Edward M. Gramlich

English

Research Papers in Economics

FEDERAL  RESERVE  BANK  OF  ST. LOUIS
7
MARCH/APRIL  1998
Mending But
Not Ending
Social Security:
The Individual
Accounts Plan
Edward M. Gramlich
T
he U.S. Social Security System, ﬁrst
formed back in the 1930s, is a govern-
ment-deﬁned beneﬁt pension program
ﬁnanced by worker payroll taxes.  As work-
ers pay in their payroll taxes, they accumu-
late beneﬁt credits.  At any point in time,
one can make some economic and demo-
graphic assumptions, project forward tax
inﬂows and beneﬁt outﬂows, and determine
the long-run actuarial soundness of the sys-
tem, or really the long-term consistency of
the present set of tax and beneﬁt schedules.
Every year such forecasts are made by
the Social Security and Medicare Trustees—
three cabinet ofﬁcers, the Commissioner of
Social Security, and two outside members.
Although earlier Social Security legislation
mandated that quadrennial outside advisory
councils be appointed to review these fore-
casts and to comment on relevant policy
issues, the last such council to examine the
retirement system was the famous Greenspan
Commission in 1983.  But a new advisory
council was formed in 1994, and I was
asked to chair it.  It included three mem-
bers from business, three from unions, 
and various others from the private pen-
sion industry, the self-employment sector,
independent representatives, and so forth,
making 13 members in all.  We met monthly
from mid-1994 to mid-1996, commissioned
a number of special studies, appointed two
technical panels that made reports, and in
January 1997 issued our own report.  In
this paper I discuss this report and the
policy proposal I put forward for dealing
with Social Security.
THE 1995 TRUSTEES’
REPORT
Our main point of departure was the
1995 Trustees’ Report.  As has been widely
reported in the press, the intermediate
assumptions of this report were that the
combined assets of the Old-Age, Survivors,
and Disability (OASDI) Trust Funds would
go below the safety level (a year’s worth of
beneﬁts) in 2030, and that the assets of the
Medicare Hospitalization Insurance (HI)
Trust Fund (a separate entity that we are not
examining here) would go below the safety
level in 2002—a far more urgent situation.
But since the conventional wisdom up to
that point had been that these trust funds
should be actuarially sound for 75 years, 
the fact that the OASDI trust fund assets
were projected to go below the safety level 
as soon as 2030 was alarming enough.  
With both trust funds, the underlying 
demographics of the country are such that
projected beneﬁts are rising rapidly com-
pared to payroll tax inﬂows, so that when the
fund assets ﬁrst go below the safety level—
say in 2030—the funds will be increasingly 
far out of actuarial balance after that date.
These numbers reﬂect two deeper 
pension savings issues for the United States.
One involves actuarial balance.  In a stable,
deﬁned-beneﬁt Social Security System with
pay-as-you-go (PAYG) ﬁnancing, the under-
lying accounting identity can be written 
as follows:
(1)            t = (B/W) (S/N) = r x d,
where t is the OASDI tax rate on taxable
wages, B is the average value of Social
Security beneﬁts, W is average taxable
wages, S is the number of Social Security
recipients, and N is the number of workers.
The overall numerator, (B x S), is aggregate
Edward M. Gramlich is a member of the Board of Governors of the Federal Reserve System. When this article was written, he was a professor
in and Dean of the School of Public Policy at the University of Michigan.FEDERAL  RESERVE  BANK  OF  ST. LOUIS
8
MARCH/APRIL  1998
Social Security beneﬁts, and the overall
denominator, (W  x  N), is aggregate taxable
wages, with the overall right-hand side
equaling the payroll tax rate because of 
the PAYG identity.  This identity can also
be written as the product of the aggregate
replacement rate, (r  = B/W), and the
dependency ratio, (d  = S/N).
The United States now has an aging
population, with people living longer and
not having enough babies to stabilize the
population share of young people.  This
means that the dependency ratio, d, is
steadily rising, from about 0.29 today to
about 0.56 by the end of the 75-year fore-
cast period. According to the PAYG identity,
if nothing is done to aggregate replacement
rates, the payroll tax rate will need to rise
steadily to pay for the existing deﬁned-
beneﬁt Social Security plan.
The second issue involves the rate of
return.  Another property of a PAYG system,
ﬁrst pointed out by Paul Samuelson,  is 
that the equilibrium real rate of return on
worker contributions equals the rate of
growth of the economy’s real wage base
(real wages times number of workers).
This real wage base is slated to grow 
about 1 percent in the Trustees’ long-term
forecasts, which means that discounted
beneﬁts will become smaller relative to
discounted tax payments for each new
cohort of young adults (using the overall
real interest rate of 2.3 percent as the dis-
count factor).  Money’s worth ratios, the
ratio of discounted beneﬁts to discounted
taxes paid by employees and employers on
behalf of employees, can be computed for
past and future cohorts.
Taking into account the redistribution
within Social Security, spousal beneﬁt levels
and the likely share of families receiving them,
disability insurance levels and the likely
share of families receiving them, and sur-
vivor beneﬁt levels and the likely share of
families receiving them, the weighted
average money’s worth ratio for people
retiring now is about 1.0.  This means that,
for those who retire this year, Social Secu-
rity is approximately as good a ﬁnancial
deal as government bonds, which gener-
ally should be an attractive proposition in
light of the social protections that Social
Security confers.  But while the overall
ratio cycles a bit because of past move-
ments in real interest rates, over the long
run the aggregate money’s worth ratio 
falls to about 0.7 for younger workers,
even before any policy changes in OASDI
replacement or tax rates are made.  If policy
changes are made to bring the system into
actuarial balance, these money’s worth
ratios will become lower yet.
The interaction between these two
issues sets up a difﬁcult problem in polit-
ical economics.  Taxes could be raised or
replacement ratios cut to keep the system 
