SOCIAL SECURITY

| MEMORANDUM |
|------------|
| Date:      | November 4, 2002 | Refer To:    | TCA |
| To:        | Robert C. Pozen, John Olin Visiting ProfessorHarvard Law School |
| From:      | Stephen C. Goss, Chief ActuaryAlice H. Wade, Deputy Chief Actuary |
| Subject:   | Estimates of Financial Effects for a Three-Part Proposal to Reform the Social Security Program |

This memorandum provides estimates of the financial effects of the three-part proposal you have developed for presentation in the Harvard Business Review. This new proposal includes several provisions from Model 3 developed by the President's Commission to Strengthen Social Security (PCSSS), but it also differs in several important ways. Like the PCSSS Model 3, this proposal includes voluntary personal accounts and other provisions that would assure sustainable solvency for the OASDI program throughout the next 75 years, and beyond.

Estimates of the expected effects of this proposal on selected aggregate financial measures are provided below. These include the financial operations of the combined Trust Funds of the Old-Age and Survivors Insurance (OASI) and the Disability Insurance (DI) programs, aggregate flows and accumulations for personal accounts, effects on annual Federal unified budget balances, and cash flows from the General Fund of the Treasury to the OASDI Trust Funds. Illustrations of selected individual measures (expected future total personal account accumulations and expected total benefit levels at retirement) are not included here as they would be the same as provided for PCSSS Model 3 in our memorandum dated January 31, 2002.

All estimates are based on the intermediate assumptions of the 2001 OASDI Trustees Report, with additional assumptions related to returns on private securities, individual account and annuity administrative expenses, and individual account participation rates.    These assumptions are described later in the memorandum.

The new proposal is described in some detail below. As already mentioned, this proposal is based on PCSSS Model 3 with three principal modifications. The first modification is to replace dedicated transfers from the General Fund of the Treasury with an extension of the payroll tax, at a reduced rate of 3.9 percent (about one third of the full 12.4 percent rate), above the current maximum taxable amount ($84,900 for 2002). The second modification is to finance the 2.5-percentage-point government contribution to personal accounts from the OASDI Trust Funds only when the ratio of Trust Fund assets exceed 200 percent of the projected cost of the program for the following year. Otherwise the government contribution would be made from the General Fund of the Treasury. The third modification is to provide additional transfers from the General Fund of the Treasury to the Trust Funds whenever the assets fall below 90 percent (rather than 100 percent) of the projected cost of the OASDI program for the following year.

A. Proposal Specifications 

The proposal is described as having three parts. The first two parts include basic provisions that would modify revenue and benefits for the current OASDI program, and would restore long-range (75-year) solvency under the intermediate assumptions of the 2001 Trustees Report. The third part would provide for voluntary personal accounts, with benefit offsets, and would include an additional provision to assure sustainable solvency for the OASDI program through the next 75 years and beyond.

Part 1. Basic Provision for Payroll Tax Contributions Above the Current Maximum

a) Under current law, the OASDI payroll tax contribution rate (for wages and salaries the contribution is split between the employee and the employer) is scheduled to be 12.4 percent of covered earnings up to the taxable maximum amount, which is $84,900 for 2002. This provision would provide for a payroll tax contribution rate of 3.9 percent for OASDI covered earnings in excess of the current-law "full-rate" taxable maximum amount starting in 2004.

b) For the purpose of OASDI benefit computation, earnings subject to the 3.9-percent payroll tax contribution rate would be credited in a proportionate manner. Specifically, covered earnings for each year 2004 and later that are beyond the full-rate taxable maximum would be multiplied by 3.9/12.4 and added to earnings up to the full-rate taxable maximum amount. This adjusted taxable earnings amount would be used in computing the Social Security average indexed monthly earnings (AIME) used in the computation of benefit amounts.

This provision (Part 1) alone would reduce the long-range actuarial deficit by about 0.57 percent of taxable payroll. However, if earnings above the full-rate taxable maximum were not credited in computing OASDI benefits, then a similar overall financial effect would be achieved with about a 2.9 percent payroll tax contribution rate. 

