Younger workers' retirement security would be greatly improved by President George W. Bush's plan to allow them to establish Social Security Personal Retirement Accounts (PRAs). At the same time, workers who are 55 and older, including today's retirees, would receive every cent that they have been promised, including annual cost-of-living increases. Overall, the President has put forward a bold and responsible proposal that would permanently save Social Security and make the program a better deal for all Americans.  

The Bush PRA plan would be voluntary. PRAs would be part of the existing Social Security system and would help to finance the retirement benefits for younger workers. These workers would receive a retirement benefit that is paid in part by the existing Social Security system and in part from the money in their PRAs. The level of their retirement benefits would not be determined solely by the amounts in their PRAs. Instead, a benefit formula similar to the one used today would establish a retirement benefit based on their earnings history. The PRA could increase this amount, but the base benefit would not drop below a certain level determined. Anyone who does not wish to have a PRA could remain in the existing system and receive whatever retirement benefit Social Security is able to pay at the time that they retire.

One aspect of reform that the President discussed in general terms is a method to bring the retirement benefits promised to younger workers closer to what the system will be able to pay. Admirably, the President made clear that such a fix must be a part of reform. This could be accomplished in many ways, ranging from changing the way that past earnings are indexed to subtle shifts in the benefit formula itself. Since these are controversial changes, it is not surprising that the Bush administration wants Congress to develop a method that it is comfortable passing. Still, the President will have to exercise strong leadership to ensure that it is not left out of the final legislation. Failure to change the growth of future benefits would undermine Social Security's financial future, even with the establishment of PRAs.

How the Bush Plan Would Work

Current retirees and workers age 55 and older. Workers and retirees born before 1950 would not be affected at all. They would stay in the current system and receive 100 percent of the benefits that they have been promised under today's system, including annual cost-of-living adjustments.

Workers born between 1950 and 1965. In the first year of the plan's existence, workers born between these years would be allowed to establish a PRA if they so wished. They would not be required to do so.

Workers born between 1965 and 1978.In the second year that PRAs are available, workers born in these years would be able to establish a PRA. Any workers born between 1950 and 1965 who have not already established a PRA would also be able to open one.

Workers born after 1978.In the third year that PRAs are offered, workers born after 1978 and any workers born after 1950 who have not already established a PRA would be able to open one.

PRA contributions. In the first year, workers would be able to invest 4 percent of their wages in their PRA. That year, the maximum amount that could go into the account would be $1,000. This means that anyone making $25,000 a year or less could invest the full 4 percent, while workers earning more than that would invest a smaller percentage.

Starting in the second year, the $1,000 maximum investment would climb by $100 a year until it reaches a point when all workers could invest the full 4 percent. This phase-in allows lower income workers who are less likely to have significant retirement savings to make the full investment first. At $100 a year, it would take 18 years before workers earning today's maximum taxable income of $90,000 a year to be able to save the full 4 percent of income.

Investment structure.PRAs would be invested through a government-managed central management structure similar to the Thrift Savings Plan that is available today to government employees. The actual investments would be handled by a professional funds manager that would be chosen in a bidding process. This simple structure provides the necessary infrastructure at the lowest possible cost to the individual. The Bush Administration estimates that workers would pay fees equal to only about 0.3 percent of the money in their account annually. Most of those fees would go the government agency managing the accounts. Only a small proportion would go to the funds manager.

Investments. Workers would be limited to a few basic and diversified investment choices. The default portfolio would likely consist of up of 50 percent stock index funds, 30 percent corporate bond index funds, and 20 percent government bonds. On average, this mixture would pay about 4.6 percent after inflation annually, even after subtracting administrative fees.

Lifespan fund. Workers would be able to invest in a lifespan fund. This is an investment program that automatically rebalances a workers account as he ages. Younger workers who are far from retirement would have most of their money invested in stock index funds. As they get older, their investments would gradually and automatically shift into bonds and other  less volatile investments. This means that if the stock market went down just before their retirement, workers who invested in a lifespan fund would not see a significant change in their PRA, as they would have only a small amount invested in stocks at that time. Lifespan funds have been gaining popularity in employer sponsored retirement plans, such as 401(k)s, because they automatically make the kind of portfolio adjustments that investment professionals recommend for all workers nearing retirement.

