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The Basics
The new Social Security
The Bush administration wants to let you invest part of your payroll deductions through a personal account. Here's what your future might look like.
By Rick VanderKnyff
As he promised the day after his re-election, President Bush is putting his newfound political muscle into Social Security reform, declaring "now is the time" to confront the issue and making it the domestic centerpiece of his State of the Union address.
Some details are still forthcoming, but Bush has made one thing clear: He aims to give workers the chance to divert some of their payroll withholdings into "personal retirement accounts" that they control.
It will be a hard sell. But if Bush gets his way, how will "personal retirement accounts" work for participants? By looking at some of the proposals that have surfaced and talking to experts, we've made an educated guess at answering some of the questions you might have.
Currently, employees and employers each pay 6.2% of a worker's pay, a total of 12.4% of gross income. Withholding stops at $90,000 in 2005, capping an individual's deduction at $5,580.
Under the model that Bush favors, workers born after 1949 could eventually put 4% of gross income into a private account, up to $1,000 a year at first. The remaining 8.4% would go into the existing Social Security system to pay the benefits of current retirees.
The personal accounts would be phased in between 2009 and 2011. Workers would be able to choose among several stock, bond and mixed-investment funds. They would have no access to the accounts before retirement and could not borrow against them. Retirees would be required to buy annuities to ensure steady income.
Retirees would also get the monthly Social Security checks they now know and love, prorated to account for the deductions that were diverted into the personal account.
It's important to note that private accounts are only part of the president's reform plan; other measures will be needed to balance the books in time to head off predicted shortfalls in system funding. One option floated recently by the White House would cut future benefit levels by changing the way initial benefit levels are calculated (read more here). The president on Wednesday said he was open to a variety of options, including extending the retirement age and trimming benefits for wealthier retirees.
He emphasized that benefits for current retirees and workers 55 or older would not be affected, though, under his proposal.
Other details are lacking so far, but the groundwork laid by the president's Commission to Strengthen Social Security provides good clues.
Has anyone done this kind of thing before?
A number of countries allow at least some measure of private investment as part of a national retirement system, and proponents frequently hold Chile up as a model. Since 1981, workers there have been able to opt entirely out of the government-run pension system; instead, 10% of pretax wages are deposited into a personal account that grows tax-free.
While Bush has called Chile's system a "great success" and advocates point to average returns of 10% annually with 95% participation by covered workers, a study by Carnegie Mellon University concluded that the number of people covered by social security in Chile has actually fallen under privatization.
Then there's the Thrift Savings Plan for federal workers, established in 1986 and touted as a model by the president in his State of the Union. More than 85% of federal workers participate, choosing from a range of equity and bond funds. Of course, the TSP is used by a single (albeit very large) employer with automated payroll systems; how the model would scale up is an open question.
Would it work like my 401(k)?
Well, yes and no. In theory, it works essentially like any defined-contribution plan an employer might provide, with a percentage of wages deducted and then directed into an equity- or bond-based fund of the worker's choosing.
It's likely to be quite a bit less flexible than a deluxe 401(k) plan might be, however, both in terms of investment choice and in ease of access to account information. That's because Bush wants to keep administrative costs as low as possible (30 basis points is a target) and because the sheer logistics of coordinating personal accounts for potentially tens of millions of participants (who work for some 7 million U.S. employers, most of whom still use paper-based payroll) will necessitate a Spartan plan.
As the non-partisan Employee Benefits Research Institute put it in a briefing: "If a typical Internet-based 401(k) . . . can be described as the 'Porsche' of retirement savings plans, then the public should realize that a workable, cost-effective individual account within Social Security will most likely look like a 'Model T.'"
Look for monthly or quarterly statements mailed to your home, and perhaps one annual opportunity to adjust your distribution. Online account information? Not likely, at least to start.
How would I sign up?
Opt-in is likely to be a paper process, much like the current W-4 form you fill out when you start a new job, says Berna Brannon, a Social Security analyst with the Cato Institute. All three models forwarded by the president's commission are voluntary -- if you don't sign up, you stay within the current system.
Whether you can change your mind and sign up later is another open question. "For the Cato plan, we thought you could opt in at any time," Brannon says. "If you decide not to opt in when it's first offered, you should not be penalized if you decide to opt in a few years later."
How would the money be collected?
