Social security in the 105th Congress.

As Congress heads into its 105th legislative session, one hot issue is the future financial solvency of the Social Security system. While Congress and President Clinton will be focusing on balancing the budget before tackling such issues as Social Security, Medicaid, or Medicare, these programs inevitably will be part of any comprehensive balanced budget discussions. These three entitlement programs alone represented 30 percent of the federal budget in FY1995 and are expected to grow with the aging of the population.

Social Security serves as a primary source of income for a large proportion of retirees in the United States, and the system has been expanded over several years to include state and local governments. In 1951, state governments could participate in a Section 218 agreement whereby current employees would participate in Social Security. Subsequent Section 218 agreements also could be used to opt out of Social Security coverage for any group. In 1983, public employers were required to continue coverage under Social Security for any employees that had previously been covered (i.e., Section 218 agreements could no longer be used to opt out of coverage with respect to any covered group). Finally, in 1991, all state or local government employees not covered by a public retirement system or under a Section 218 agreement became subject to mandatory Social Security participation (with a few exceptions). As of 1995, more than 30 percent of full-time public-sector employees are not covered by Social Security. These employees are provided a pension plan, and oftentimes supplemental coverage, outside of the system.

Recent reports indicate that Social Security will be bankrupt as early as 2030. Reforms under consideration affect all state and local governments - both those currently participating and those that are not but may face mandatory participation in the future. This article discusses the reforms currently being proposed and notes concerns state and local governments will have if Social Security is made mandatory.

Three Social Security Reforms

The Advisory Council on Social Security, created every four years by the Secretary of the U.S. Department of Health and Human Services, in the past has recommended one course of actions affecting the Social Security system, which usually is adopted by Congress. The current 13-member council could not agree on one long-term, broad proposal for reform and, for the first time in the council's history, proposed three options for reform. The council's issuance of three proposals in its report on January 6, 1997, will make the ensuing debate more heated and political.

The council members did come to consensus on a number of issues. Beyond general issues such as the importance of retirement savings and equity across generations, the members concurred that average indexed earnings should be extended from 35 years to 38 years, income taxation of Social Security benefits should be revised, and the increase in the age of eligibility for full retirement benefits should be accelerated.

The group generally concurs that all state and local government employees hired after 1997 should be covered by Social Security. The objective is to reach the goal of universal coverage and to improve the solvency of the overall system. It is estimated that including newly hired public employees will save 10 percent of the present long-term actuarial deficit. Three of the council members do not agree with this provision due to the financial burden that would be placed on employees and employers who are already contributing to other public pension systems.

Maintenance of Benefits. The council's first proposal makes modest changes to the current system but maintains its structure as a defined benefit plan. The specific provisions of this proposal include more fully taxing Social Security benefits and either increasing the benefit computation period or increasing contribution rates in 1998. An increase in the payroll tax would be considered in 2045. Another major tenet of this proposal is to cover all newly hired public employees after 1997. As mentioned earlier, this idea is supported by 10 of the 13 advisory council members.

This proposal also asks for further study of investing a portion of future trust fund assets in stocks of private companies indexed to the broad market. The proposal suggests eventually investing up to 40 percent of the fund in equities. The objective of equity investments would be to eliminate any remaining payroll deficit through the expected long-term higher return of these investments. Oversight for the investments would be by a policy board appointed by the President and confirmed by the Senate. Several observers have raised concerns with the large amount of the stock market that may be controlled by the federal government under this system, how investment decisions would be made and impact the market, whether such decisions would become politically driven, and how proxies would be voted.

Publicly Held Individual Accounts. The second option would add a mandatory savings program to the 12.4 percent of payroll tax. Employees would contribute an additional 1.6 percent of covered payroll to an individual account. Taxation of the savings program's benefits would be similar to that of other defined contribution pension savings. The Social Security Administration would collect and manage the money and set up investment options from which individuals could select, including indexed equity and indexed bond options.

This proposal also would accelerate the increase in the retirement age, slow the growth of basic benefits for middle- and high-wage workers, and change spousal benefits. As with the maintenance of benefits option, this proposal would tax some Social Security benefits, mandate coverage for state and local government employees hired after 1997, and change the benefit computation period.

Again, there are concerns about such large holdings of the stock and bond markets being controlled by the government, even though these would be individually directed rather than pooled as in the maintenance of benefits option.

Two-tier System with Privately Held Individual Accounts. The final and most comprehensive reform option would completely replace the present Social Security system with a two-tier system. The first tier would provide a flat retirement benefit, while the second tier would provide fully funded, individually owned defined contribution retirement accounts. These individual accounts are referred to as personal security accounts (PSAs). This system would be implemented on January 1, 1998, and fully effective for those under age 25.

While the PSAs would be funded with a 5 percent payroll tax, the tier 1 benefits would be financed with the remaining 7.4 percent. To start decreasing the cost of current benefits, this proposal would cover newly hired state and local employees and raise the retirement age. Further, a payroll tax increase of 1.52 percentage points would be considered.

