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The 6.2 Percent Solution: A Plan for Reforming Social Security, Cato Social Security Choice Paper No. 32

The 6.2 Percent Solution: A Plan for Reforming Social Security, Cato Social Security Choice Paper No. 32

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Published by Cato Institute
Executive Summary

For the past several years there has been a

growing consensus about the need to reform

Social Security. Now, however, the debate has

advanced to the point where it becomes important

to move beyond generalities and provide specific

proposals for transforming Social Security to a

system of individual accounts. The Cato Project

on Social Security Choice, therefore, has developed

a proposal to give workers ownership of and

control over their retirement funds.



Under this proposal:



Individuals would be allowed to divert their

half (6.2 percentage points) of the payroll

tax to individually owned, privately invested

accounts. Those who chose to do so

would agree to forgo all future accrual of

retirement benefits under the traditional

Social Security system.

The remaining 6.2 percentage points of

payroll taxes would be used to pay transition

costs and to fund disability and survivors'

benefits.

Workers who chose the individual account

option would receive a "recognition bond" based on the accrued value of their lifetime-to-date benefits. Those bonds, redeemable at

the worker's retirement, would be fully tradable

in secondary markets.

Those who wished to remain in the traditional

Social Security system would be free

to do so, accepting a level of benefits

payable with the current level of revenue.



We expect this plan to restore Social Security

to long-term and sustainable solvency and to do

so at a cost that is less than the cost of simply

propping up the existing program. And it would

do far more than that.

Younger workers who chose the individual

account option would receive benefits substantially

higher than those that could be paid under

traditional Social Security. At the same time,

the plan would treat women and minorities

more fairly and allow low-income workers to

accumulate real wealth.

Most important, this proposal would reduce

Americans' reliance on government and give

individuals greater ownership of wealth, as well

as responsibility for and control over their own

lives. It would be a profound and significant

increase in individual liberty.
Executive Summary

For the past several years there has been a

growing consensus about the need to reform

Social Security. Now, however, the debate has

advanced to the point where it becomes important

to move beyond generalities and provide specific

proposals for transforming Social Security to a

system of individual accounts. The Cato Project

on Social Security Choice, therefore, has developed

a proposal to give workers ownership of and

control over their retirement funds.



Under this proposal:



Individuals would be allowed to divert their

half (6.2 percentage points) of the payroll

tax to individually owned, privately invested

accounts. Those who chose to do so

would agree to forgo all future accrual of

retirement benefits under the traditional

Social Security system.

The remaining 6.2 percentage points of

payroll taxes would be used to pay transition

costs and to fund disability and survivors'

benefits.

Workers who chose the individual account

option would receive a "recognition bond" based on the accrued value of their lifetime-to-date benefits. Those bonds, redeemable at

the worker's retirement, would be fully tradable

in secondary markets.

Those who wished to remain in the traditional

Social Security system would be free

to do so, accepting a level of benefits

payable with the current level of revenue.



We expect this plan to restore Social Security

to long-term and sustainable solvency and to do

so at a cost that is less than the cost of simply

propping up the existing program. And it would

do far more than that.

Younger workers who chose the individual

account option would receive benefits substantially

higher than those that could be paid under

traditional Social Security. At the same time,

the plan would treat women and minorities

more fairly and allow low-income workers to

accumulate real wealth.

Most important, this proposal would reduce

Americans' reliance on government and give

individuals greater ownership of wealth, as well

as responsibility for and control over their own

lives. It would be a profound and significant

increase in individual liberty.

