Journal Issue

Interview with John Shoven: Personal retirement accounts can be a long-term fix for U.S. Social Security

International Monetary Fund. External Relations Dept.
Published Date:
January 2002
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MacDonagh-Dumler: The debate on how to “save Social Security” has produced many options, but few proposals advocate meaningful change, particularly given Social Security’ s current large surpluses. Indeed, why should we change now?

Shoven: Whatever changes are needed for 2017 and beyond, it is better politically and economically to announce them now, so that people can plan for them. Don’t be fooled by the surpluses; they are merely the product of uneven demographics. If you simply look at the cash flow, Social Security is doing fine and will continue to do well for another decade or so. But the surpluses are misleading. They reflect the taxes of a large cohort of baby boomers who are in their peak earning years. These taxes are underwriting the current benefits of a relatively small cohort born during the Great Depression and World War II. We have 6 to 10 years before the first baby boomers—those born in 1946 and 1947—begin to retire. After that, the number of baby-boomer retirees will grow quickly, and the economics of the system will deteriorate rapidly. But this is all foreseeable, and we would be foolish to do nothing until that happens.

MacDonagh-Dumler: How would your proposed system work, and how does it contrast with the three proposals that came out of the Bush administration’s Commission to Strengthen Social Security?

Shoven: Our plan, developed jointly with Syl Schieber of Watson Wyatt, takes a “clean sheet” approach. It entails virtually a complete change in the system, but is phased in very gradually. Under our plan, those currently over the age of 55 would receive exactly their present legislated benefits. Anyone under 25 would be solely on this new plan. For everyone between the ages of 25 and 55, benefits would reflect a mix of the old and new plans.

Our proposal has two components. The first tier is a safety net; it would provide a flat monthly benefit of $550 in today’s dollars. Two-earner married couples would get $1,100. For low-income workers, $550 is a pretty solid floor. For those making $80,000, $550 a month does not look nearly as good, but that is how we wanted it.

The second tier is a mandatory personal retirement account that reflects 5 percent of a worker’s wage up to an $85,000 cap. Workers would contribute 2½ percent of their pay; and the government would match this on a 1:1 basis. It would be similar to a 401(k) account with a 100 percent match—something that is very popular in the U.S. private sector. Of course, workers would still need to pay existing payroll taxes to fund the program for the current set of retirees. Using assumptions from the Office of the Chief Actuary for Social Security, our system is financially viable. We have estimated that total benefits would very likely be as high as, or higher than, current legislated benefits. I say “very likely” because investments in risky assets, such as stocks and bonds, have uncertain rates of return. If you took no risks and invested in inflation-indexed government bonds, most people would receive a little bit more than they would today.,

So, the benefits are as generous as today’s, but the program requires an additional contribution of 2½ percent. No plan to return Social Security to financial soundness will work if it does not cut benefits or find new money. We decided to find more money. Two of the three Bush commission proposals went in the opposite direction and cut benefits.

We can fiddle with the retirement age, adjust the way initial benefits are indexed, raise taxes, or do some of each. But a significant overhaul is needed to save the traditional system.

–John Shoven

MacDonagh-Dumler: Are benefit cuts the biggest difference between the commission’s plans and yours?

Shoven: Essentially. I would be very happy—and I hope the commission would be happy—if people recognized that there are only two options: provide additional money or cut benefits.

While there are several ways to cut benefits, the commission suggested one that has not received much attention but deserves greater scrutiny because it can greatly improve the system’s finances by changing the way initial benefits are indexed. Under the current system, initial benefits are based on a retiree’s past wages, with past wages brought up to date using an index of U.S. wage inflation during the retiree’s working years. During retirement, these benefits then increase with the consumer price index (CPI). One of the commission’s plans would switch the indexing of initial benefits from average wages to the CPI. This simple change nearly returns the system to solvency without raising taxes.

However, the change is larger than it seems. Fifty years from now, those benefits would be quite a bit lower than current legislative promises—maybe one-third lower. But that is the magnitude of the problem and the amount by which benefits will need to be cut if taxes are not raised. The bottom line is that benefits need to be cut by 30–40 percent or taxes raised by 40–50 percent.

