With the caucuses and primaries fast approaching, presidential candidates are beginning to focus on policy. Former Sen. Fred Thompson spoke recently on Social Security reform. And he should be commended for offering a solution — but not for the solution he offered.
Like so many before him, Mr. Thompson has fallen into the trap that the objective is to preserve and save Social Security rather than to provide retirement income cost effectively. Social Security, as a tax-financed system, is not cost-effective because benefits are tied to the increase in wages, which historically has been about 1½ percent per annum. To the extent that capital markets return more than 1½ percent, and historically they have by a very wide margin, then saving and investing provide the same retirement benefit at a much lower cost.
Indeed, there is no less expensive way to provide for one's retirement than saving and investing during one's working career.
The senator's plan seems to understand this, but only marginally, for it keeps the tax-based structure intact, and adds only a modicum of market-based financing. The result is a contrivance that attempts a political compromise by offering something for everyone, while not dealing substantively with fundamental reform.
The plan requires all workers to pay the present Old Age and Survivors Insurance 10.6 percent tax, employee and employer combined, on their wage income. In addition, workers may save 2 percent of their wage in a voluntary personal retirement account. If they do, then there is a match of 2½ to 1 on the first $1,000 of monthly earnings and 0.5 to 1 above $1,000. Taxpayers finance the match. For an average-income worker making $40,000 a year the total resources allocated for retirement, taxes and saving combined, are $5,920 or 14.8 percent of his wage.
But the match has a catch: For a 22-year-old who works for 45 years, the eligible age when he can receive Social Security benefits is delayed by about 5½ years. The Thompson plan offers that this delay can be financed by withdrawing from the personal retirement account. The delay is the equivalent of a benefit cut, and one of the reasons the plan reduces the system's unfunded liability. Another reason is that future benefits are reduced further by indexing them to prices instead of wages.
Under his plan, benefits are to be financed not only by payroll taxes, the historical norm, but by general revenues. This is new and worrisome for it makes the cost of benefits more opaque, and it shifts — at least to some extent — the incidence and the burden of the tax from the worker to others. Therefore, from the worker's point of view, some of his benefits appear costless.
Had the Thompson plan taken a different approach by simply allowing all workers the choice to leave Social Security for a market-based structure, but requiring no one to do so, it would have achieved greater retirement benefits at a much lower cost, and with less complexity.
To make the point, assume a plan in which the saving rate is only 5 percent of wage income, and that the investment real rates of return are 6 and 4 percent during the accumulation and distribution phases, well below the historical norm. Further assume one works and saves for 45 years, and that life expectancy at age 65 in 2007 and 2050 is the same as Social Security's assumptions. Under these constraints, benefits as a percent of one's last year's wage would be 52 and 49 percent in 2007 and 2050, respectively. These benefits are higher than what Social Security offers, specifically 40.2 and 36.3 percent, at a fraction of the cost.
If one withdrew the lower Social Security's benefits from his account, his assets would last to age 90 and 96 in 2007 and 2050. Or to put it differently, one's retirement account would last much longer than projected life expectancy. It is true that during the transition from the tax-based to the market-based system additional resources would be necessary. But importantly, without reform those additional resources would be significantly greater.
But beyond the numbers, this reform would provide for lower taxes, higher benefits, choice, the freedom to choose, the ability to bequeath one's assets to whomever one wishes, and smaller government.
Mr. Thompson's plan has not elicited an enthusiastic response. Understandably so. But his willingness to lead on the issue may encourage others. We'll see as we approach the caucuses and primaries.