Backers of partial privatization say they do not want to add any burden to employers, so the money would most likely be collected through payroll tax deductions. But that does pose the challenge of sorting out individual "ownership" of funds from the aggregate taxes that employers pay to the government.
That means it could take about 15 months on average to credit your payroll contribution to your personal account. Economist Thomas R. Saving, who was among the commission members who met with the president on Dec. 9, is sanguine about the lag time. "It's not a problem," he said. The government could invest the pool in Treasury bonds and "credit the individual at the average rate."
What investing choices would I have?
No details are final yet, of course, but the president's commission on Social Security reform envisioned a two-tier system for personal accounts. Under Tier 1, participants would choose a default balanced fund or any combination of five index funds and an inflation-protected bond fund. When the fund reaches a threshold amount ($5,000 or $7,500 have been suggested), the commission proposed, participants could move to a private-sector provider.
The range of available investments would still be tightly regulated, however. "You aren't going to allow gambling in these portfolios," says Saving. Workers will have less flexibility "because this is your primary retirement account."
Brannon says she expects a three-tier system, with funds invested in a money market-style account until it hits a $1,000 threshold. The administrative costs for smaller accounts, she said, would just be too high.
"The goal here is greater security in retirement, so we will set careful guidelines for personal accounts," Bush said in his address. "We will make sure the money can only go into a conservative mix of bonds and stock funds."
What about education?
Critics have wondered how the government would educate millions of first-time investors, pointing to 401(k) disasters at places like Enron, as well as less spectacular (but pervasive) examples of workers who do poorly in 401(k) investing.
Saving says that it will be much more important to have a diversified default portfolio, as well as safeguards against speculative or overly aggressive investing, than to spend untold millions on education. "You're not educating people about the current Social Security system," he points out. "The current portfolio is in non-negotiable bonds, and if people were educated they would never invest in those."
Would I be better off with this system?
The commission says that its model "enables future retirees to receive Social Security benefits that are at least as great as today's retirees, even after adjusting for inflation, and increases Social Security benefits paid to low-income workers." The report projects that a participating medium-wage worker who retires in 2032 would do so with 22% higher benefits than a current retiree, in 2001 dollars; by 2052, the increase is projected at 59%.
This is based on the premise that the stock market will continue to perform at historical rates of return. According to the Social Security Administration's own projections, equities can be expected to earn a real annual rate of return of about 6.5%; Treasury bonds can be expected to yield about 3%.
What if the market tanks?
The president's commission, in its report, is careful to spell out the long-term growth of the stock market. It hedges when it comes to recommending any guarantees, however, pointing to the potential cost of such a guarantee.
President Bush, in his State of the Union, implied that he would include some protections: "We'll make sure there are good options to protect your investments from sudden market swings on the eve of your retirement."
The commission did show some openness to something adopted in Germany and Japan called a "principal guarantee" -- meaning that a worker is guaranteed at least the amount of money he or she contributed to the system. Another flavor: guaranteeing the total lifetime contribution plus the rate of inflation at retirement.
The "traditional" part of Social Security remains, and the commission does propose a minimum benefit to 30-year minimum-wage workers of 120% of the poverty line.
Will partial privatization save Social Security?
There is general agreement that the system is in trouble, though proposed solutions vary widely. The main issues boil down to a long-term funding gap: As the population ages and the ratio of current workers to retirees shrinks, the system will someday (by 2018, some estimate) take in less money in payroll taxes than it pays out in benefits. (See "The truth about Social Security is ugly" for some unsettling details).
Because current payroll taxes pay for the benefits of current retirees, any plan that allows workers to divert money into private accounts will create an imbalance in the short run. The commission's Model 2 would cost about $2 trillion over a decade in transition costs, it is estimated.
Commission members say their proposals will tame the system over the long haul without raising payroll taxes or cutting benefits, but periodic and substantial infusions of general revenue funds will be needed to reach that goal.
It's worth noting that the commission models achieve most of their long-term savings not through the personal accounts, but by tying raises in future benefit levels for new retirees to the price index rather than to the currently used wage index (which goes up at a faster clip).
Is this really going to happen?
Observers are predicting a tough fight over significant changes to what has long been called the "third rail" of American politics, and the politically powerful AARP is running advertisements against personal accounts. Bush appears determined, but members of Congress sensitive to re-election pressures may not have the stomach for the fight.
Even if significant reform does make it to the president's desk, personal accounts would likely take years to implement. So . . . keep on saving for retirement in the meantime.
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