution one, it makes little sense to engineer a shift to individual accounts within the core layer of financial security provided by Social Security.
A final issue regarding Social Security involves the relative magnitudes of the actuarial deficit in Social Security and the cost of the recent tax cuts. Over the next 75 years, the Social Security actuarial deficit amounts to 0.7 percent of GDP. Over the same period, the tax cuts (if they are extended and protected from being erased by the Alternative Minimum Tax) amount to more than 2 percent of GDP. In other words, the tax cuts cost more than three times the actuarial deficit in Social Security.
The relative size of the tax cuts and the Social Security deficit underscores two points:
First, the tax cuts dissipate revenue that could have instead been used for more constructive purposes, including to shore up the Social Security system. Since the tax cuts sunset in 2010 or before, we still face a choice. Assuming an Alternative Minimum Tax reform, the cost of extending the tax cuts (that is, ignoring the costs that arise before the enacted tax cuts sunset) is 1.8 percent of GDP over the next 75 years. That is more than 2.5 times as large as the actuarial deficit in Social Security over the same period.
Second, even if it were sensible to finance regressive tax cuts through reductions in progressive benefit programs, it is not realistic to “pay for” the tax cuts through reduced Social Security benefits. The relative magnitudes mean that the math doesn’t even come close to working (assuming that one is not willing to enact benefit reductions that are even more severe than the extreme of eliminating the entire Social Security deficit on the benefit side).
Expanding retirement saving on top of Social Security
Various types of savings incentives already exist for households to supplement the key protections offered by Social Security. These savings incentives, however, are upside-down:
First, they give the strongest incentives to participate to higher-income households who least need to save more to achieve an adequate retirement living standard and who are the most likely to use pensions as a tax shelter, rather than as a vehicle to raise saving.
Second, the subsidies are worth the least to households who most need to save more for retirement and who, if they do contribute, are most likely to use the accounts to raise net saving.
In part reflecting this upside-down set of incentives, the nation’s broader pension system betrays several serious shortcomings:
Only about half of workers participate in an employer-based pension plan in any given year, and participation rates in Individual Retirement Accounts (IRAs) are substantially lower. Participation is particularly low among lower earners: Only about one-fifth of workers in households with income of less than $20,000 participated in some form of tax-preferred savings plan in 1997.
Even those workers who participate in tax-preferred retirement saving plans rarely make the maximum allowable contributions. Only about 5 percent of 401(k) participants make the maximum contribution allowed by law, and only about 5 percent of those eligible for IRAs make the maximum allowable contribution.
Despite the shift from defined benefit to defined contribution plans, many households approach retirement with meager defined contribution balances. The median defined contribution balance among all households aged 55 to 59 in 2001 was only about $10,000. Many households thus appear to have substantial difficulty in saving significant amounts for retirement.
The bulk of the policy changes that have been enacted in recent years, moreover, move the tax-preferred pension system further in the wrong direction. They provide disproportionate tax benefits to high-income households who would save adequately for retirement even in the absence of additional tax breaks, while doing little to encourage lower- and moderate-income households to save more.
The Administration’s new savings proposals would exacerbate this flawed approach. The Retirement Saving Account proposal and Lifetime Saving Account proposal would induce substantial asset shifting by high-income households, do little to boost saving among moderate- income households, and significantly reduce revenue over the long term. Over the next 75 years, the revenue cost of the proposals would amount to a third or more of the actuarial deficit in Social Security.
A better strategy would encourage expanded pension coverage and participation among low- and middle-income households by:
Expanding the income eligibility range for the saver’s credit and making the credit refundable;
Reducing the implicit taxes on saving done by moderate-income households through the asset tests under certain government programs;
Encouraging financial education provided by disinterested parties; and
Promoting automatic saving, including through changes to the default choices in 401(k) plans and through the “split refund” proposal included in the Administration’s budget.
Retirement Security Project
A new Retirement Security Project at Brookings and George Washington University, funded by the Pew Charitable Trusts, is studying ways of bolstering financial security for America’s aging population by raising retirement savings and improving long-term care insurance products. It brings together pension researchers and health care experts to examine areas such as the opportunities and challenges involved in using home equity to purchase long-term care insurance; reforming the existing saver’s credit to strengthen its incentives for moderate-income households to save; and removing the disincentive for pension saving implicit in the existing asset tests under various means-tested government programs.
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