Simcivic Update #2:

Is President Bush on the Right Track?

Highlights

In this Simcivic Update, we use the Social Security Solvency Simulator to analyze President Bush's basic strategy for Social Security reform.

This is what we find.

Do-Nothing Strategy. A Do-Nothing Strategy results in a benefits crash once Baby Boomers have retired, with payable benefits declining to 67% of the current benefit schedule by the end of Social Security's long-range forecast.

This sets the first bar for President Bush's strategic approach. Can his strategy achieve solvency and deliver benefits higher than 67%?

Pay As You Go Solvency. A planned reduction in benefits, beginning in 2010, ending in 2040, achieves lasting solvency a little more easily, with long-range benefits stabilized at 74% of the current-law benefit schedule. This sets the second bar for President Bush's strategy.

Bush's PRA Strategy. As we learn from using the Simulator, President Bush's strategic approach reaches the first bar but falls short of the second. Assume a base Social Security tax rate of 10.4%, and a PRA tax rate of 2.0%. A PRA plan based on President Bush's principles delivers long-term solvency only if the long-range benefit schedule is trimmed to 57% of its current level. PRA's can be expected to deliver an additional 14%, on average, for an expected total benefit level of 71%.

A better result than Do-Nothing's 67%. Not as good as Pay-As-You-Go's planned 74%.

Simcivic Update #2 walks you through the analysis, with images from the Simulator that show in graphic form exactly how the Inputs are entered and what the Results look like. If you like, you can repeat the analysis yourself, by visiting our Social Security Solvency Simulator on-line. We suggest starting at www.sscommonsense.org/SimIntro.html, though you may prefer to go directly to the Solvency Simulator.

Introduction

President Bush has made Social Security reform one of the key priorities of his Administration. While the details of President Bush's reform proposal have yet to be spelled out, its broad outlines are clear. He recognizes the financial challenge facing Social Security once the massive Baby Boomer generation retires. He opposes any increase in the payroll tax. He wants to assure long-range solvency. And he believes Personal Retirement Accounts, PRA's, can cure Social Security's long-range financial woes.

Is the President on the right track? If you're looking for dependable answers, our Social Security Solvency Simulator can be of help. It's neutral, it's bipartisan, and it reflects the view that facts are more important than ideology. Let us show you...

. . . if Nothing Is Done

First, in order to have a baseline, we need to ask what happens if nothing at all is done. If we use Social Security's Intermediate forecast - as we must, in order to have a common touchstone for measuring all the options - we can see the difficulty facing Social Security. Long-range payable benefits collapse to 67% of currently scheduled benefits.

[All calculations have been performed on Simcivic's Social Security Solvency Simulator, available online at www.simcivic.org/SSSS.html. All images in Simcivic Update #2 are excerpted from the Simulator.]

This worrisome forecast sets the initial bar for President Bush's strategy. Can the Bush option prevent long-range benefits from dipping as low as 67% of their currently scheduled levels?

If Lasting Solvency Is Assured Through Benefit Cuts

Second, we should also ask what would happen if benefits were cut, on a planned basis, in order to assure long-range solvency. Call this option "Pay As You Go Solvency."

Turn to the simulator's Scenarios Page. Click Scenario D, "Solve for Benefit Reductions."

Click Selection OK. Click "Run The Numbers." The simulator calculates a long-range benefit level that's just low enough to assure lasting solvency.

Lasting solvency can be achieved with a long-run benefit level equal to 74% of currently-scheduled benefits.

[Raise the benefit level to 75%, and lasting solvency slips away. Lower it to 73%, and Social Security's Trust Fund accumulates assets faster than it needs to.]

With a long-run benefit level of 74% on 2D, you will also see a stable Funds-to-Benefits Ratio in Chart 1B.

The Funds-to-Benefits Ratio has stabilized, in the out-years, at a ratio of about 7:1. (Note the level blue line, circled in red.) With a stable Funds-to-Benefits Ratio, Social Security's cash flow from payroll tax receipts, benefit tax receipts, and Trust Fund earnings is sufficient to pay benefits in perpetuity - at the new, seventy-four percent level.

This, then, represents the second bar that President Bush's plan has to reach. Can the Bush strategy reach the 74% bar? And deliver lasting solvency at the same time?

Step 1 - Lower the Social Security Tax to 10.4%

It's best to take this analysis one step at a time. First we lower the Social Security tax rate from 12.4% (6.2% for employees, a matching 6.2% from employers) to 10.4%. We'll deal with PRA's a little later.

For now, turn to the Simulator's Taxes page, erase the 12.4% tax rate for Social Security, and type in 10.4%. Hit "Settings OK."

Note that the PRA Tax Rate box remains unchecked. The total tax rate from 2003 onward is now set to 10.4%. With Scenario D still selected, the Simulator will find the benefit level that delivers lasting solvency right on the nose.

