News & Events

A Reform Proposal for Social Security

A proposal that combines a private option for those with a taste for risk and better funding for those who prefer the traditional benefit.

As Published in Barron's - The Dow Jones Business and Financial Weekly Vol. XCVI No. 44

October 31, 2016

Most economists believe that the Social Security system is unsustainable as currently constituted. To quote Herbert Stein, “If something cannot go on forever, it will stop.” But few Americans are listening. Insolvency of the Social Security Trust Fund is nearly certain sometime around 2034. Yet, there has been no meaningful reform of Social Security since 1983.

Even then, the changes were timid. One, gradually increasing the normal retirement age from 65 to 67, still hasn’t been completed. In 2016, the normal retirement age is 66.

Members of Congress and presidents are adept at ignoring problems that seemingly have only castor oil remedies, especially in the absence of a public outcry. Partisan differences also play a role, with many Democrats looking to expand benefits and Republicans more inclined to scale them back.

The two parties also have starkly different attitudes toward taxes. The 12.4% Federal Insurance Contributions Act, or FICA, tax, applied to a dollar-capped wage base indexed for inflation ($118,500 in 2016) and split evenly between employee and employer, is the sole support for the Social Security Trust Fund. Republicans are loath to increase the payroll tax, but many Democrats would like to solve the whole problem with taxes by raising the wage base limit or eliminating it.

More generally, Democrats want to retain the system, but make it sound enough financially that benefits for lower-paid workers can be increased. Many Republicans favor replacing the system, at least in part, with individual account alternatives, similar to the approach unsuccessfully advocated by President George W. Bush in 2005.

The key is to address both of these goals while ensuring that all workers get something, thereby maintaining broad-based support for the program.

We propose providing a private-account alternative, while simultaneously helping to ensure the solvency of the system by reducing the number of benefit claimants and maintaining tax revenues for the Social Security Trust Fund.

Under our proposal, an individual would gain the right to make annual tax-deferred contributions to a special retirement fund, up to a maximum specified percentage of total annual compensation, in exchange for irrevocably waiving the right to receive Social Security benefits. These contributions would be in addition to whatever the individual could contribute to traditional tax-qualified retirement plans and individual retirement accounts and wouldn’t be capped like contributions to those arrangements.

Individuals who opt out of Social Security benefits, and their employers, would still have to pay FICA taxes. This is a tax increase by another name, of course, but one needed to preserve the system. The employee’s tax rate would be fixed at the rate it was when the employee exited the system; the employer, however, would pay its share according to the rules, as they may change in the future.

Paying the FICA tax and contributing to the special retirement fund may prove difficult for many, so people exiting the system who earn $100,000 to $200,000 a year might be required to pay only half of the FICA tax, and those earning under $100,000 might be totally exempt. In all cases, however, the employer would pay the employer share of the FICA tax.

THE INDIVIDUALS WHO LEAVE the system could invest their assets in the special retirement vehicle in any way they like. As with a 401(k) plan, all investment earnings would be exempt from current tax, and all distributions would be taxed at ordinary income tax rates.

To prevent creating an unjustifiably large tax shelter, the contribution percentage would be capped and should decrease as compensation increases. (One might contribute 5% of the first $250,000 of income, 4% of the next $250,000, 3% of the next $250,000, 2% of the next $250,000, and 1% of compensation over $1 million.) Older individuals might be allowed to contribute more than younger ones.
Distribution requirements would limit the ability to shelter income for long periods. Payments from the special retirement fund should begin no earlier than the participant’s Social Security early retirement age (62) or date of permanent disability, and no later than his or her normal Social Security retirement age. In addition, payments should be made over the participant’s lifetime, in accordance with life expectancy, or the joint life expectancy of the participant and spouse. The government shouldn’t stand in the way of larger withdrawals, which would generate larger tax payments.

Our proposal is not intended to allow nontaxable transfers of wealth. Within one year of the participant’s death (or the death of the participant’s surviving spouse if payments are being made over joint life expectancy), the entire remaining balance in the special retirement vehicle should be distributed to beneficiaries and taxed.
The proposal will appeal only to those who believe that they can save and earn investment returns at least equal to the value of their relinquished benefits and their FICA tax payments. Low-paid workers are unlikely to find the proposal attractive, but it is those workers for whom Social Security, with its fixed monthly payments and life-annuity characteristics, is best suited.

Social Security has been an extremely popular program because it benefits workers at all income levels. Reform proposals that would deny benefits to higher earners or raise their Social Security taxes would reduce that support and convert the program from one that resembles insurance into something more clearly a welfare arrangement.
Proposals to increase benefits without creating a more adequate funding basis will foist additional burdens on succeeding generations. Our plan allows workers who can afford to make contributions and are willing to accept investment risk to choose that form of retirement security. At the same time, it allows all other workers to benefit from a financially sounder Social Security system.

DUDLEY KIMBALL and ROBERT MORGAN, attorneys with Emmet, Marvin & Martin in New York, specialize in executive compensation and retirement planning.