Keeping Social Security out of the gap

Reports from Washington suggest that the favorite White House plan for Social Security reform is the so-called "Two Percent Solution."

What makes the plan politically attractive is that it promises to make the system solvent without cuts in pension benefits or higher taxes.

If so, that's amazing.

With its head sticking out of the political trenches, the plan of economists Martin Feldstein and Andrew Samwick is already being shot at by opponents of privatization. But it's getting much needed critical attention.

The dreaded transition period

For any privatization plan, the big problem is the "transition period." How do you get from the present system to a new one.

Under today's system, most of your payroll tax goes to pay the benefits of those who are retired or disabled.

Privatization plans change the strategy. The money you pay in now builds your own fund for when you retire.

Which leaves a gap. A complete switch to privatization leaves current and near-term Social Security recipients with no retirement funds. Any reformed system must take them into account.

Other privatization proposals do this by either cutting benefits or raising taxes.

Mr. Feldstein, a top economic adviser to former President Reagan, and Mr. Samwick, a professor at Dartmouth College, Hanover, N.H., say their plan doesn't cut benefits, doesn't raise taxes, and even increases retirement income over the current Social Security system.

To proponents, this clever plan harnesses both the higher returns of the stock market and the federal budget surpluses seen for the next decade.

Opponents see faulty assumptions.

The Feldstein-Samwick plan, presented to the National Bureau of Economic Research, Cambridge, Mass., calls for individuals to deposit 2 percent of their earnings in personal retirement accounts (PRAs).

The government would encourage PRA savings by providing a dollar's tax credit for every dollar deposited. The money would be invested in financial securities or bank deposits, just as IRAs are today.

When you reach retirement and start PRA withdrawals, your Social Security benefit that year would be reduced by 75 cents for every PRA dollar withdrawn.

Feldstein and Samwick assume that PRA assets - invested conservatively: 60 percent stocks, 40 percent bonds - would win the same 5.5 percent annual return that an investment would have returned in the post-World War II years through 1994.

If so, the current 12.4 percent payroll tax rate could continue indefinitely without any increase.

The plan's authors figure the PRA money, plus the 75 cents-per-dollar-offset on withdrawals, plus expected budget surpluses, would cover benefits through 2015.

The plan comes up short of money between 2015 and 2030. The government would have to cover the losses with new tax revenue or reduced government spending.

But after 2030, it's home free. PRA assets would make the whole thing self-financing.

A gap in their logic

"It's not really a solution," says Edith Rasell, an economist with the Economic Policy Institute, a liberal Washington think tank. Ms. Rasell calls the assumed 5.5 percent rate of return too high because it ignores an expected slowdown in the economy in coming decades.

She estimates the return at only 3.8 percent, a big difference over time, she says.

Policymakers evaluating these assumptions face a problem. Economists have trouble predicting next year's economy let alone the economy 30 years ahead.

Rasell also says annual administrative costs of the individual plans could amount to 1 to 2 percent of the assets, an amount Samwick considers too high.

Samwick and his critics agree that investing Social Security funds shrinks the budget surplus.

Yet Samwick considers it money well spent.

Rasell would rather see the surplus go toward government programs to improve education, better the environment, and encourage private research and development.