While the individual accounts suggested in the second and third options are touted as increasing personal responsibility and accountability, there are concerns that some individuals may not make prudent investment decisions. The accounts also would create new record-keeping costs. Conversion of Social Security to an individually funded system has the potential of leaving lower-paid employees worse off than they are under the present system. Even if lower-paid employees do as well or better by investing in individual accounts than they do under Social Security, higher-paid employees would be in a vastly better position.

Effect on Pension Plans

Investment of Social Security funds in equities could negatively affect pension plan investment returns. Federal Reserve Chairman Alan Greenspan has commented in several speeches on the impact of Social Security investment in the stock market. According to Greenspan, this would produce a zero-sum result. If Social Security funds were to be invested entirely in equities, other pension funds as current holders of large stock investments presumably would be pushed from the stock market to other securities. Then, the higher rate of return achieved by the Social Security funds invested in the stock market would be counterbalanced by the lower return achieved by other retirement funds. Greenspan has stated:

"The dilemma for the Social Security trust funds is that a shift to equity investments without an increase in domestic savings may not appreciably increase the rate of return of Social Security trust fund assets and, to whatever extent that it does, would likely be mirrored by a comparable decline in the incomes of private pension and retirement funds. Presumably, a similar effect would be felt by public pension funds."

Many lawmakers have estimated how individuals may invest personal Social Security accounts by referring to data on investments of Section 401(k) plans. This may lead to faulty assumptions, according to the Employee Benefit Research Institute (EBRI). EBRI argues that individuals enrolled in Section plans may invest more aggressively under the current system because they have a guaranteed Social Security benefit to rely on should their investments sour. Without such guarantees, individuals may become more conservative in their investment choices. EBRI also suggests that different groups of investors vary widely in their investment behavior and that individual accounts may benefit some groups while permanently harming others.

CPI Changes

The Advisory Council on Social Security stated that one of Social Security's most important contributions to individual security is maintaining full cost-of-living adjustments. In its analyses, the council assumed that the Consumer Price Index (CPI) will be adjusted downward in light of recommendations of the Advisory Commission to Study the Consumer Price Index, also known as the Boskin Commission. In its December 4, 1996, final report to Congress, the Boskin Commission recommends that the federal government create a new inflation measure that more accurately shows changes in the cost of living. The group states that the current CPI overstates inflation by 1.1 percent each year, implying that the federal government has paid higher benefits to retirees through Social Security than was warranted by increases in prices.

According to the Congressional Budget Office, a 1 percentage point reduction in the CPI would save $21.4 billion in Social Security payments and other retirement benefit programs by 2002. Both Republicans and Democrats realize that decreasing the CPI would make the goal of balancing the budget easier.

If the CPI is lowered, pension plans also will be affected. Any plan that provides cost-of-living increases in retirement based on changes in the CPI would be providing smaller increases if this change were made. Second, if plans base assumptions about investment returns on the CPI, funding levels may change adversely solely as a result of the lower CPI (e.g., assumed investment return of 3 percent above CPI). Finally, a lower CPI will result in slower growth of indexed numbers in the Internal Revenue Code, such as contribution and benefit limits. (For further discussion of the CPI, see the article on p. 32 of the February issue of Government Finance Review and on p. 50 of this issue.)

Changing the CPI is a politically charged issue. While decreasing the CPI would make Social Security more solvent, such a change also would lower future benefit increases to Social Security beneficiaries - a politically active group. Congressional Republicans have called on President Clinton to make the first move and will be watching for this in his FY1998 budget proposal.

Conclusion

Social Security solvency will be a growing issue, especially within the balanced budget debate. Facing these financial issues, Representatives Jim Kolbe (R-AZ) and Charles W. Stenholm (D-TX) formed the public pension reform caucus to discuss reforms of Social Security - not state and local government pension plans - and to introduce legislation in the 105th Congress.

State and local governments will need to watch Social Security reform proposals and realistically assess the potential impact on jurisdictional budgets and retiree income security.

Copies of Report of the 1994-96 Advisory Council on Social Security are available free from the Social Security Administration, Office of Public Inquiries, Social Security Annex, 6401 Security Blvd., Baltimore, MD 21235 (410/965-7700).

RELATED ARTICLE: INCREASED FEDERAL OVERSIGHT FOR PUBLIC PLANS RECOMMENDED

In its report, the Advisory Council on Social Security suggested policies regarding other retirement income. One policy is to apply certain provisions of the Employee Retirement Income Security Act (ERISA) to state and local government pension plans. Specifically, the council believes that provisions of Title I of ERISA, including disclosure, fiduciary standards, and spousal protection, should apply to governmental plans to "protect the benefits of the workers and their survivors: The council does not recommend applying other provisions of ERISA to public-sector plans.

Other general policies include creating inflation-indexed Treasury securities, encouraging broader coverage of pension plans, allowing higher funding levels of pension plans, and encouraging employees to maintain retirement savings until retirement.

Author JENNIFER D. HARRIS is director of GFOA's Pension and Benefits Project.