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Published by: Cato Institute on Mar 26, 2009
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Executive Summary
For the past several years there has been agrowing consensus about the need to reformSocial Security. Now, however, the debate hasadvanced to the point where it becomes importantto move beyond generalities and provide specificproposals for transforming Social Security to asystem of individual accounts. The Cato Projecton Social Security Choice, therefore, has devel-oped a proposal to give workers ownership of andcontrol over their retirement funds.Under this proposal:
Individuals would be allowed to divert theirhalf (6.2 percentage points) of the payrolltax to individually owned, privately invest-ed accounts. Those who chose to do sowould agree to forgo all future accrual of retirement benefits under the traditionalSocial Security system.
The remaining 6.2 percentage points of payroll taxes would be used to pay transi-tion costs and to fund disability and sur-vivors’benefits.
Workers who chose the individual accountoption would receive a “recognition bond”based on the accrued value of their lifetime-to-date benefits. Those bonds, redeemable atthe worker’s retirement, would be fully trad-able in secondary markets.
Those who wished to remain in the tradi-tional Social Security system would be freeto do so, accepting a level of benefitspayable with the current level of revenue.We expect this plan to restore Social Securityto long-term and sustainable solvency and to doso at a cost that is less than the cost of simplypropping up the existing program. And it woulddo far more than that.Younger workers who chose the individualaccount option would receive benefits substan-tially higher than those that could be paid undertraditional Social Security. At the same time,the plan would treat women and minoritiesmore fairly and allow low-income workers toaccumulate real wealth.Most important, this proposal would reduceAmericans' reliance on government and giveindividuals greater ownership of wealth, as wellas responsibility for and control over their ownlives. It would be a profound and significantincrease in individual liberty.
February 17, 2004SSPNo. 32
The 6.2 Percent Solution
 A Plan for Reforming Social Security
by Michael Tanner 
 Michael Tanner is director of the Cato Institute's Project on Social Security Choice and editor of 
SocialSecurity and Its Discontents: Perspectives on Choice
(forthcoming).
 
Introduction
For the past several years there has been agrowing consensus about the need to reformSocial Security. As the debate has developed,the Cato Institute has provided studies andother information on the problems facingSocial Security and the advantages of individ-ual accounts as a way to reform the system. Butuntil now we have not suggested a specific planfor reform.Now, however, the debate has advanced tothe point where it becomes important to movebeyond generalities and provide specific pro-posals for transforming Social Security to asystem of individual accounts. The Cato Projecton Social Security Choice, therefore, has devel-oped a proposal to give workers ownership of and control over their retirement funds.This plan would establish voluntary person-al accounts for workers born on or after January1, 1950. Workers would have the option of (a)depositing their half of the current payroll tax(6.2 percentage points) in an individual accountand forgoing future accrual of Social Securityretirement benefits or (b) remaining in the tra-ditional Social Security system and receivingthe level of retirement benefits payable on asustainable basis given current revenue andexpenditure projections.Workers choosing the individual accountoption would have a variety of investmentoptions, with the number of options increasing asthe size of their accounts increased. The initialdefault option would be a balanced fund, weight-ed 60 percent stocks and 40 percent bonds.Workers choosing the individual account optionwould also receive bonds recognizing their pastcontributions to Social Security.At retirement, workers would be able tochoose an annuity, a programmed withdrawaloption, or the combination of an annuity and alump-sum payment. The government wouldmaintain a safety net to insure that no seniorwould retire with income less than 120 percentof the poverty level.We expect this proposal to restore SocialSecurity to long-term and sustainable solvencyand to do so at a cost less than the cost of sim-ply continuing the existing program. And itwould do far more than that.Workers who chose the individual accountoption could accumulate retirement resourcessubstantially greater than those that are current-ly payable under traditional Social Security.They would own and control those assets. Atthe same time, women and minorities would betreated fairly, and low-income workers couldaccumulate real wealth.Most important, this proposal would reduceAmericans’reliance on government and giveindividuals greater responsibility for and con-trol over their own lives. It would provide aprofound and significant increase in individualliberty.
The Social Security Crisis
Social Security as we know it is facing irre-sistible demographic and fiscal pressures thatthreaten the future retirement benefits of today’syoung workers. Although Social Security is cur-rently running a surplus, according to the sys-tem’s own trustees, that surplus will turn into adeficit within the next 15 years.
1
That is, by 2018Social Security will be paying out more in bene-fits than it takes in through taxes (Figure 1).In theory, Social Security is supposed to con-tinue paying benefits after 2018 by drawing onthe Social Security Trust Fund. The trust fund issupposed to provide sufficient funds to contin-ue paying full benefits until 2042, after which itwill be exhausted. At that point, by law, SocialSecurity benefits will have to be cut by approx-imately 27 percent.
2
However, in reality, the Social Security TrustFund is not an asset that can be used to pay ben-efits. Any Social Security surpluses accumulat-ed to date have been spent, leaving a trust fundthat consists only of government bonds (IOUs)that will eventually have to be repaid by tax-payers. As the Clinton administration’s fiscalyear 2000 budget explained it:These [Trust Fund] balances are availableto finance future benefit payments andother Trust Fund expenditures—but onlyin a bookkeeping sense. . . .
They do not consist of real economic assets that can bedrawn down in the future to fund benefits
.Instead, they are claims on the Treasurythat, when redeemed, will have to befinanced by raising taxes, borrowing fromthe public, or reducing benefits or otherexpenditures. The existence of large Trust
We expect thisproposal torestore SocialSecurity to long-term andsustainablesolvency andto do so at acost less thanthe cost of simplycontinuing theexistingprogram.
2
 
