June 28, 2005
JS-2610
The Honorable Mark W. Warshawsky
Prepared Remarks
American Bankers Association
June 28, 2005
Washington, DC
Thank you for such a welcome introduction. I appreciate the opportunity the American Bankers Association has given me to discuss the Administration's proposal to permanently fix Social Security and reform and strengthen the single-employer defined benefit pension system against the background of the larger issue of promoting national savings.
President Bush said in his
Social Security Reform
President Bush has made Social Security reform a major priority of his second term. Today I'll explain why it is so important that responsible Social Security reform occur now, and why one element of a successful reform plan must be personal retirement accounts that give individuals more control over their financial futures.
The Size of Social Security's Financial Shortfall
How big is Social Security's current funding gap? The most widely cited measure of that gap is the 75-year actuarial imbalance, which is now estimated at $4.3 trillion or 1.92 percent of taxable payroll. This measure suggests that immediately raising the payroll tax rate by 1.92 percentage points, to 14.32 percent, would permanently fix Social Security. But as many of you are aware, that is not true. With each passing year, the Trustees would report an ever larger financial imbalance as the 75-year scoring window is moved forward to include years with ever larger gaps between expected system costs and income.
As this example makes clear, estimates made over a 75 year horizon do not fully capture the financial status of the Social Security program. In fact, no finite forecast period completely embodies the financial status of the program because people pay taxes in advance of receiving benefits; at any finite cutoff date, people will have accrued benefits that have not yet been paid.
In order to get a complete picture of Social Security's permanent financial problem, the time horizon for calculating income and costs must be extended to the indefinite future. Such a calculation is provided in the 2005 Trustees Report; it is estimated there that for the entire past and future of the program, the present value of scheduled benefits exceeds the present value of scheduled tax income by $11.1 trillion. To put this in perspective, eliminating the permanent deficit could be accomplished with an immediate and permanent 3.5 percentage point increase in the payroll tax rate (to 15.9 percent), or with a 22 percent reduction in all current and future benefits. In both cases, it would be worth noting, there would be massive near-term Trust Fund accumulations.
Intergenerational Equity: Why Social Security Must be Reformed Now
It is clear that the Social Security system is not financially viable and must be fixed. How to close the permanent financing gap raises difficult questions over how the net benefits of Social Security should be shared across generations. In this context, it is important to recognize that the large unfunded obligations in the system are primarily the consequence of the past system generosity to generations that are now either dead or retired. Of course, those early generations are beyond reform's reach, so the entitlement reforms needed to close the financing gap must fall entirely on later generations.
Viewing Social Security from the perspective of how it affects generations and individuals explains why it is imperative that Social Security be reformed now. Delaying reform only reduces the options for fairly distributing the benefits of Social Security across generations. Most people agree that it would not be fair to alter Social Security's promises to retirees and near retirees. The longer reform is delayed, the fewer generations that are left to participate in a reformed entitlement system so as to close Social Security's funding gap, and the more severe those reforms will be.
To make this point more concretely, consider a policy of closing Social Security's permanent financing gap by immediately increasing the payroll tax rate by 3.5 percentage points. If the tax increase were instead delayed until 2041 when the trust fund is depleted, the requisite tax increase would be 6.3 percentage points. Clearly, I do not advocate any of these policies. My point is that there is no doubt that fairness to future generations requires that action be taken now.
I would also point out that purely pay-as-you go financing of Social Security would be grossly unfair to future generations. For example, one way to make Social Security solvent would be to leave benefits unchanged and to raise payroll taxes year by year beginning when the Trust Fund is exhausted. According to current projections, the payroll tax rate under that policy would steadily rise beginning in 2041 and reach 19 percent at the end of the 75-year projection period and would continue to rise thereafter. No reasonable person would view that as a fair policy. I conclude that any reform that is fair across generations would avoid pay-as-you go financing and therefore would at least partially pre-fund Social Security benefits.
Administration Proposal: Permanently Fixing Social Security
The President supports Social Security reform that increases the power of the individual, does not increase the tax burden, and provides economic opportunity for more Americans. One important component of reform is the introduction of personal retirement accounts (PRAs). PRAs provide individual control, ownership, and are an effective vehicle for pre-funding more of our Social Security benefits. PRAs also offer individuals the opportunity to build a nest-egg that the government cannot take away. They allow individuals to partake in the benefits of investing in the financial markets. Individual control and ownership means that people would be free to pass any unused portion of accounts to their heirs.
Today I'll briefly discuss the
Let me make two critical points up front. First, the system needs to be reformed to make it permanently sustainable. The President is committed to doing this while maintaining the progressivity of the system. The second critical point is that personal retirement accounts will be voluntary. At any time a worker can "opt in" by making a one-time election to put a portion of his or her payroll taxes into a personal retirement account. A worker who chooses not to opt in will receive traditional Social Security benefits, reformed to be permanently sustainable.
