Linking Social Security reform with Private Saving Reform

Increases in the eligibility age for Social Security benefits need to be phased in slowly to prevent financial shocks to households nearing retirement and coupled with new policies that increase savings by younger adults. This post considers how a gradual change in Social Security benefits could be attached to proposals that promote increased private saving.

Introduction:  One approach being considered to expand the lifespan of the Social Security Trust fund involves increases in the eligibility age for receipt of the minimum and full retirement benefit.  This approach would result in substantial improvements in the financial condition of the Trust fund.  It would both increase revenue by forcing people to work longer and would delay outflows from the Trust fund.  It would reduce the future debt to GDP ratio and reduce the likelihood of future increases in taxes to pay off debt.  

However, there are adverse impacts and limitations associated with increases in the eligibility age for Social Security benefits.

First, most current retirees are highly dependent on Social Security.  (A study based on data from the Current Population Survey reveals 52 percent of older households receive more than half of their income from Social Security and a third receive more than 75 percent of income from Social Security.)  Workers currently nearing retirement could not be expected to substantially increase their savings to prepare for the increased retirement age. 

Second, A phased in increase in the retirement age would not prevent project automatic reductions in Social Security benefits associated with reduced Trust fund reserves.

Third, many workers when they near the eligibility age for Social Security benefits need to retire or need to reduce the hours, they work because of health concerns.  Health related problems impacting older workers will impact both current workers nearing retirement and future cohorts of workers. 

Fourth, younger adults are having an extremely hard time saving for retirement.  Student debt is at a record level and continues to climb with college cost and many young adults with high student debt burdens are either delaying saving for retirement or disbursing funds in retirement accounts early in their careers to meet current obligations.  A discussion of the use of pre-retirement funds prior to retirement can be found here.  In addition, young workers must save more for retirement than previous retirees because they are less likely to have access to a traditional defined benefit pension plan.

Changes to Social Security retirement benefit formulas need to be implemented gradually to avoid an abrupt economic shock impacting people nearing retirement and need to be linked with changes in savings incentives and economic reforms which facilitate increased private savings for retirement.

Increasing the eligibility age for Social Security Benefits:  Under current law, workers initially become eligible to claim Social Security retirement benefits at age 62.  People born after 1960 are eligible for the full Social Security retirement benefit at age 67.  The largest possible Social Security benefit is received by people who delay claiming until 70.

Changes to three parameters – the initial eligibility age for Social Security benefits, the eligibility age for the full benefit, and the age where people receive the maximum allowable benefit – are considered here.  The proposed changes would start five years after enactment after legislation.  The three retirement age parameters would increase by one month every two years until all three retirement ages increased by two years.  After the full enactment of the increased retirement age, the minimum eligibility age would be 64, the age of full benefits would be 69 and the age of the maximum benefit would be 72.

When the Social Security eligibility age is phased in many recipients will receive two fewer years of benefits over their lifetime.  

The phased in benefit reductions put the United States on a more favorable and sounder fiscal trajectory. These benefit reductions will reduce the future debt to GDP ratio.  However, the phased in adjustments do not prevent the automatic reductions in Social Security, which are current projected to occur in 2034.  The prevention of the automatic benefit cuts requires some other action by Congress.

One approach to deal with the automatic benefit cuts would involve the use of general tax revenue, which would lead to higher annual budgets. The projected future debt to GDP ratio is a more important measure of fiscal health than annual budget deficits because markets are forward looking, hence the prospect of lower future debt levels will restrain interest rates even if deficits rise in the short term.

The avoidance of projected automatic cuts to Social Security will also require some additional revenue from an increase in the payroll tax or some other tax.

The phase in of these changes would have to be slow to avoid financial shocks on people nearing retirement and to allow for increased private savings. The slow phase of the benefit changes allows for people to increase retirement savings prior to retirement. Younger adults will experience the full brunt of the change in the Social Security eligibility change but will also have more time to take advantage of reforms that will facilitate increased private savings.

