by Robert Eisner

A Change For the Better:

Voluntary Supplementary Contributions to Social Security

All current benefits of Social Security should be preserved and extended.Rather than diminishing Social Security by privatizing it, I proposegreater public provision of benefits on the basis of voluntary, supplementary contributions to the trust funds. I would add to our present public system, not subtract from it. For those concerned about the trust funds, implementation of my proposal can contribute to making them solvent indefinitely but will entail no new taxes. It will offer additional inducements to save. Most important, it can increase the retirement benefits of most Americans.

Millions of workers do not have access to 401(k)s or private pension funds at work. Those who contribute to individual retirement accounts (IRAs) are generally limited to $2,000 per year per person. Many would at various times, if not steadily, contribute more to retirement were an appropriate vehicle, particularly a tax-exempt one, available.

But millions of Americans-and it is easy to underestimate their number-are unsophisticated in the ways of private investment and uncertain and fearful about the risks. Despite all the unfortunate doubts and cynicism about its reliability, Social Security is the best game in town in the eyes of millions of Americans who have seen their parents and grandparents saved from poverty.

If a voluntary, supplementary Social Security program with a few simple options were put into operation, and if it were adequately publicized, it seems reasonable to believe that it would become enormously popular. For those anxious to minimize risk, an option of investment in Treasury securities would be attractive. For the more ambitious, looking for somewhat higher returns, a bond index fund could be made available. For those still more adventurous, hoping for even higher returns, there could be a passive stock index fund. And all could have the actuarially fair annuities and cost-of-living adjustments not available in the private market.

My basic proposal is simple, although there can be various useful elaborations and corollaries. All participants in the Social Security system-which should be as universal as possible¹-should be offered the opportunity, but not compelled, to make supplementary contributions to the trust funds, and those contributions would be credited to their own individual accounts. Unlike current, required employee payroll contributions, but like most contributions to private pension plans, they would be tax deductible. Interest or other income earned on the supplemental balances would also be tax-exempt, but the resulting additions to retirement income, as with most private pensions,² would be taxable.

Unlike many private pension arrangements, however, while there would be benefits for the survivors of those who die before retirement and, to some extent, for survivors of those who die early in their retirement years, contributors would not be permitted to cash out their investments. This is important to keep the program focused on supplementing retirement benefits rather than merely offering new channels of investment. It is also important to minimize the role of adverse selection, which would complicate the provision of actuarially fair benefits.³

Contributors to supplementary accounts would have a choice of the following investments: 1) a fully passive stock index fund; 2) a fully passive bond index fund; 3) Treasury securities; 4) any combination of the above. The returns on these investments would be credited to the OASDI Trust Funds but earmarked to the individual accounts of the investors. The new accounts would represent public counterparts of private Keogh plans, IRAs, and 401(k)s, 403(b)s, and 457s.⁴ They would have significant advantages over what is provided in existing private plans.

The consolidation of investments in a minimum number of funds or securities and of supplemental accounts in the already existing Social Security system would offer major savings as compared with the administrative costs, commissions, and profits that eat into net private returns. The public system would offer actuarially fair benefits from the accumulations available at retirement; it would offer automatic cost-of-living adjustments; and it would offer appealing new opportunities to millions of Americans unsophisticated in the ways of Wall Street and fearful, often justifiably so, of the siren songs of those who would take their money.

The public investments would thus be highly desirable to many, both as supplements to and, if need be, substitutes for employer pension plans⁵ and individual retirement accounts. They would also draw in funds from those who have tried to provide for their retirement by way of uncertain individual investments that do not offer annuities. And they might attract entirely new saving from many who would find these new options sufficiently attractive to warrant the sacrifice of present consumption in the interest of more for their golden years.

It might be deemed judicious to put an upper limit on the amount of tax-deductible contributions to prevent the very rich from using these contributions to make a mockery of the progressivity of the income tax. If so, however, I would urge that the ceiling should be high-perhaps identical to the $9,500 of 401(k) contributions-so that the new investments offer opportunities for higher-income participants to do substantially more than move savings from existing pension and retirement plans.