At retirement. Retirees with a PRA would receive benefits that are partly paid by the government and partly paid from the PRA. First, the amount of monthly benefit would be determined with a formula similar to the one used by Social Security today. Then, the proportion of that monthly benefit to be paid by the government would be determined. Social Security would calculate how large the PRA would have been if it had only earned 3 percent annually after inflation (the average amount earned by government bonds) and, using an annuity calculator, convert that hypothetical lump sum into a monthly payment. That hypothetical monthly payment would be subtracted from the retirement benefit, and the government would pay the rest.

For example, if the Social Security benefit formula determined that a worker should receive $1,200 a month and the hypothetical calculation showed that the PRA could pay $400 a month, then the government would pay $800. When the $800 is added to the $400 from the PRA, the $1,200 monthly benefit is reached. But if the PRA actually earned more than 3 percent annually after inflation, then the worker would either have money left over for a nest egg or could choose to take a higher retirement benefit.

Annuities or phased withdrawals. Workers would be required to either annuitize enough of their PRA to produce a total monthly benefit that is at least at the poverty level or to leave enough in their PRA to pay a poverty-level benefit. Workers could annuitize more if they wished and thus receive a higher monthly benefit. This feature guarantees that workers would have at least a basic level of income no matter what happens. The ability to choose whether to annuitize or to leave money in the PRA increases the ability of workers of all income levels to build a nest egg.

Nest eggs. The Bush plan would give most workers the opportunity to build a nest egg that could be used for emergencies or left to their families. Unused amounts in the PRA are fully inheritable. This means that if a worker died before reaching retirement age, his or her PRA would remain in the family.

What Will It Cost?

The Bush Administration estimates that its PRA plan would require an additional $664 billion over the next 10 years. This represents the total amount of money that would go into PRAs during that time. Assuming that this amount is borrowed, the total cost over 10 years would be $754 billion when interest is included.

However, this only covers the cost of establishing the accounts. It does not bring the system into long-term balance. That can be accomplished only by bringing the promised level of benefits closer to what the system can afford to pay. Until Congress decides how to accomplish this reduction in benefit growth, it will be impossible to determine the total amount of general revenue needed to permanently preserve Social Security. However, SSA scoring of comparable PRA plans show that the total cost over the first 75 years is about 40 percent less than the cost of the current system.

In terms of long-term balance, everything is on the table, said the President, with one exception: raising the payroll tax. This is sensible. Raising the payroll tax would damage the economy and make Social Security an even worse deal for workers than it already is. And by itself, raising the tax would only push Social Security's looming insolvency into the future, rather than solving the problem permanently. Altogether, then, the President's proposal provides Congress with needed flexibility while setting appropriate limits.  

How to reduce benefit growth. Under the current system's benefit formula, workers who retire this year will receive benefits that, on average, are about 5 percent to 7 percent higher (after inflation) than workers with identical work histories who retired five years ago. These increases must be reduced to save Social Security.

This growth in benefits could be reduced using one or more of several methods. These range from switching the indexation of past earnings when a worker's retirement benefit is calculated from growth in real wages to growth in inflation. Alternatives to this method might include using an index that is halfway between the two measures or applying the indexing change to only part of the benefit formula. In all, there are many ways to slow the growth of benefits, and the method chosen will determine the total amount of additional revenue needed to save Social Security.

Conclusion

The Bush plan offers younger workers an opportunity for the same retirement security that their parents and grandparents have enjoyed. It is far superior to the alternative, which is some combination of massive tax increases and sharp benefit cuts.

It is a sign of the President's seriousness and the responsibility of his proposal that he discussed directly the need to bring future retirement benefits into line with what the system can afford to pay. Any PRA plan that ignores this necessary step will fall short of the President's goal of permanently fixing Social Security.

David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.