Individual Accounts for Social Security?

Article excerpt

The recent slide in stock market prices will surely dampen efforts to replace all or a portion of the current Social Security system with a system of fully funded individual retirement savings accounts.

The small, but sure, returns that we earn on our payroll tax investments in Social Security look pretty good, compared to the stock market's recent double-digit losses.

Even if the stock market were doing better, however, Social Security's financial troubles pose a serious impediment to replacing all or a portion of the current system with a system of fully funded individual accounts.

According to the Social Security actuaries, if the government were to shut down the current Social Security system and replace it with a system of individual accounts, the government would need to come up with $10.8 trillion to cover the benefits that have already been earned by today's retirees and workers.

But there is another approach that could achieve many of the same advantages of a system of funded individual accounts. We could replace all (or a portion) of the current Social Security system with a system of hypothetical or "notional" accounts. Unlike a system of funded individual accounts, a system of hypothetical individual accounts could continue to run on a pay-as-you-go, or PAYGO, basis. Like the current Social Security system, current payroll taxes would go largely to pay current benefits.

Indeed, several countries have already replaced their traditional Social Security programs with so-called "notional defined contribution" systems, where notional contributions are used to "purchase" annuities at retirement.

Under this approach, the bulk of a country's underfunded Social Security system is reconstituted into a system of unfunded (i.e. "notional" individual accounts that mimic fully funded, individual defined contribution accounts. These hypothetical accounts are credited with "interest" under a statutory formula that takes into account current and prospective demographic and productivity changes.

In short, under the notional defined contribution (NDC) approach, a country's underfunded Social Security system is replaced with a system of individual accounts that are also financed on a pay-as- you-go basis.

Sweden, Poland, Italy, and Latvia have already adopted this notional approach; and many other countries are actively considering it.

For example, in 1998, Sweden enacted legislation that transformed most of its Social Security system into a Notional Defined Contribution system. Under the new system, each worker will have two individual accounts. These accounts will be financed by a payroll tax equal to 18.5 percent of payroll up to a ceiling -- split equally between employers and employees. Sixteen percent of earnings will be credited to a notional individual account for each worker, and the remaining 2.5 percent of earnings will go to a funded individual account. In addition, the pension system will provide a means-tested minimum welfare benefit for those individuals who earn no or low pensions under the new system.

The key to Sweden's new public pension system is the individual notional defined contribution accounts. While this part of the system continues to operate on a pay-as-you-go basis, an individual's pension benefits are tied to the hypothetical account balances in these new accounts. These notional accounts are credited with annual "contributions" -- 16-percent of earnings up to a ceiling. …