An Investment-Based Social Security System Can Benefit Low-Income Groups

Summary of working paper 7492
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All demographic groups regardless of marital status, race, and education experience an increase in average benefits under the mixed plan.

One of the most talked about problems facing the United States is the impending social security funding crisis. Social security payroll taxes will have to rise sharply to meet the needs of growing numbers of elderly Americans or else future benefits will be slashed. An alternative to this dire scenario is to introduce an investment-based social security system. Until now, one of the major criticisms of such a plan was that it would leave low-income earners much worse off. But a new NBER study by Martin Feldstein and Jeffrey Liebman finds that is simply not the case. In fact, their results show that it is possible to design an investment-based plan under which the vast majority of retirees would have higher benefits than they would under the current pay-as-you-go system.

In The Distributional Effects of an Investment-Based Social Security System (NBER Working Paper No. 7492), Feldstein and Liebman compare both average and individual benefits under the current social security system with benefits under a pure investment-based system and a mixed system. Although they acknowledge that a pure investment-based approach is not a realistic option, the authors argue that it is worth using as a benchmark. A more realistic option would be a mixed approach that incorporates the stability of the current system with the higher funding potential from an investment-based plan.

Under a mixed system, Feldstein and Liebman assume that the payroll tax funding the traditional benefit remains at the current 12.4 percent rate and that the investment component amounts to an additional 3 percent contribution to Personal Retirement Accounts (PRAs) that invest 60 percent in stocks and 40 percent in bonds. Given this mixed system, the authors find that in the long run more than 90 percent of individual retirees would be better off than under the current system, even assuming market returns below those experienced in the post-war period. On average, retirees would experience a 39 percent increase in their annual benefits. In addition, all demographic groups regardless of marital status, race, and education experience an increase in average benefits under the mixed plan.

So who are the big winners under the mixed plan? According to the study, whites gain more than blacks under a mixed system, but the potential poverty reduction among blacks is more substantial than whites. Hispanics gain the least, but the authors believe this is because their sample includes a large number of immigrants who receive substantial benefits under the existing social security system. The potential poverty reduction for elderly widows is large as well.

Another important benefit of shifting to a mixed system is that it reduces the long-run cost of funding social security. Feldstein and Liebman point out that if the current system remained in place, payroll tax rates would have to rise from today's level of 12.4 percent to 19 percent to maintain the level of retiree benefits projected in current law. By increasing current contribution rates, the mixed system results in much higher benefits for virtually all groups at a substantially lower long-run cost. Instead of the additional 6.6 percent increase in taxes, a mixed system would involve only a 3 percent increase in the form of new savings contributions.

As an added safety check to their study of pure and mixed systems, Feldstein and Liebman examine what happens to benefits if the investment picture deteriorates. In their base scenario, the authors assume a real rate of return on investments of 5.5 percent (quite low by historic standards). But to lay any criticism to rest that returns may be much lower in the future, they adopt a real rate of return of 3.5 percent. Even taking into account a much lower rate of return, retirees on average are still better off under a mixed system. Average benefits in the scenario would amount to $9,401 in the mixed plan versus $9,280 under the current system.

-- Anna Bernasek