To ease the transition to a personal retirement account system, participation will be phased in according to the age of the worker. In the first year of implementation, 2009, workers currently between the age of 40 and 54 (born between 1950 and 1965) would have the option of establishing personal retirement accounts. In the second year, 2010, workers currently between the age of 26 and 54 (born between 1950 and 1978) would be given the option and by the end of the third year, 2011, all workers born in 1950 or later who want to participate in personal retirement accounts would be able to do so.
Even after the initial implementation, personal retirement accounts will start gradually. Although all participants will eventually be allowed to contribute 4 percentage points of their payroll taxes to a personal account, the annual contributions to personal retirement accounts initially would be capped at $1,000 per year. The cap would rise gradually over time, growing $100 per year, plus growth in average wages. Starting with the full 4 percentage point PRA contribution ensures that low-income workers can get appreciable gains from the accounts. If we started out with a lower percentage contribution, the potential dollar gains for low-income workers would be much more limited.
There has been a great deal of discussion about how PRAs will interact with the traditional Social Security benefit. The PRA structure that the President has proposed is a "carve out" or "offset" PRA. An offset PRA simply means that workers who choose to contribute payroll taxes to a PRA will have their defined Social Security benefit adjusted by an actuarially fair amount. The government borrowing rate is the appropriate and fair offset rate or assumed rate of return.
As proposed by the President, PRAs are designed to hold down administrative costs, encourage careful and cautious investing, and provide a reliable income for the full length of retirement.
Centralized administration and limited choice will hold down administrative costs. The PRA administration and investment options will be modeled on the Thrift Savings Plan (TSP). TSP is a voluntary retirement savings plan offered to federal employees, including members of Congress. TSP offers comparable benefits and features to those available to private sector employees in 401(k) retirement plans. The Social Security
The PRAs will limit the risk of investments with low-risk, low-cost options like the broad index funds available to federal employees in TSP. Similarly to TSP, the index funds could include, for instance, a government securities fund; an investment-grade corporate bond index fund; a small-cap stock index fund; a large-cap stock index fund; and an international stock index fund. In addition to these TSP-type funds, workers could choose a Treasury Inflation-Protected Securities fund.
Workers will also be able to choose a "life cycle portfolio" that would automatically adjust the level of risk of the investments as the worker aged. As the individual neared retirement age, the life cycle fund automatically and gradually shifts the allocation of investment funds so that it is weighted more heavily toward bonds. The President's plan includes a mechanism that will protect near-retirees from sudden market swings on the eve of retirement. PRA balances would be automatically invested in the "life cycle portfolio" when a worker reaches age 47, unless the worker and his or her spouse specifically opted out by signing a waiver form stating they are aware of the risks involved.
Because these are specifically designed as retirement accounts, PRAs would not be accessible prior to retirement. Workers who choose personal retirement accounts would not be allowed to make withdrawals from, take loans from, or borrow against their accounts prior to retirement.
The distribution options for PRAs will include restrictions on withdrawals to discourage outliving ones assets. Procedures would be established to govern how account balances would be withdrawn at retirement. This would involve some combination of inflation indexed annuities to ensure a stream of monthly income over the worker's life expectancy, phased withdrawals indexed to life expectancy, and lump sum withdrawals. Individuals would not be permitted to withdraw funds from their personal retirement accounts as lump sums if doing so would result in their moving below the poverty line. Account balances in excess of the poverty-protection threshold requirement could be withdrawn as a lump sum for any purpose or left in the account to accumulate investment earnings.
Some have raised concerns about the public borrowing that might be needed to help finance PRA contributions. Such an increase in public borrowing is often referred to as a "transition cost," but I want to argue here that the term is a misnomer; the increased public borrowing does not represent an increase in the cost of paying retirement benefits and hence is not a cost in the sense that people would normally believe. PRAs increase public debt in the short term, but ultimately leave public debt unchanged when factoring in the outlay reductions deriving from the reduction in defined benefits. Because long-term public debt is unchanged, the policy is neutral with respect to the long-term cost of paying retirement benefits.
Most importantly, PRAs allow individuals to save now to help fund their retirement incomes. In principle, that could be done with reforms that save tax revenues in the Social Security Trust Fund. But such "saving" would almost certainly be undone by political pressures to increase government spending and hence produce larger deficits outside of Social Security. The only way to truly save for our retirement and give our children and grandchildren a fair deal is with personal accounts. Personal accounts serve as private and therefore effective "lock boxes". When pre-funding is done using a personal account, there is no pressure to increase government spending, because this pre-funding belongs to individuals and does not appear on the government balance sheet as budget surpluses.