Click on "Run the Numbers." Chart 2D shows the results.

If benefits are trimmed to 58% of the current benefit schedule, lasting solvency can be achieved with a combined employer-employee payroll tax of 10.4%.
By the way, this is precisely the approach taken by Republican Jim Kolbe of Arizona and Democrat Charles Stenholm of Texas in their proposal for long-term solvency. The Kolbe-Stenholm Plan trims the tax rate to 10.4%, trims the benefit schedule by more than 40%, and then layers on a 2% tax to fund PRA's.

Chart 1B Shows Lasting Solvency

Turn now to Chart 1B to see what happens to the Funds to Benefits Ratio in this scenario.

Again you can see (as emphasized by the red circle we've added) the Fund to Benefit Ratio leveling off at the end of the forecasting period. The Ratio isn't going down - a sign of eventual insolvency. Nor is it rising appreciably - a sign either that benefits are too low or taxes too high. The Fund-to-Benefit Ratio has leveled off, just as the goal of lasting solvency requires.

Cutting the Benefit Schedule - What That Really Means

By the way, a 42% cut in the benefit schedule isn't synonymous with a 42% cut in current benefits.

Why not? Today's Social Security law calls for new retiree benefit levels to rise, slowly but steadily, so that benefits received can more or less keep pace with rising wages. If real wages double between now and 2050, Social Security benefits at retirement should double as well (in 2002 dollars).

If a typical retiree draws Social Security benefits equal to 35% of his or her pre-retirement salary today, then, by current law, a similar retiree in 2050 will also draw Social Security benefits equaling 35% of pre-retirement salary.

Imagine an individual who, after earning $30,000 last year, retires this year with an annual Social Security benefit of $10,500.

Fifty years from now, that same individual might earn $60,000 (in today's dollars) just before retirement, then receive Social Security benefits equaling $21,000 a year.

A 42% cut in the current benefit schedule means that Social Security would pay a benefit that's 42% smaller. Instead of $21,000, the 2050 retiree would receive $12,180.

How should this be interpreted? Is it a "cut"? Or a "reduced increase"? Or both?

Some will look at these numbers and point out that retiree benefits have actually risen - in real terms - from $10,500 a year to $12,180. In looking at the real dollar growth from $10,500 to $12,180, they'll call this "an affordable growth in benefits."

Others will look at the drop from $21,000 to $12,180 and call this a "benefit cut."

Is the glass filling slowly? Or much emptier than it's supposed to be? For our part, we try to remain technically correct by phrasing the change as "a 42% reduction in the current benefit schedule."

Step 2 - Add the PRA Layer to the Bush Strategy

Now it's time to add some financing for President Bush's PRA strategy. Turn again to the Taxes page.

Click first on the Federal Subsidy box, so that ongoing federal subsidies to Social Security are allowed, if needed. As you'll see in future issues of Simcivic Updates, allowing the Simulator to add a small subsidy will vastly improve apples-to-apples comparability.

Then click on the PRA Tax Rate box, so that it's checked, and type in a 2.0% tax rate for PRA's.

The excerpted image from the Simulator shows you what this looks like. The Ongoing Federal Subsidy box is checked. The PRA Tax Rate box is checked. A tax rate of 2.0% has been filled in for PRA's. The Simulator adds the two rates together, and shows a Total Tax Rate of 12.4% - the same as today - from 2003 onward.

The essence of President Bush's strategy has now been entered in the Simulator. A total tax rate of 12.4%, just like today. A PRA tax of 2%. And a commitment to long-range solvency.

Keep Scenario D checked. Now click "Settings OK," then click "Run the Numbers." The Simulator again searches for and delivers a benefit level that puts the Funds-to-Benefits Ratio (Chart 1B) on an even keel in the 2070's.

This time, you can see the PRA funds layered in on top of Social Security's basic benefit level.

The darker blue line reflects the benefits to be paid by Social Security. The light greenish line reflects the annuity payments to be expected from PRA's. The 71% figure reflects the base total of 57% plus an additional 14% from PRA's.

You may have noticed a slight drop in the base benefit level for Social Security, from 58% to 57%. Why? Because - at 58% - the top line in Chart 1B's Funds-to-Benefits Ratio hadn't quite leveled out yet. The Simulator dropped the benefit level another percentage point, and, finally, both lines leveled out. As soon as the lasting solvency test is met, the Simulator stops and reports its results.

Chart 1B shows the critical results.

Again, the critical ratios have leveled out, signaling lasting solvency. And again, we've drawn red circles around the end sections of the ratio lines.


Caveat One - A More Realistic Rate of Return for Stocks

The Bush Social Security Commission used a real return estimate for PRA stock investments of 6.5%. We disagree with that estimate, for reasons we've spelled out very carefully in the article "Are Seven Percent Returns Realistic?" The Simulator's default setting is 5.0%, and all our calculations use the 5% rate. (If anything, we worry that long-run stock index fund returns won't even hit 5%.)

