Where to turn next on Social Security reform? The presumptive Republican nom-inee for president, John McCain, like President Bush, supports introducing fully funded personal accounts within the program. Still, the odds are against a push for such accounts anytime soon. Too many Republican politicians believe, rightly or wrongly, that the president’s 2005 effort hurt them in 2006.
But even if Bush-style personal accounts are beyond reach, Social Security reform remains necessary. The Social Security Administration expects the U.S. population age 65 and older to increase by more than 40 percent between 2006 and 2020. Projections show Social Security’s costs will begin to exceed revenue in 2017, with the gap widening rapidly thereafter. Pressure is building for a sizable increase in payroll taxes.
But if not fully funded personal accounts, then what? Surprisingly, the answer might be found in Europe. With populations aging more rapidly and financial problems even more pressing than in the United States, several European governments have moved aggressively over the past decade to implement conservative-leaning pension reforms. Sweden’s innovative social security plan is a notable example.
For decades, Sweden maintained a conventional, pay-as-you-go, defined-benefit public pension, not unlike Social Security. By the late 1980s, it was apparent that rapid population aging would force tax hikes to an extent that even Swedish voters would find unacceptable. Pushed to act by a faltering economy, Sweden’s leading political parties joined together in the 1990s to pass and implement a sweeping overhaul. Benefit payments under the new system began in 2001.
The Swedish reform introduced a new concept–”notional defined contribution” accounts, assigned to every worker participating in the public pension system. These notional accounts look like 401(k)s. They track worker “contributions,” assign “investment earnings,” and report “account balances”–except there are no financial resources in them. They’re tracking devices. Pensions are still financed on a pay-as-you-go basis, with payroll taxes collected today to cover monthly benefits for current retirees.
What’s different is the pension calculation at retirement. New Swedish retirees get a pension based on the balance in their own notional account, which is converted into a monthly benefit much as the balance in a 401(k) could be used to purchase an annuity. The retirement benefit is set at the amount that would, when drawn monthly, deplete the worker’s “account” over his or her expected remaining life span.
The Swedish reform is permanently solvent thanks to provisions which automatically adjust payouts to stay within available revenue. The accounts are set by default to grow at the same rate as wages, but the rate of growth can be reduced if key demographic variables make such a return unaffordable. For instance, if low fertility were to mean a smaller than expected workforce, the rate of return would be cut automatically to a level consistent with the smaller base of working participants. Similarly, if Swedes live longer than currently expected, the annuity calculation will cut monthly payouts to ensure notional account balances are not overdrawn.
The Swedish reform should improve work incentives too. The only way younger Swedes can boost their pension entitlement is by earning higher wages and thus “contributing” more to their notional accounts. For those nearing retirement, the automatic reductions in monthly benefits for an early workforce exit should encourage more to delay their retirement.
Swedish social security is still too expensive, requiring a 16 percent payroll tax rate (not including a 2.5 percent tax for mandatory retirement savings or the cost of additional support for low-income elderly). The U.S. Social Security payroll tax rate is 12.4 percent, but the program has a $14 trillion unfunded liability. The Swedes face no such shortfall. Long-term projections confirm Swedish pension obligations can be met indefinitely without a tax increase, even with population aging.
Switching to notional accounts would make a later switch to fully funded accounts simpler. Once up and running, workers would begin to wonder why they can’t invest their contributions themselves and have a chance at better returns than the government provides.
President Bush fell short on Social Security in part because it is difficult to move away from a pay-as-you-go system. Sweden’s reform, since copied by several other governments in Europe, demonstrates that it is possible to secure some of the benefits of personalization within a pay-as-you-go framework. Such a reform would be a significant improvement over the existing U.S. system, most especially because it would make a damaging payroll tax increase unnecessary.
– James C. Capretta is a fellow at the Ethics and Public Policy Center and the author of “Global Aging and the Sustainability of Public Pension Systems,” published by the Center for Strategic and International Studies.