Sen. Chuck Hagel has introduced a serious Social Security reform proposal.  It would gradually phase-in voluntary personal accounts and corresponding reductions in defined benefits.   More importantly, the plan includes “tough choices” to restore the solvency of the Social Security system. 

Senator Hagel’s proposal makes a constructive contribution to the Social Security debate.  It is also encouraging that most Democrats in Congress have refrained from criticizing the increase in the retirement age and other benefit changes in the Hagel bill.

Outline:

Four Components of Hagel Bill

Increase in Normal Retirement Age to 68

Longevity factor

Actuarial adjustment for early retirement

Individual accounts

Positive Features of Hagel Bill

Fiscal Concerns

Conclusion
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The Hagel bill (S. 540) has four components:

Increase in Normal Retirement Age to 68.  Under current law, the Normal Retirement Age is scheduled to increase to 67 for workers reaching 62 in 2022.  The Hagel bill would increase the normal retirement age by an additional year for workers reaching 62 in 2023 and beyond.  The early eligibility age would remain at 62.

Longevity factor.  The benefit formula would be adjusted based on increases in life expectancy so that total expected benefits over an individual’s lifetime would remain constant.   The initial benefit levels would be gradually reduced as retirees are expected to live longer and therefore receive benefits for a longer period of time.  This provision has an impact similar to an increase in the retirement age, but gives workers flexibility to retire and become eligible for benefits without an explicit increase in the retirement age.  This is based on reforms in the Swedish retirement system which give workers flexibility to decide when they retire and sets benefit levels based on life expectancy at retirement.

Actuarial adjustment for early retirement.  The actuarial adjustment for early retirement reduces initial benefits to take into account the additional years the individual is expected to receive benefits.  There is a similar provision increasing benefits for workers who delay retirement after the Normal Retirement Age (NRA).  This provision would modify the actuarial adjustment to reflect the additional payroll taxes individuals pay while working past NRA and the payroll taxes that a worker who takes early retirement would have paid if he had continued working until reaching NRA. Currently, the delayed retirement credit does not compensate workers for the years of additional payroll taxes individuals pay while working past the NRA.  In addition to producing savings, this provision would encourage workers to delay retirement and work to a later age.

Individual accounts.  The plan establishes voluntary individual accounts that largely mirror the President’s proposal with a few changes.  Individuals who will be 45 or younger on January 1, 2006 would have the option of diverting 4% of their 12.4% payroll tax into an individual account.  Unlike the President’s proposal, there would not be a dollar cap on the amount of payroll taxes that could be diverted to an individual account.  There would be an offset in the defined benefit for workers who chose voluntary accounts to reflect the lower amount of taxes they paid into the defined benefit system. 

This offset is necessary to ensure that the accounts are actuarially neutral and prevent workers from “double dipping” by putting payroll taxes into an individual account while being credited for additional benefits based on those same payroll tax contributions.   The proposal effectively requires workers to purchase an annuity through the Social Security system sufficient to ensure that their income from Social Security was at least equal to 135% of poverty.  The individual would have complete flexibility on the use of any account balances remaining above that amount.

The Hagel proposal has several positive features.

• It achieves sustainable solvency for the Social Security trust fund.
• The increase in the retirement age and increased penalty for early retirement would help address labor shortages in the future by creating incentives to work longer.
• It avoids the problems associated with how to apply changes in the benefit formula for retired workers to disability benefits, since increasing the retirement age and longevity indexing would not affect disability benefits in any event.

The proposal does raise concerns from a fiscal perspective.  The transition costs associated with the accounts are higher than the President’s proposal because the accounts begin earlier and there is no dollar limit on the annual contributions to the accounts.  The savings from increasing the retirement age and implementing longevity indexing will be substantial over time, but do not materialize for many years.

The proposal relies on substantial general revenue transfers to maintain stability of the trust fund during the transition period.  These transfers would reach 4.8% of payroll by 2030. Although the proposal would restore solvency over the 75 year period and beyond, it would only reduce the general revenue needs of the Social Security system from $3.7 trillion to $3.6 trillion in net present value.  To gain bipartisan support, additional funding mechanisms will have to be added to the Hagel proposal to reduce the transition costs and general revenue needs of the plan. 

On balance, the Hagel proposal is a constructive addition to the Social Security debate and is worthy of bipartisan consideration.  It puts forward several specific options for restoring solvency that have other policy benefits as well. These policies should be considered as part of any solution to the challenges facing Social Security.