Does it matter? Not a great deal, actually. Change the Simulator's stock return setting (on the Assumptions page) from 5% to 6.5% and rerun the numbers. You'll see the total benefit line shift upward, from 71% to 73%. Still not enough.

Caveat Two - No Coordination of Benefits

While we don't follow the Bush Commission's lead on future stock market returns, because it would produce misleading results if we did, we do follow the Commission's lead on another important point - the issue of whether or not Social Security benefit payments should be coordinated with PRA annuity payments. The Commission says No. And that's the default setting the Simulator uses - No coordination of benefits.

You can test this for yourself, if you like, by turning to the Simulator's Funding page. (Its coordination option is shown in the following image.)

If you agree with the Commission, leave the box unchecked. If you'd like to test coordinated benefits, check the box, then select a coordination percentage - 100%, 90%, 75%, or 50%. (The Simulator defaults to 90% when you select Coordination, but you can change that.)

Many PRA supporters recommend coordinating the two benefit streams. For every dollar in PRA annuity payments received, economist Martin Feldstein would reduce the Social Security benefit by seventy-five cents.

The Archer-Shaw plan, proposed in the previous Congress, goes even further. For every dollar in PRA annuity payments received, the Archer-Shaw plan would reduce that retiree's Social Security benefits by a full dollar.

Opponents of coordinated benefits refer to this derisively as a "Clawback." Supporters point out the equity advantage. Those who belong to age groups unlucky enough to hit retirement age just as the stock market bottoms out will find themselves better off in a coordinated benefits regime. They'll receive more of their scheduled Social Security benefits, to compensate for the anemic PRA annuity payments they're getting.

Recall the chart above? That shows a 57% base benefit level? And a combined 71% benefit level? It should be noted that 71% is merely an average. Those who retire during stock market peaks may hit 74% or better. Those who retire during troughs may be lucky to reach 68%. If annuity payments and Social Security benefit payments are not coordinated, the annuity payment variations among different age groups will be quite noticeable.

Caveat Three - Inheritance Leakage

In cases where PRA owners die before retirement, there's an inheritance issue to be considered. To the Bush Commission, though, it matters not who might inherit the money or how they might use it. So what if as much as 100% of PRA inheritance cash leaks away from the Social Security retirement system? No problem.

In selecting a default setting for the Solvency Simulator, we chose to match the Bush Commission's position. The Simulator's default setting assumes that 100% of all PRA inheritance dollars will leak out of the retirement system.

The impact is rather severe. You may wish to check it for yourself. Replace the 100% leak rate with a 10% rate. Change the Spouse rate from 0% to something more reasonable; we recommend 65%. Change the Children's rate from 0% to 20%. Change the Grandkids' rate to 5%.

[NOTE: The four rates combined must sum to 100% for the Simulator to accept them.]

Now rerun the Bush scenario. You'll find PRA's looking somewhat more attractive if the inheritance leak is plugged. Now set the inheritance leak rate back to 100%. Rerun the numbers. See the difference? More than a sixth of all working people die before reaching retirement age. Draining their accumulated PRA funds out of the retirement system substantially weakens the potential value of any PRA system.


Summary

We began by asking if President Bush's strategy is likely to put Social Security on the right track. Here's what we learned by testing his strategy on the Solvency Simulator.

The Crash Scenario. If nothing is done, Social Security's financial structure crashes of its own accord once the Baby Boomers retire, with funds available to pay only 67% of currently scheduled benefits as the forecasting period ends.

The Pay As You Go Solvency Scenario. If benefits are reduced on a planned basis to 74% of their currently scheduled level, Social Security's lasting solvency can be achieved.

The Bush PRA Scenario. If President Bush implements a PRA plan that meets his central tenets, he'll end up creating a base system that pays 57% of currently scheduled benefits, topped by an "every retiree for himself" program that delivers annuity payments averaging 14% of currently scheduled benefits.

Does the scenario we've painted for President Bush exactly match the Bush Commission recommendations? No. The Bush Commission wasn't willing to trim benefits by enough to assure lasting solvency. Asked to show how solvency could be achieved, the Commission backed away from its central assignment.

We've taken the Bush parameters, we've taken the central assignment seriously, and we've shown what it takes for the Bush strategy to put Social Security onto a path that leads to lasting solvency. As we've seen, the numbers tell an interesting story. A Bush-style PRA option isn't as potent as it's claimed to be.

Steven H. Johnson
President, Simcivic.org

If this represents the type of solution that he favors, is Congressman Matsui on the right track?

Is Professor Modigliani on the right track?

• BET's Robert Johnson (also a Bush Commission member) thinks PRA's can help poor families build wealth.

Is Robert Johnson's wealth-building strategy on the right track?

Is Dean Baker on the right track?

Is the Cato Institute on the right track?

Is Gary Burtless on the right track?