As Bill Clintonpointed out,the only wayto keep SocialSecuritysolvent is toraise taxes, cutbenefits, orget a higherrate of returnthroughprivate capitalinvestment.
3Fund balances, therefore, does not by itself have any impact on the Government’s abil-ity to pay benefits.
3
Even if Congress can find a way to redeemthe bonds, the trust fund surplus will be com-pletely exhausted by 2042. At that point, SocialSecurity will have to rely solely on revenuefrom the payroll tax—but that revenue will notbe sufficient to pay all promised benefits.Overall, Social Security faces unfunded liabili-ties of nearly $26 trillion.
4
Clearly, SocialSecurity is not sustainable in its current form.There are few options for dealing with theproblem. That opinion is held by people whoare not supporters of individual accounts aswell as by those who are. As former presidentBill Clinton pointed out, the only way to keepSocial Security solvent is to (a) raise taxes, (b)cut benefits, or (c) get a higher rate of returnthrough private capital investment.
5
HenryAaron of the Brookings Institution, a leadingopponent of individual accounts, agrees.“Increased funding to raise pension reserves ispossible only with some combination of addi-tional tax revenues, reduced benefits, orincreased investment returns from investing inhigher yield assets,” he told Congress in 1999.
6
The tax increases or benefit cuts would have tobe quite large. To maintain benefits in the firstyear after Social Security starts running a deficit,the government must acquire revenues equiva-lent to $197 per worker. By 2042, the additionaltax burden increases to $1,976 per worker, and by2078 it reaches an astounding $4,193 per worker(in constant 2003 dollars).
7
And it continues torise thereafter. Functionally, that would translateinto either a huge increase in the payroll tax, fromthe current 12.4 percent to as much as 18.9 per-cent by 2077, or an equivalent increase in incomeor other taxes.
8
A Declining Rate of Return
Social Security taxes are already so high, rel-ative to benefits, that Social Security has quitesimply become a bad deal for younger workers,providing a low, below-market rate of return.As Figure 2 shows, that return has been steadi-ly declining and is expected to be less than 2percent for most of today’s workers.The poor rate of return means that manyyoung workers’retirement benefits will be farlower than if they were able to invest their pay-roll taxes privately.
9
On the other hand, a sys-tem of individual accounts, based on privatecapital investment, would provide most work-ers with significantly higher returns. Thosehigher returns would translate into higherretirement benefits, leading to a more secureretirement for millions of seniors.
-8-7-6-5-4-3-2-101232003200920152021202720332039204520512057206320692075
Figure 1Social Security’s Payroll Tax Surplus orDeficit
Source:
2003 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds
, table IV.B1.
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