Originally published in THE NEW YORK TIMES


Monday, MAY 22, 2000

Bush's Low-Risk Pension Reforms


Gov George W. Bush recently proposed supplementing traditional Social Security with personal retirement accounts. Individuals would invest a portion of their Social Security payroll taxes. Such a proposal naturally raises a question: In such a mixed system, are future retirees at risk of receiving significantly lower benefits? The answer is no. Adding individual retirement accounts will only make future retirement incomes more secure.

Of course, the current pay-as-you- go system is itself risky. Without changes, benefits will exceed tax revenue by 2015, and the trust fund will be empty by 2037. Moreover, maintaining currently projected benefits would require raising the payroll tax from the current 12.4 percent to more than 19 percent. If taxes aren't raised, benefits will have to be cut by one-third.

Although Governor Bush has not developed a detailed blueprint, a study I conducted two years ago with Elena Ranguelova of Harvard and Andrew Samwick of Dartmouth shows how adding individual accounts can succeed with no increase in tax rates and little or no risk to future retirees.

We analyzed the risks that retirees would face if the Social Security tax were not increased and government deposited amounts equal to 2 percent of each individual's earnings into new personal retirement accounts. The deposits could be financed from the projected budget surpluses with out any increase in tax rates.

In our analysis, individuals invest the money in a balanced portfolio of 60 percent stocks and 40 percent corporate bonds. Such a portfolio had an average return over the last 50 years of more than 6 percent, after inflation. When individuals reach retirement age, the money in these accounts supplements their Social Security benefits.

The plan has another bonus: the increased national savings means more corporate investment and profits and therefore more corporate tax payments. That extra revenue can be used to supplement the Social Security trust fund.

These calculations are easily adapted to a plan like the one Governor Bush suggests: allowing individuals to use a small percentage of their Social Security taxes to finance their personal retirement accounts.

Assume that 2 percent of the 12.4 percent Social Security tax is deposited in personal retirement accounts. The rate of return on these accounts would exceed the return in the Social Security trust fund. Traditional tax- financed benefits combined with payouts from personal retirement accounts can therefore maintain retirement incomes at the level now projected. And with corporations making greater profits, as a result of increased national saving, and therefore paying more taxes, the trust fund remains permanently solvent.

In the early years, Social Security benefits would be financed almost solely through the traditional method. So, for those who are now retired, there would be no risk, since the new system would not apply to them. Over time, the importance of the investment-based benefits would in crease. But eventually, the 12.4 per cent payroll tax would finance at least two-thirds of the projected benefit amount.

Although investing does have some risk, it is very small, and retirees stand a good chance of receiving substantially more than what is projected for them now.

Take a 21-year-old, who will have average earnings each year until he retires and invests his personal retirement account deposits of 2 percent of earnings in the balanced stock-bond portfolio. Based on the market's volatility in the last 50 years, he has a 50 percent chance that his combined benefits will exceed his currently projected Social Security benefits by at least one-third. There is a better than 10 percent chance that his combined benefits will more than double his projected Social Security benefits.

The downside is not very risky. There is less than 10 percent chance that his combined benefits will be less than 90 percent of his projected Social Security benefits.

Even these relatively small risks for future retirees could be eliminated by a government guarantee that anyone who invests in the standard stock-bond portfolio would be compensated if his annuity falls below the benefits projected in current law. (Individuals would be free to invest in other approved portfolios, but the guarantee would reflect only the performance of the standard stock-bond portfolio.)

Our study implies that in most years, guarantee payments would not be needed. And there is a less than 1 percent chance that the total taxpayer cost - including the payroll tax as well as the guarantee payment - would be as large as the 19 percent tax rate that would be required to finance the same level of benefits if there is no reform.

The real risk to future retirees is not that individual accounts would be too risky. The real risk would be in not reforming Social Security now, before the demographic problem becomes overwhelming.

Martin Feldstein, an economics professor at Harvard, is an adviser to Gov. George W. Bush.