The Brookings Institution, Washington, D.C. Individual Accounts, Social Security Reform, and Retirement Security Peter R. Orszag Joseph A. Pechman Senior Fellow The Brookings Institution Director, Retirement Security Project November 18, 2004

The Brookings Institution, Washington, D.C. Individual Accounts: An Overview Individual accounts, such as 401(k)s and IRAs, provide useful supplements to Social Security Growing body of evidence on how to boost saving in 401(k)s and IRAs But: Individual accounts are inappropriate for basic tier of income during retirement, disability, and other times of need. Social Security is only source of income for 1/5 of elderly beneficiaries, 90+ of income for 1/3

The Brookings Institution, Washington, D.C. Individual accounts within Social Security: The financing problem

The Brookings Institution, Washington, D.C. Even apart from financing problems, accounts don’t make sense for base income Social Security provides assured level of benefits protected from stock market collapses, inflation, and risk of outliving assets Social Security benefit formula is progressive, replacing larger share of previous earnings for lower than higher earners (social insurance) As pension system moves toward individuals bearing more risks, individual accounts in Social Security make even less sense

The Brookings Institution, Washington, D.C. Other problems Administrative costs UK experience: More than 40 percent of account balances prior to retirement consumed by fees Average US mutual fund: Roughly 1.25 percent per year Individual account system may respond to political pressure for: early withdrawals no annuitization which would undermine retirement security

The Brookings Institution, Washington, D.C. Bottom line on individual accounts in Social Security Even without transition issues, trading Social Security benefits for individual accounts is a bad deal Individuals already bearing more risk on top of Social Security Political pressure to undermine retirement security Financing issues are important

The Brookings Institution, Washington, D.C. Diamond and Orszag, Saving Social Security Restore long-term sustainable solvency Do not destroy program in order to save it No accounting gimmicks or magic asterisks No general revenue transfers, no ignoring risks of stocks Combine benefit reductions and revenue increases, rather than relying solely on either Follow precedent of 1983 Greenspan reforms

The Brookings Institution, Washington, D.C. A Progressive Reform Protect most vulnerable: disabled workers, young surviving children, lifetime low earners, widows Ask average earners to accept modest sacrifices Ask higher earners to play somewhat larger role in reaching long-term balance

The Brookings Institution, Washington, D.C. Bottom line: Benefits for medium earners Benefit reductions less substantial for lower earners and more substantial for higher earners. Real benefit levels continue to increase from one generation to the next because of ongoing productivity growth.

The Brookings Institution, Washington, D.C. Bottom line: Payroll tax rate If 2045 increase implemented this year, $35,000 earner would pay extra $37 per month in combined employer-employee taxes For 25-year-old average earner, present value of additional lifetime tax is 0.3 percent of career wages

The Brookings Institution, Washington, D.C. Saving on top of Social Security: Existing tax preferences upside-down Tax preferences provide larger incentives to high-income households (in 35 percent bracket) than lower-income households To raise private saving, must not simply cause shifts of assets but generate additional contributions Studies confirm that upper-income households tend to simply shift existing savings, not save more

The Brookings Institution, Washington, D.C. What works: How to boost saving Make it easier to save Automatic enrollment plans Split tax refunds Increase incentive to save for low- and middle-income households Strengthen saver’s tax credit Reduce implicit taxes on saving (e.g., higher ed rules) Revenue-neutral shift from deductions to universal credit? New Retirement Security Project on these issues, funded by Pew Charitable Trusts

The Brookings Institution, Washington, D.C. Conclusions Individual accounts do not make sense as part of Social Security Social Security is like a car with a flat tire. Let’s fix the flat tire, not replace the car. Exciting new evidence on ways to boost saving on top of Social Security for low- and moderate-income households Keep an eye on the Retirement Security Project