While the increased tax deductions would cause some initial loss in income tax revenues, the Treasury and the trust funds would eventually gain much more through the inflow of the supplementary contributions or the income they generate and through the taxes on benefits. The initial loss to the Treasury might be made less by restricting the tax deductibility of these contributions to $2,000 per person, the current upper limit on IRA contributions, rather than the higher 401(k) limit suggested above. The limit might then rise over time with an index for inflation.

I would predict that, with sufficient publicity, many millions of participants in the Social Security system would make major voluntary, additional contributions and would significantly raise their prospective retirement income. Just how much they would gain clearly would depend upon how much they contribute and how well their investments perform.

The Specifics

How all this would work may be shown with projections derived from elementary assumptions that, however simple, capture the essence of my proposal.

1. All covered workers in Social Security will be given the opportunity to make additional contributions that they can designate to be invested in Treasury securities or in a bond or stock index fund to be bought by the Old-Age and Survivors Insurance (OASI) Trust Fund. These extra contributions will be tax deductible, but ultimately the benefits received from them will be taxable. I assume an average marginal tax rate of 20 percent.
2. Participants in this Supplementary Social Security program who choose to invest in Treasury securities would have their balances credited at the same rates as the basic Social Security balances.⁶ To the extent they select indexed stock or bond funds they will be credited with whatever return those funds earn.
3. I will assume that the program begins in 1998. To facilitate projections of results, I shall present a model built on a number of simplifying assumptions. First, all cohorts from the age of thirty-five to sixty-four shall be eligible to contribute, and all benefits will begin at age sixty-five and be paid for twenty years. Those born in 1934 will thus be the oldest to participate. They will be able to contribute for only one year and will then begin to receive benefits. The 1963 cohort will be the first one with the opportunity to contribute for a full thirty years.
   I shall assume further, to make the calculations easy, that each cohort's size remains the same after it enters the program; this could be taken to mean that everybody lives eighty-five years and that death comes on one's eighty-fifth birthday, with no survivor benefits. Alternatively, it can be taken to mean that the assumption of no change in cohort size, at least after retirement, reflects the benefits received by survivors. And I shall assume that the cohorts aged thirty-five to sixty-four account for all of the projected taxable payroll of $3,350 billion and the 147 million covered workers in 1998.
   These assumptions and parameters, while arbitrary, facilitate the illustrations. Results should not be expected to differ fundamentally if contributions could be made at any age and if ages of death and retirement varied from individual to individual and from cohort to cohort.
4. In my first illustration, the mean supplementary contribution will be 3.1 percent of taxable payroll, thus adding 50 percent to the current mandatory employee contribution of 6.2 percent of taxable wages. This additional contribution in 1998 would average $706 per person, and with about 147 million contributors in the program, it would come to a total of $103.85 billion. Each individual's contributions will increase by 3.96 percent per year thereafter, slightly less than the forecast mean per annum rate of increase of 4.39 percent from 1998 to 2075 of the Social Security Administration average wage index. Taking into account a projected rate of growth of cohort size of 1 percent per year, the forecast rate of increase of aggregate wages-and I presume GDP as well-is then 5 percent per year,⁷ very close to the OASDI projection of 4.87 percent.
   In alternate simulations I will assume that each individual's contribution will increase by only the amount of the OASDI intermediate forecast of a 0.9 percent per annum increase in real wages, adjusted for the rate of inflation, and that the growth in cohort size will follow the OASDI projections for the population aged twenty to sixty-four. Since this growth is expected to slow markedly from about 1 percent per annum over the next two decades, approximating zero after thirty years, the growth in contributions will slow as well, from an initial 4.79 percent to 4.20 percent by 2025 and to 4.13 percent by 2047.
   While the OASDI intermediate forecast sets the long-range inflation rate at 3.5 percent,⁸ I assume initially yearly inflation of 2.5 percent, closer to the rate implied by the difference between interest rates on conventional bonds and on the new, inflation-indexed Treasury securities9 (and still above the 2.1 percent rate registered over the past year). I shall also, however, demonstrate the effects of rates of inflation held constant at both 2.1 percent and 3.5 percent.
   The OASDI intermediate forecast, as indicated above, sets the per annum, long-run increase in real wages at 0.9 percent. I hope and believe that this forecast is unduly pessimistic. But total wages covered in payrolls will also increase as a consequence of the rising upper limit on taxable wages per worker. The assumptions of 2.5 percent price inflation and a 3.96 percent increase in contributions based on wages do not therefore necessarily imply an increase in real hourly wage rates of 1.4 percent per year, which would conflict with the OASDI assumption as to real wage growth. I shall, however, model some alternative assumptions, particularly on the premise that the increase in total wages is slowed in future years by decelerating growth in the size of the working-age population.
5. I shall assume initially that the indexed funds actually earn 8 percent per year, which is credited to the individual accounts. I shall then note the implications of different rates of return on these funds, and I will give consideration to those that put their supplementary contributions into Treasury securities as well.
6. Benefits will be paid on an actuarially fair basis over the twenty-year retirement period,with the assumed rate of return credited on the remaining balance throughout the span. Initial payments will be scaled down to accommodate the cost-of-living adjustment. The balance at the end of the twenty-year period will thus be zero.

