November 27, 2004

ANSWERING CHALLENGES:

How Bush's Plan Would Secure Social Security: Funding a personal account is like prepaying a mortgage (Glenn Hubbard, 11/29/04, Business Week)

[R]eform would strengthen opportunities to build wealth for millions of Americans, many of whom have few financial assets today. Personal accounts also offer a surer way to prefund our obligation to pay future Social Security benefits. While lawmakers find it difficult to "save" rather than spend Social Security surpluses (the excess of current payroll tax over current benefits), personal accounts would be off-limits to politicians. The emergence of Social Security reform as a domestic policy priority is encouraging, but the focus on personal accounts raises both challenging questions and questionable challenges that need to be addressed.

CHALLENGING QUESTIONS. To start, what are the objectives of Social Security reform? One obvious objective is to advance the President's ownership society agenda. The transition costs to personal accounts will actually put Social Security on a firmer footing. As long as future net obligations are reduced by prefunding Social Security benefits through personal accounts, the diversion of a portion of payroll taxes to personal accounts is akin to prepaying part of a mortgage. If the transition costs are borrowed, the resulting higher explicit federal debt in the near term is offset by lower implicit debt (Social Security obligations) in the longer run. The present value of Social Security's unfunded liabilities is lowered.

This point relates to the second challenging question. Will the reform put Social Security on a better financial footing? The long-term funding gap facing Social Security is large because promised benefits exceed payroll tax receipts by trillions of dollars. Personal accounts alone will not secure Social Security's long-term financial future. The President has stated that there would be no change for current retirees or those nearing retirement. Hence, to close the gap without raising taxes, younger workers will need to receive lower benefits relative to their previous earnings than today's retirees do.

Under current law, initial benefits are indexed to average wage growth in the economy during the years that the retiree worked. Since young workers start their careers at a higher wage level than older workers, they get a larger Social Security benefit in real terms when they retire. One reform plan that replaces this wage indexing with price indexing eliminates almost all of the unfunded liabilities of the system. Benefits received relative to wages would decline (along with Social Security's liabilities), but they would be supplemented by expanded savings from the personal accounts.

Posted by Orrin Judd at November 27, 2004 6:30 AM
Comments

Sounds good, in the sense that recovering 50¢ on the dollar is better than 0¢.

Posted by: Michael Herdegen at November 27, 2004 1:07 PM
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