The time is ripe for Social Security reform. Last month AARP—a historic foe of such reform—announced its openness to modest benefit reductions in order to restore the program to solvency. This week President Obama offered major reforms to Social Security as part of a far-reaching debt reduction deal.
The outflows from Social Security exceeded its inflows in 2010, and it is projected to become insolvent around 2037 — requiring benefit cuts of 25% at that time.
To avoid these across-the-board cuts, Congress needs to package Social Security with measures that attract voters in the middle range of the wage spectrum.
Most proposals for reforming Social Security preserve the current benefit schedule for low wage earners and limit the growth of benefits for high wage earners.
While these two aspects of reform seem to be politically acceptable, the challenge is replacing any benefit reductions for workers in the middle-wage range — with salaries and bonuses (not other income) between $35,000 and $85,000 per year.
To deal with this political challenge, Congress should offer a government match to retirement contributions by workers in this middle-wage range. Specifically, Congress should adopt the Obama Administration's 2010 proposal for an enhanced Saver's Credit – whereby the federal government would match each year a $500 contribution to a retirement plan by any eligible worker with a $250 contribution.
Workers eligible for the full match would include couples with adjusted gross incomes of $65,000 per year or less ($32,500 for singles), with lower matches available to couples with adjusted gross incomes up to $85,000 per year ($42,500 for singles).
The value of this federal match, conservatively invested over a long career, would roughly offset the proposed reductions in scheduled Social Security benefits for the median worker.
Suppose a married male worker at age 30 receives the median US wage of $37,000 per year, and his spouse has annual wages of $13,000 for part time work. He contributes $500 each year to an IRA, which is matched by $250 from the federal government, until he retires at age 66.
If this $250 annual match were invested in a balanced fund – half in long-term government bonds and half in an S&P 500 index – with a real return averaging 5.8% per year, the total value of this match would be $30,150 at his retirement. With that sum at a 5.8% interest rate, he could buy a fixed annuity with monthly payments of $255 for the rest of his life.
These annuity payments from the Savers' Credit would make up most of the modest benefit reductions for middle-wage workers in the future—reductions likely needed to make Social Security solvent.
For example, actuaries estimate that the scheduled monthly benefits of the median worker retiring in 2045 would be reduced by approximately 16%, or $290, under my progressive indexing plan for reforming Social Security. That $290 reduction would be largely offset by the $255 supplemental retirement benefit from the lifetime annuity funded entirely by the federal match.
As a result, the total monthly payments of this median worker — from his federal match and a solvent Social Security program — would be almost the same as the current benefit schedule. And the worker will receive more each month to the extent that federal match induced him to contribute more to his retirement plan.
It bears emphasis that this federal match would come entirely from the Congressional appropriations process, and would not divert any monies from Social Security. This is not a proposal to privatize Social Security.
The proposed federal match will cost $30 billion over the next decade, according to official budget projections. However, if this federal match is the political "sweetener" to help enact Social Security reform, Congress should estimate the cost of the match over the next 75 years – the standard period for measuring Social Security's deficit. Assuming that the cost of federal match grows at a rate of 3% per year, its 75-year cost would be approximately $850 billion.
This is a relatively small price to pay to facilitate the passage of Social Security reform. Without such reform, Congress would have to appropriate more than $13 trillion over the next 75 years to make up the shortfall between the estimated revenues and annual obligations of Social Security.
In short, Congress should combine a generous Savers Credit with a progressive plan to eliminate the long-term deficit of Social Security. The combination would make up a significant portion of the benefit reductions that the AARP recognizes as necessary to restore the program to solvency.
And the combination would not undermine the current economic recovery, since these changes in Social Security would be phased in gradually and would not apply to anyone who is now over age 59.
Robert Pozen will appear today at 4:15 p.m. on Closing Bell with Maria Bartiromo.
Robert Pozen is Chairman Emeritus of MFS Investment Management. He currently is a senior lecturer at Harvard Business School.