Laurence Seidman, Professor of Economics, University of Delaware

Social Security does not have to be changed to avoid a financial collapse. Even if nothing is done, benefits due under the current Social Security benefit formula will be paid until 2042, and after 2042 payroll taxes will be sufficient to finance a monthly benefit equal to 73% of the benefit due under the current benefit formula. This post-2042 benefit will be greater after inflation than today's benefit. In this sense, there is no crisis in Social Security.

There will, however, be a serious problem four decades from now. If nothing is done before 2042, the 27% benefit cut after 2042 will be abrupt, and this would clearly be extremely undesirable. Steps must be taken as soon as possible to ensure that there will never be an abrupt cut in Social Security benefits. What is needed is a repeat of the bipartisan Social Security reform of 1983. The buildup of the Trust Fund needs to be made larger by gradually raising payroll tax revenue a bit further above benefits, raising the age of full benefits sooner and a year further than scheduled, raising the early retirement age one year, and phasing in a small downward adjustment in the benefit formula for high-income workers.

I offer the following three recommendations: (1) tax payroll above the ceiling; (2) gradually reduce the replacement rate for high earners; and (3) gradually raise the age of full benefits and the age of early retirement by one year.

With private sector pensions increasingly becoming defined—contribution rather than defined-benefit plans, it makes sense for Social Security to remain primarily a defined-benefit plan in which each retiree's benefit depends on his own wage history, not his own investment history. Moreover, under Social Security's progressive defined-benefit formula, there is some redistribution from high-wage to low-wage workers when they retire. For anyone who favors such partial redistribution, this is an important virtue of defined benefit Social Security, and a crucial reason for limiting voluntary opting out of the defined-benefit plan by high-wage workers.

Nevertheless, in an effort to forge a bipartisan Social Security reform package, I recommend considering the proposal to give each worker the option of diverting a few percentage points (up to a dollar cap) of his Social Security payroll tax to his own individual account provided seven conditions are met: (1) the individual accounts are limited to a small portion of Social Security– 2 percentage points of the payroll tax up to a dollar cap– so that Social Security remains primarily a defined-benefit plan; (2) the government provides a progressive match for low-income workers‘ contributions to their new individual accounts; (3) the dollar amount of payroll tax that a high-income worker can divert to his individual account is capped at the maximum dollar amount that can be diverted by a moderate-income worker; (4) the Social Security Administration provides a limited menu of investment options and administers the program in order to avoid excessive advertising and administrative costs; (5) the amount diverted from the Trust Fund to individual accounts is immediately replaced so that the buildup of U.S. government bonds in the Trust Fund is unaffected; (6) both these replacement transfers and the progressive match are financed by increasing the tax on payroll above the ceiling, not by borrowing from the public; and (7) the three recommendations proposed above to strengthen defined-benefit Social Security are accepted.

Posted on: April 11, 2005


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