Facilitating increased private savings:  Since most households nearing retirement age will be highly dependent on Social Security and most younger households have either delayed or reduced saving for retirement to meet current needs the proposed increase in the eligibility age for Social Security benefits must be accompanied by policies that lead to increased savings for retirement. 

The first set of policy proposals involves direct improvements to savings incentives and investment vehicles offered by investment firms.  The proposed changes in tax incentives and financial rules favor households which are currently having a difficult time saving for retirement, including people without access to the most generous employer-sponsored and people reducing retirement savings because of medical expenses.  The new tax and financial rules will provide incentives for workers to start saving for retirement at a younger age.

 Modifications to Direct Savings Incentives and Rules:

Tax and pension rules should be changed to equalize savings opportunities for workers dependent IRAs and 401(k) plans

  • Currently, higher income taxpayers will receive a higher tax savings from a 401(k) contribution than a low-income taxpayer.  This disparity would be eliminated by replacing the tax credit for contributions to retirement plans with a tax credit.
  • Current tax law allows employers to match employee contributions to 401(k) plans but does not allow for matching contributions to IRAs.  The rules should be changed to allow employers to contribute match employee contributions to IRAs as well as to 401(k) plans.
  • Tax law could be changed to allow firms to provide tax free contributions to retirement accounts of gig employees.  
  • Current limits on employee contributions to IRAs are lower than contributions to 401(k) plans.  These contribution limits should be equalized.

Improve the automatic 401(k) enrollment option and create a similar automatic savings option for firms that do not offer a 401(k) plan.  

  • The newly enacted automatic 401(k) enrollment option allows for firms to automatically enroll workers in 401(K) plans that charge high fees or have few investment opportunities.  The government could improve investment outcomes and increase wealth at retirement by limiting fees and by requiring access to low-cost or zero-cost investment options like direct investments in Treasury securities.
  • Automatic enrollment into IRAs or savings through Series I savings bonds should be created for workers employed at firms without a 401(k) plan.  The new automatic enrollment provision would be patterned after the 401(k) automatic enrollment provision, which allows workers to opt out of the automatic contribution and sets the initial contribution at 3 percent of income.  The expanded automatic enrollment provisions create an incentive for younger adults to either open an IRA or some other savings vehicle.  (Most young workers do not have access to a firm-sponsored retirement plan or are subject to vesting requirements.)   The initiation of saving at a younger age is a crucial reform needed to assure increased wealth at retirement.

Create rules that prevent use of all retirement fund prior to retirement and encourage workers to reduce leakages of funds from retirement accounts.

  • Current tax laws allow for investors to disburse all savings from a 401(k) plan or IRA prior to retirement.  (Disbursement rules are complex and often involve payment of tax and penalty.)  A new rule might prohibit pre-retirement disbursements greater than a certain percent of contributions, perhaps 50 percent of contributions.
  • Many young workers automatically disburse all funds contributed to a retirement plan at their first permanent job.  The default option for 401(k) funds during job transfers should be automatic transfer to a low-fee independent account. The worker who wants to maintain retirement savings at her old employer or withdrawing funds from an existing account would have the option of opting out of default arrangement.

Modify tax rules governing Flexible Savings Accounts (FSAs) and Health Saving Accounts to allow for increased savings.

  • Current rules governing FSAs result in the FSA owner losing any unused funds in the account at the end of the year.  A change in FSA rules that allows unused FSA funds to be rolled over into a 401(k) or an IRA would encourage greater contributions to FSA accounts and increase retirement savings.
  • Current rules only allow people with qualified high deductible health insurance plans to contribute funds to a health savings account. A change in these rules to allow for health savings account contributions for people with a wider variety of accounts could expand savings for health care and for retirement.   The new rule could lower rate of depletion of funds in the health savings account or increase contributions to retirement accounts since health savings accounts are often funded by decreased contributions to retirement accounts.