in long-term PAYG balance.  But the mere
act of doing either of these things worsens
the money’s worth ratios for younger cohorts
and threatens the future popularity of the
system.  The question of how to bring the
system into ﬁnancial balance while pre-
serving its political popularity was the
central issue faced by our council.
DEALING WITH THE SOCIAL
SECURITY DILEMMA: 
THREE PROPOSALS
The council had three different
approaches for dealing with this double
dilemma.  Each approach takes advantage
of the macroeconomic proposition that
future returns on both stocks and bonds
are likely to exceed the implicit PAYG return
of the present OASDI system.  Two of the
approaches take advantage of the addi-
tional macroeconomic proposition that 
the best way to insure a healthy retire-
ment system in the 21st century is to 
raise national saving now.
One approach, known as the Maintain
Beneﬁts plan, would make minimal changes
in beneﬁt schedules, tax rates, and hence
underlying rates of national saving.  The
trust fund ﬁnances would be preserved,
and the money’s worth ratios for younger
workers raised through a huge investment
of Social Security funds in equities.  There
are a number of difﬁculties with such an
approach, and in fact in the end those
favoring the Maintain Beneﬁts approachFEDERAL  RESERVE  BANK  OF  ST. LOUIS
9
MARCH/APRIL  1998
wanted only to “study” central fund equity
investment, not actually to do it.  From a
macroeconomic point of view, this approach
could also be criticized as involving only an
asset swap with the private sector—not new
saving or new wealth creation.
A second approach, called the Personal
Security Accounts plan, would replace the
present deﬁned beneﬁt system with large-scale
deﬁned contributions held outside the OASDI
trust fund.  These accounts would be privately
owned and managed, and hence  more risky.
The OASDI beneﬁt schedule would revert to a
poverty-line ﬂat beneﬁt, again increasing the
risk that individuals who did not invest well
would not receive many retirement beneﬁts.
Since the present-day payroll tax would be
largely diverted to the personal accounts, a
huge amount of transition ﬁnancing would be
required for such a plan.
I personally do not favor either
approach and have tried to come up with
an intermediate approach that preserves
the important social protections of the pre-
sent Social Security System, does this in a
ﬁnancially prudent way without relying on
OASDI equity investment, and still adds
what I consider to be badly needed new
savings for retirement.  My Individual
Accounts (IA) plan does all three.
COMPONENTS OF 
THE INDIVIDUAL 
ACCOUNTS PLAN
The ﬁrst component of the IA plan is
what might be called  “kind and gentle” ben-
eﬁt cuts.  Most of the cuts would be felt by
high-wage workers, while disabled and low-
wage workers would be largely protected
from cuts.  The IA plan would involve some
technical change; for example,  all state and
local new hires would be included in Social
Security, and Social Security beneﬁts would
be subject to consistent income tax treat-
ment.  These changes are also part of the
council’s other plans and go some way
toward eliminating Social Security’s
actuarial deﬁcit.
Then, beginning in the 21st century,
the changes would be supplemented with
two other measures.  There would be a slight
increase in the normal retirement age for all
workers.  There would also be a slight change
in the beneﬁt formula to reduce the growth of
Social Security beneﬁts for high-wage workers.
Both of these changes would be phased in very
gradually to avoid actual beneﬁt cuts for pre-
sent retirees and “notches” in the beneﬁt
schedule (instances when younger workers
with the same earnings records get lower real
beneﬁts than older workers).  The result of
all changes would be a modest reduction in
the overall OASDI replacement rate of Equa-
tion 1 to leave OASDI payroll tax rates stable
into the future.  In the context of the rising
number of retirees, the share of the nation’s
output devoted to Social Security spending
would be approximately the same as at pre-
sent, eliminating this part of the impending
explosion in future entitlement spending.  
Of the three plans suggested by our council,
my plan is clearly the best for achieving  short-
term and long-term balance in the federal
budget.
These beneﬁt cuts alone would mean
that high-wage workers would not experience
rising real beneﬁts as their real wages grew,
so I would supplement these changes with
another measure to raise overall retirement
(and national) savings.  Workers  would be
required to contribute an extra 1.6 percent
of their pay to individually owned accounts,
which would be centrally managed.  The
workers would be able to allocate their funds
among ﬁve to 10 broad mutual funds cov-
ering stocks and bonds.  At the same time,
central management of the funds would cut
down the risk that they would be invested
unwisely.  It would also cut administrative
costs and would mean that Wall Street ﬁrms
would not ﬁnd these individual  accounts a
ﬁnancial bonanza.  The funds would be
converted to real annuities upon the
employee’s retirement to protect against
inﬂation and the chance that retirees would
overspend in their early retirement years.
CONCLUSION
These changes, taken together, would
mean that all wage classes of workers, of all
ages, would receive approximately the levelFEDERAL RESERVE BANK OF ST. LOUIS
10
MARCH/APRIL 1998
of beneﬁts that is currently in place.  The dif-
ference between this outcome and present
law is that, under this IA plan, the beneﬁts
would be affordable; under present law, they
are not.  The changes would eliminate
Social Security’s long-term ﬁnancial deﬁcit
while preserving the important retirement
safety net provided by Social Security.  They
would signiﬁcantly raise the return on
invested contributions for younger workers.
They would reduce the growth of overall
entitlement spending and improve the fed-
eral budget outlook, even in the near term.
And the changes would move beyond the
present PAYG ﬁnancing scheme by building
up the nation’s capital stock in advance of
the baby boom retirement crunch.

Mending but not ending Social Security: the individual accounts plan

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Mending but not ending Social Security: the individual accounts plan

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