It is also worth debating a change in the normal retirement age or, more accurately, the age when one can claim full Social Security benefits. Under current law, the normal retirement age increases to 67 in the mid-2020s, but remains fixed at 67 thereafter. It seems reasonable to expect that by 2080, life expectancy will be four years longer, so the retirement age should also increase to help keep the system in balance. The proposal that Schieber and I developed would index increases in the retirement age to changes in life expectancy to keep the proportion of working life to the length of retirement constant.

MacDonagh-Dumler: In last year’s report on the U.S. economy, IMF staff noted that with relatively small parametric changes—for example, a 2-4 percentage point increase in payroll taxes—the United States could maintain the current system. This does not seem like a large increase. Are more resources required than that?

Shoven: No, but you have only 100 percentage points to play with, so 2-4 percentage points should not be taken lightly. Our plan has a mandatory contribution of 2½ percent, which—over 40 years—is equivalent to one year’s pay that is being forced into an account. A plan to maintain the current system would divert even more. We can fiddle with the retirement age, adjust the way initial benefits are indexed, raise taxes, or do some of each. But a significant overhaul is needed to save the traditional system.

If the retirement portion of Social Security were the only problem, shoring up the current system would be more thinkable. However, Medicare—the health care portion of Social Security—is, by most accounts, in even worse shape. It will, almost inevitably, need more taxes. Neither we nor the commission has come up with a Medicare fix.

MacDonagh-Dumler: An often overlooked component of personal retirement accounts is how to draw down the money during retirement. Currently, retirees use annuities, but the annuity market is actuarially unfair. Does your plan address this? And, do you require annuitization?

Shoven: Great question. Why are annuity markets unfair? Adverse selection. The only retirees who currently want an annuity are those who are in good health and expect to live longer than the average age.

The private part of our plan would be susceptible to this problem. People will be free to do what they want with their own part of the individual account. But the government’s half would be mandatorily annuitized and, for that half, there would be no adverse selection. I would encourage people to annuitize their own money as well, but economists do believe in choice, particularly with one’s own money.

MacDonagh-Dumler: What impact would these accounts have on the annuity market?

Shoven: With or without these proposed individual accounts, the annuity market in the United States is going to grow rapidly. The 401(k)s and IRAs [individual retirement accounts], which became popular in the mid-1980s, are still in the accumulation phase. The payout phase is approaching, though, with the impending retirement of the baby-boom generation. As that generation begins to retire, the annuity market will grow. Obviously, a new system of individual accounts would just increase the attention paid to annuities.

Now, will we need additional regulation? I would be tempted to wait and see as we get to this payout phase.

MacDonagh-Dumler: What can the IMF do to help advance the Social Security debate?

Shoven: I see two important roles for the IMF. First, greater attention needs to be paid to the impact of demographics on current budgets. The current method of fiscal accounting in the United States can hide the impact of demographics and make budget surpluses seem larger than they really are.

Second, U.S. budgets are not consistent in their handling of trust funds. In many ways, the U.S. government has used trust funds—such as the Social Security trust fund—to hide liabilities in the same way that U.S. corporations have used offshore accounts to shelter themselves from taxes. The U.S. government budget has announced artificially large surpluses (and smaller deficits) because U.S. consolidated budget accounting has counted the Social Security surplus toward the overall budget surplus but excluded interest payments on those trust funds.

If there were proper accounting, one of two things would happen. Either trust funds would not count their bonds as assets—in which case the surplus calculation is correct but the Social Security System will be insolvent in 2017 when benefits exceed tax revenues. Or it could extend the life of Social Security to about 2040 by treating the trust fund bonds as legitimate assets, but then the U.S. government could not count the trust fund surpluses as income and would have to recognize the interest payments it makes on trust fund bonds. If the government took these steps, then the announced deficit would be significantly higher (by at least $200 billion).

The magnitude of this error is so large because it is not only Social Security, but Medicare, highway, and military retirement trust funds that we are talking about. Taken together, these account for $2 trillion in government bonds. If the United States charged itself interest on its trust funds and kept its hands off the Social Security trust fund, the United States would be running a much larger deficit.

I would like to see the IMF look at government and trust fund accounting and ask the questions that the auditors should have asked of Enron. The U.S. government should not be able to commit the same accounting sins that the private sector did. In many ways, these trust funds have been the “offshore” accounts for the U.S. government, allowing Congress or the administration to consolidate the surpluses—and exclude the costs—when it is politically expedient.

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