Expand investment opportunities in 401(k) and 529 college savings plans to allow for direct investment in Treasury securities including Series I Savings bonds and the tax-free conversion of 529 assets to 401(k) plans:

  • Many retirement plans and virtually all College Savings 529 plans allow for investments in a few fixed-income and equity funds and do not allow for workers to purchase bonds with a specific maturity date.   These bond funds, even those with short maturity assets fall in value when interest rates rise.  Investors should be given the option of holding Treasury securities to maturity when they will be guaranteed access to the initial bond purchase and all interest.
  • Rules should require retirement plans to provide access to all Treasury bonds including Series I bonds and Treasury Inflation Protected Securities (TIPs).  Access to these investments would reduce loss of wealth from fees and reduce portfolio risk.  
  • Current law taxes disbursements from 529 plans not used for educational purchases.  Workers should be allowed to convert part of the unused 529 plans to a 401(k or IRA without paying tax.  (Typically, the 529 contribution is exempt for state tax but not exempt from federal tax.  Since the initial contribution to the 529 plan was subject to federal tax the loss of federal tax revenue from this proposal might be modest.) 

Removal of Impediments to Saving for Retirement:

Many people fail to save for retirement because they get caught in a spiral of debt and live paycheck to paycheck for a prolonged period.  Often young adults delay saving for retirement or even raid their retirement plan to maintain their student debt payments. Roughly 9 million borrowers over the age of 50 are still making payments on their federal student loans and are having trouble meeting expenses in retirement.  

Other households, especially people with employer-based health insurance often lose health insurance during job transitions.  A loss of health coverage and increased medical debt exacerbating disruptions in the process of savings for retirement routinely occur during recessions.  

A second set of policy initiatives attempts to remove impediments to saving experienced by people who have high student debt or lose health insurance during job transitions.

Implement policies to reduce student debt burdens to facilitate increased savings for retirement.

  • Many of the most vulnerable student borrowers that have difficulty both repaying their student debt and saving are people who borrow but never complete their degree.  The number of households in this situation could be drastically reduced by the implementation of policies that reduce or eliminate debt by first-year students.  The elimination of first-year student debt would also reduce average student debt burdens for all students with debt.  This proposal is far less expensive than the Sanders program to eliminate all college debt at public universities. 
  • Currently student borrowers must choose between a standard student loan contract and an Income Driven Loan (IDR) program as soon as they start loan repayment. In some instances, people who chose the IDR program paid more on their loan over the lifetime of the loan or failed to get the timely debt discharge as promised.  The standard loan contract does not offer the possibility of a loan discharge even if the borrower has low income in the future.   These problems can be mitigated by a modification of the standard student loan contract to include the elimination of all interest charges combined with accelerated repayment obligations 10 years after the initiation of repayment.

Modify rules governing tax incentives for employer-based health insurance and state exchange health insurance to allow for reduced loss of health insurance during economic downturns

  • The proposed solution to discontinuities in insurance coverage stemming from changes in employment involve – a rule change allowing employer subsidies of state-exchange insurance instead of employer-based insurance, the automatic conversion of employer-based insurance to state exchange insurance when employees are laid off, and a modification of the premium tax credit for state exchange insurance. More information on this proposal and other health care reforms can be found here.

New Political and Economic Dynamics:  The current political debate on Social Security involves proposals to either cut benefits or increase taxes and ignores problems caused by disparities in private retirement savings.

Any change to an inter-generational program must be phased in slowly to avoid political and economic turmoil.

However, most young adults would be unable to substantially increase their savings rate given current savings incentives or high debt burdens.

A higher eligibility age for Social Security benefits must be accompanied by reforms designed to reduce disparities in private savings.  These reforms will reduce the dependence of future generations on the Social Security program.

Many of the improvements in savings incentives, reductions in student debt and improvements to health insurance proposed here, are unaffordable if not accompanied by substantial new revenue or budget cuts.

Increases in retirement savings require changes in retirement plan rules and procedures.  Many current rules favor Wall Street over investors and tie investors into expensive products offering suboptimal returns or high levels of risk.

Social Security reform and private savings reform are intrinsically linked.

The proposals presented here would reduce wealth inequality and will improve the fiscal condition of the nation, truly a rare combination.

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