In addition to addressing Social Security's solvency, this administration is also proposing ways to encourage national savings and ensuring that the pensions workers have earned will be honored.
Encouraging National Savings
As far back as 1776, Adam Smith identified capital accumulation as the key force in promoting growth in the wealth of nations. Smith also identified the key force in capital accumulation: increasing national savings. Since Smith's time, almost all economists have come to understand the vital nature of national saving, and increasing saving has become a standard policy prescription for enhancing economic growth and raising living standards.
We know the
Despite the fact that this prescription is well-known, the evidence suggests it is exceptionally hard to follow. Net private saving (gross private saving less depreciation on plant, equipment, and housing stock) as a share of national income averaged about 11 percent from 1955 through 1985, but since then has trended steadily down. Over the past ten years, it has averaged about 5-1/2 percent of GDP, or about 5 percentage points below where it was during the decades of the 1950s, 60s, 70s, and most of the 80s.
One reason the saving prescription is difficult to follow is that incentives work against it. Our tax system, for example, has, for a long time, encouraged Americans to spend first and save second. To reverse, this, the Administration has worked hard to set in place the incentives that encourage saving. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) cut the top tax rates which raised the after-tax rate of return on capital income – encouraging savings. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) cut taxes on capital income.
But even with these positive changes, the Federal income tax code still discourages saving. To combat this, the President has proposed Retirement Savings Accounts, which would replace the complex array of retirement saving incentives currently in the tax code, such as IRAs, Roth IRAs, and similar saving vehicles. The President has also proposed Employer Retirement Savings Accounts to simplify the saving opportunities individuals have through their employers. The President's Lifetime Savings Accounts would, for the first time, allow individuals to save on a tax-preferred basis for any purpose. This can be especially important to low-income individuals and families who need to save, but cannot afford to lock up funds for retirement that may be needed for an emergency in the near-term. The President also proposed Individual Development Accounts that would give extra financial incentive to certain low-income families to set aside funds for major purchases, such as a first home.
Pensions also play a critical role in saving. Accumulating financial assets for future retirement is one of the main reasons households save at all. If individuals and households believe they will receive a pension in retirement, that influences their saving and asset accumulation behavior. If, in fact, those promised benefits are not available because of pension under funding, then the household's saving, and, in aggregate, national saving, is less than it otherwise would have been had their pension been adequately funded.
The single employer pension system is in serious financial trouble. Many plans are badly under funded, jeopardizing the pensions of millions of American workers, and the insurance system which protects those workers in the event that their own pension plans fail has a substantial deficit.
Administration Proposal: Pension Reform
The primary goal of any pension reform effort should be to ensure that retirees and workers receive the pension benefits they have earned. Clearly the current funding rules have failed to meet this goal. As part of its reform proposal the Administration has designed a new set of funding rules that we think will ensure that participants receive the benefits they have earned from their pension plans.
For any set of funding rules to function well, assets and liabilities must be measured accurately. The system of smoothing embodied in current law serves only to mask the true financial condition of pension plans. Under our proposal, assets will be marked to market. Liabilities will be measured using a current spot yield curve that takes account of the timing of future benefit payments summed across all plan participants. Discounting future benefit cash flows using the rates from the spot yield curve is the most accurate way to measure a plan's liability. Liabilities computed using the yield curve match the timing of obligations with discount rates of appropriate maturities. Proper matching of discount rates and obligations is the most accurate way to measure today's cost of meeting pension obligations.
The Administration recognizes that the current minimum funding rules have contributed to funding volatility. Particular problem areas are the deficit reduction contribution mechanism and the limits on tax deductibility of contributions. Our proposal is designed to remedy these issues by giving plans the tools needed to smooth contributions over the business cycle. These tools include:
- Increasing the deductible contribution limit will give plan sponsors additional ability to fund during good times.
- Increasing the amortization period for funding deficits to seven years compared to a period as short as four years under current law, and
- The freedom plans already have to choose prudent pension fund investments. Plan sponsors may choose to limit volatility by choosing an asset allocation strategy or conservative funding level so that financial market changes will not result in large increases in minimum contributions.
These are appropriate methods for dealing with risk; it is inappropriate to limit contribution volatility by transferring risk to plan participants and the PBGC.
Under our proposal, plan funding targets for healthy plan sponsors will be established at a level that reflects the full value of benefits earned to date under the assumption than plan participant behavior remains largely consistent with the past history of an on-going concern. Plans sponsored by firms with below investment grade credit will be required to fund to a higher standard that reflects the increased risk that these plans will terminate. Pension plans sponsored by firms with poor credit ratings pose the greatest risk of default. It is only natural that pension plans with sponsors that fall into this readily observable high risk category should have more stringent funding standards. Credit ratings are used throughout the economy and in many government regulations to measure the risk that a firm will default on its financial obligations. A prudent system of pension regulation and insurance would be lacking if it did not use this information.