1. Recall my suggestion above that the current system, financed with income taxes instead of payroll taxes, might offer benefits to all who contribute, whether out of labor income or capital income. I have refrained from adding this extension to my proposal for supplementary contributions, but it might readily be included.

2. Other than those generated by the new, "back-loaded" Roth IRA, effective January 1, 1998. This option offers the possibility of contributions that are not tax deductible but with ultimate returns that are tax-free.

3. Adverse selection may occur to the extent that income is positively associated with longevity. Those with higher incomes will be most likely to make voluntary contributions, so that, given this positive association, the expected lives of those with supplementary accounts will be greater than average. They would be receiving retirement benefits longer than predicted on the basis of actuarial tables for the general population. This would mean that benefit payments based on those actuarial tables would turn out to be too large. Retirees would, in fact, on average get back more than their supplementary contributions and the earnings on them. It might prove desirable, therefore, to offer annuities that are actuarially fair to the subset of those who contribute rather than the larger annuities that would be calculated by applying tables relating to the general population. If contributors could withdraw or cash out their investments, however, the adverse selection might become much more serious. Then, those who learned they would not live long would withdraw, raising still more the average life expectancy of those remaining in the supplementary system. This would contribute to adverse selection an active, causal factor for which it would be difficult to control.

4. For private businesses, nonprofit enterprises, and state and local government employees, respectively.

5. The supplementary contributions might ideally extend to employers who would match their employees' contributions. The employers would benefit from the lower administrative costs. Employees would benefit from the full portability of their pensions, akin to what college professors enjoy in the TIAA-CREF program as they move from one participating institution to another.

6. The Old-Age and Survivors Insurance Trust Fund was credited with a 7.7 percent rate of return on its U.S. Treasury securities in 1996 and with a 7.9 percent rate in 1995. These rates reflect higher interest rates on Treasury obligations acquired by the funds in the past. The interest rate on special issues purchased by the OASI Trust Fund in June 1996 was 7.0 percent (OASDI Report, p. 44). Yields on marketable, long-term, thirty-year Treasury bonds are currently (as of February 1998) 5.9 percent and generally somewhat lower on shorter maturities.

7. The 3.96 percent per year increase in individual contributions is assumed in order to arrive at the round number of 5 percent for aggregate contributions. Precisely, 1.0396 times 1.01 = 1.05, thus a 5 percent increase per year.

8. OASDI Report, p.13.