April 25, 2006

Fixing Social Security

Progressive Personal Accounts — a new plan for reforming the U.S. public pension system — could satisfy Democrats and Republicans.


Fixing Social Security

Last year Americans spent a great deal of time debating Social Security reform. While both major political parties claim they are committed to improving this important program, neither side has yet put forward a politically acceptable solution. President Bush’s proposal to partially privatize the system attracted strong opposition from Democrats and only lukewarm support from Republicans. That plan would have allowed younger workers to divert some of their Social Security taxes into individual accounts invested in stocks and bonds.

“One of the things that Republicans value most about individual account proposals is the enhancement of property rights,” says Professor Stephen P. Zeldes. “You have a certain amount of money that’s yours, and the government can’t take it away. They also like the transparency of individual accounts and the market valuation of assets — the fact that you can see how much your assets are worth in the marketplace.”

But for many Democrats, the president’s proposal was too risky, especially from the perspective of lower-income workers. The features of the current system that Democrats value most are guaranteed benefits and redistribution — the fact that lower-income people get a higher payback for each dollar they pay into the system. “Democrats also like the fact that there’s some insurance across generations,” Zeldes says. “Benefits are tied to aggregate average wages, so if young workers are doing well, it improves the benefits of workers who are about to retire.”

Working under a grant from the Social Security Administration, Zeldes and Professor John Geanakoplos of Yale have come up with an individual accounts proposal that could please Democrats as well as Republicans. Their progressive personal accounts (PPA) proposal combines the core features that matter most to both parties.

The first step toward a politically feasible solution was using new language. “Even though the current system is usually couched in terms of defined benefits,” Zeldes says, “with some relabeling, it’s actually not that different from a personal accounts system.”

The next step was devising a system that offers property rights, market valuation and transparency while preserving the redistribution, risk-sharing and security aspects of Social Security that are important to Democrats.

Here’s how a PPA system would meet all of those requirements:

Property rights: The government issues a new type of financial security called a PAAW (personal annuitized average wage). It’s like a bond, but its payoff is tied to economy-wide average labor earnings. You accumulate PAAWs in a personal account, accruing so many units for each dollar you contribute in Social Security taxes.

Market valuation: The government requires you to sell a small percentage of your PAAWs. These assets get pooled and traded in financial markets, and their market price gives you an indicator of the current value of the benefits you will eventually receive.

Transparency: Your accrued benefits are clearly spelled out and measured in units of a security with a well-defined payoff.

Redistribution: The government matches your contributions — like a 401(k) — but the level of the match varies based on your total past contributions. So people with a low lifetime income get a higher match, while people with a high lifetime income get a lower match or, possibly, a tax.

Risk sharing: When you retire, each PAAW in your account pays a fraction of the average labor earnings in the economy in that year.

Security: The payouts on your PAAWs, which automatically rise to compensate for inflation, continue for as long as you live, thus providing considerable security in your old age. Because you are allowed to sell only a small fraction of your PAAWs, there is very little portfolio choice and thus limited opportunity to make costly mistakes.

Zeldes and Geanakoplos are currently refining their proposal so that the system becomes self-balancing, reducing the future need for Congress to tinker with the program rules. Because implementing a PPA system would require some intermediate steps, including the creation of a new security, the proposal does not offer an immediate solution. But based on the outcome of last year’s debate, a quick fix for Social Security is unlikely to emerge.

“We’re hoping,” says Zeldes, “ that this plan could be the best of both worlds.”

 

Stephen Zeldes is the Benjamin Rosen Professor of Finance and Economics at Columbia Business School.

Read the Research

John Geanakoplos, Stephen Zeldes

"Reforming Social Security with Progressive Personal Accounts"

View abstract/citation  Download PDF  

John Geanakoplos, Olivia Mitchell, Stephen Zeldes

"Social Security Money's Worth"

View abstract/citation  View Research  

John Geanakoplos, Olivia Mitchell, Stephen Zeldes

"Would a Privatized Social Security System Really Pay a Higher Rate of Return?"

View abstract/citation  Download PDF   View Research  

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