Credit balances are created when a plan makes a contribution that is greater than the required minimum. Under current law, a credit balance, plus an assumed rate of return, can be used to offset future contributions. We see two problems with this system. First, the assets that underlie credit balances may lose rather than gain value. Second, and far more important, credit balances allow plans that are seriously under funded to take funding holidays. In our view every under funded plan should make minimum annual contributions.
Under our proposal, contributions in excess of the minimum still reduce future minimum contributions. The value of these contributions is added to the plan's assets and, all other things equal, reduces the amount of time that the sponsor must make minimum contributions to the plan. In combination with the rest of the proposal, there is more than adequate incentive for plan sponsors to fund above the minimum. In fact here are four other reasons that employers might choose to contribute more than the minimum: (1) The increased deductibility provisions allow sponsors to accumulate on a pre-tax basis; (2) Disclosure of funded status to workers will encourage better funding; (3) A better funded status results in lower PBGC premiums, and (4) A better funded status make benefit restrictions less likely.
The current rules often fail to ensure adequate plan funding – recent history has made this obvious. Formally we might say that the current set of rules has created a partially pay-as-you-go private pension system by allowing some accrued liabilities to be unfunded. That is, in general, when plans are not fully funded, the system basically operates by transferring contributions associated with younger workers to the current retired workers.
The funding rules proposed by the Administration, whereby sponsors that fall below the accurately measured minimum funding levels are required to fund up towards their target in a timely manner, move the system in the direction of being fully-funded. In a fully-funded system the contributions associated with each generation of workers are invested and fund their own retirements. A basic result in macroeconomics is that a pay-as-you-go system results in less saving, a slower rate of capital accumulation, and a lower steady state capital stock. Therefore the Administration's proposal – through the move towards more fully funded private defined benefit pensions – is consistent with the Administration goal of increasing saving and greater capital accumulation.
Our lump-sum proposal would replace the use of 30-year Treasury rates for purposes of determining lump sum settlements under qualified plans with a yield curve approach. Current law use of the 30-year treasury rate to determine the minimum lump sum amount often inflates the lump sums in comparison with the value of the annuity that the employee would otherwise receive. Under our proposal, lump sum settlements would be calculated using the same interest rates that are used in discounting pension liabilities: interest rates that are drawn from a zero-coupon corporate bond yield curve based on the interest rates for high quality corporate bonds. This reform will include a transition period, so that employees who are expecting to retire in the near future are not subject to an abrupt change in the amount of their lump sums as a result of changes in law. The new basis would not apply to distributions in 2005 and 2006 and would be phased in for distributions in 2007 and 2008, with full implementation beginning only in 2009.
We also want to make improvements to defined contribution retirement plans. Congress successfully passed two proposals originally set forth in the President's Retirement Security Plan with the enactment of the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act (1) guarantees that workers will now receive notice 30 days prior to a pension plan blackout period and (2) prohibits corporate officers from selling their own company stock during blackout periods.
The other components of the President's reform plan are to:
Improve choice by allowing participants to diversify their investments by selling their company stock after three years. The use of employer stock allows companies to be more generous with their matching contributions. Workers, however, should also have the right to choose how they want to invest their retirement savings. The President's plan would ensure that workers could sell company stock and diversify into other investment options after three years of participation in the plan.
Enhance information by requiring quarterly benefit statements to be sent to participants. A meaningful ability to change investments also depends on workers receiving timely information about their 401(k) accounts. The President's plan would require companies to provide workers with quarterly benefit statements with information about their accounts including the value of their assets, their rights to diversify, and the importance of maintaining a diversified portfolio.
Increase confidence by providing participants with increased access to professional investment advice. Current ERISA law raises barriers against employers and investment firms providing individual investment advice to workers. The President's plan would increase workers' access to professional investment advice. By relying on expert advisers who assume full fiduciary responsibility for their counsel and disclose relationships and fees associated with investment alternatives, American workers will have the information to make better retirement decisions.
Conclusion
Defined benefit plans are a vital source of retirement income for millions of Americans. The Administration is committed to ensuring that these plans remain a viable retirement option for those firms that wish to offer them to their employees. The long run viability of the system, however, depends on ensuring that it is financially sound. The Administration's proposal is designed to put the system on secure financial footing in order to safeguard the benefits that plan participants have earned and will earn in the future. We are committed to working with Congress to ensure that effective defined benefit pension reforms that protect worker's pensions are enacted into law.
It has been my pleasure to provide this discussion of this administration's proposal to permanently address Social Security's solvency; encourage national savings; and protect workers' pensions.
- 30 -