Commentary

How Should Social Security Be Reformed? Look to the States

By Carrie Lips
March 24, 1999

One serious look at the higher taxes and slashed benefits that’ll be required to “save” the Social Security system in its present form is enough to make you want to hide your FICA taxes under your mattress. Anything to keep the money out of the hands of Washington politicians. But some lucky Americans enjoy a far better alternative.

There are 5 million state and local government workers throughout the country who are exempt from Social Security and participate instead in retirement plans administered at the state and local levels.

Analysis of the state and local retirement plans reveals that those programs generally provide greater benefits and more flexibility for participants than does Social Security. They can offer more generous benefits because, unlike Social Security, which immediately uses payroll taxes to pay benefits, state and local programs save and invest at least a portion of workers’ contributions, generating additional revenue for the programs.

Unlike the one-size-fits-all structure of Social Security programs, state and local retirement programs are tailored to meet the needs of specific employee groups. For example, plans covering police and fire fighters often provide greater disability benefits and flexibility in retirement age. Participants often have a menu of benefit payment options, which allows a participant who is single and childless to avoid wasting money on survivor coverage.

A particularly successful program is the retirement plan in San Diego, California, where officials opted out of Social Security in 1981 and replaced it with a defined-contribution program called the Supplemental Pension Savings Plan. Today, city employees are required to contribute at least 3 percent — and at their option, they may contribute up to 7.5 percent — of their salaries to their SPSP accounts. The city matches employees’ contributions dollar for dollar. At retirement, SPSP participants use the assets in their accounts to provide retirement income.

When the program began, all assets in the employees’ accounts were invested by the city treasurer in low-risk products that returned an average nominal rate of return of 8 percent. In 1996 San Diego restructured SPSP to resemble a 401(k) plan by giving individuals control over their investment selections. Today, participants have a choice of five mutual funds, which have provided an average annual rate of return of more than 14 percent.

The benefits for SPSP participants of saving and investing their contributions throughout their working lives are substantial. For example, a 30-year-old San Diego employee who earns a salary of $30,000 for 35 years and contributes 6 percent to his SPSP account will have amassed more than $500,000 by age 65, assuming his investments earn a real return of 7 percent. That asset would provide him with monthly retirement income of approximately $3,000. Under Social Security, that worker would pay 6.2% of his annual salary in FICA taxes and be eligible for a payment of approximately $1,077 per month at age 65.

Unlike San Diego’s program, most state and local retirement plans are defined-benefit plans, and in that respect they are more like Social Security. In defined-benefit programs, employees do not own accounts. Instead, their payments into the system are pooled and invested by plan administrators.

Although defined-benefit plans confirm the financial benefits of investing, they also reveal how political interests often affect investment selection when governments invest. When making investments, many state and local pension administrators use political criteria, targeting favored local projects or forbidding certain investments — in tobacco companies or producers of “gangsta rap” for instance — for “moral” reasons. There is little doubt that federal government investing of Social Security trust funds in stocks would become politicized as well, with far more pervasive impact on the American economy as a whole because of the huge amounts of money involved. Alan Greenspan, chairman of the Federal Reserve, has called giving the federal government the power to invest “dangerous,” and he’s in a position to know.

In this and other areas, the experience of state and local retirement plans provides valuable information about the benefits and hazards of different retirement structures — information that should guide the national debate about the future of Social Security.

San Diego’s retirement program provides policymakers with an example of how a system of personal retirement accounts can successfully replace Social Security. It highlights the many benefits of allowing individuals to own their retirement savings: participants enjoy a market rate of return and are encouraged to save more. More than 85 percent of San Diego participants choose to save more than the minimum amount in their SPSP accounts. Moreover, since participants in San Diego own their contributions, they have real security and, unlike Social Security participants, don’t have to worry that their benefits will have to be cut.

Policymakers attempting to reform Social Security should take to heart the lessons learned from state and local retirement plans and give all Americans the security they deserve by moving toward a system of individually owned, privately invested retirement accounts.

Carrie Lips is a Social Security analyst at the Cato Institute.