Part 2. Additional Basic Provision for Solvency

a.1) *Longevity-Indexed Benefits*: This provision would slow the growth across generations in the primary insurance amount (PIA) for all OASDI beneficiaries by an amount that would roughly offset the effects of increasing longevity on the average duration of benefit receipt for aged beneficiaries. Initially, PIA factors (90, 32, and 15) would be scheduled to be adjusted by a successive multiplier of 0.995 annually beginning 2009. This is about one-half the expected effect of "CPI-Indexing". This adjustment reduces monthly benefit levels by an amount that is roughly equivalent to increasing the normal retirement age (NRA) for retired workers by enough to maintain a constant life expectancy at NRA, for any fixed age of benefit entitlement. Calculations of this adjustment use the mortality assumptions for the intermediate estimates of the 2001 OASDI Trustees Report and the actuarial reduction factors in current law. Under this provision, the 0.995 multiplier would be updated every 10 years (starting after 2010) to reflect actual historical increases in longevity as determined by the Social Security Administration for the most recent decade (as 2000 to 2010 for the first adjustment) and actuarial reduction factors in current law (without regard to the other provisions of this proposal). Note that this provision would apply in addition to the NRA increase already scheduled in current law. This provision alone would increase the size of the long-range OASDI actuarial balance (reduce the actuarial deficit) by an estimated 1.17 percent of taxable payroll.

a.2) *Reduce Benefits for High Earners*: Gradually reduce the third PIA factor, from 15 to 10, by 0.25 per year from 2009 through 2028. This reduction would be applied each year to the original 15 factor, prior to applying the cumulative effect of provision 1. This provision alone would increase the size of the long-range OASDI actuarial balance (reduce the actuarial deficit) by an estimated 0.16 percent of taxable payroll. The incremental effect of this provision after provision a.1 would be to increase the size of the long-range OASDI actuarial balance by an estimated 0.14 percent of taxable payroll.

b) *Modify Actuarial Reduction and Increment Factors*: This provision is intended to provide a greater marginal incentive to work past the retirement earliest eligibility age (EEA). The chart below displays the proposed monthly early retirement reductions that would be applicable for retired worker beneficiaries for the first 36 months for which benefits are received prior to NRA under both current law and the provision. (Different factors apply to aged spouse beneficiaries and aged widow beneficiaries.)

| Age 62 in:  | 2008   | 2009   | 2010   | 2011   | 2012   | 2013+  |
|-------------|--------|--------|--------|--------|--------|--------|
| Present Law | 20/36% | 20/36% | 20/36% | 20/36% | 20/36% | 20/36% |
| Model 3     | 20/36% | 21/36% | 22/36% | 23/36% | 24/36% | 25/36% |

Similar increases for aged spouse beneficiaries would be applied, increasing the monthly reduction for the first 36 months of entitlement before NRA from 25/36 percent under present law to 30/36 percent under the provision.

The reductions that are proposed for the fourth and fifth year of benefit entitlement before NRA are 12/24% per month (current law reductions are 10/24% per month) for both retired worker and aged spouse beneficiaries. The reductions for the fourth and fifth year of entitlement before NRA are applicable to all new eligibles who reach age 62 after 2008.

The ultimate percentages of PIA payable for retired workers by age at initial benefit entitlement are shown in the table below. 

| Age at Initial Entitlement: | NRA-5 | NRA-4 | NRA-3 | NRA-2 | NRA-1 | NRA |
|-----------------------------|-------|-------|-------|-------|-------|-----|
| Present Law                 | 70    | 75    | 80    | 86.7  | 93.3  | 100 |
| Model 3                     | 63    | 69    | 75    | 83.3  | 91.7  | 100 |

The percentage of PIA payable for non-disabled aged widow beneficiaries newly eligible at age 60 would remain at 71.5 percent. The percentages payable for those newly eligible at ages between 60 and the NRA would scale linearly between 71.5 and 100 percent, as under present law. 

The delayed retirement credit (DRC) under present law is scheduled to increase to 8% per year for workers attaining age 65 after 2007. Under this provision, the DRC would continue to increase at the rate of 0.5 percentage point every two years, with the first new increase applied to those attaining age 65 in 2010. An ultimate factor of 10 percentage points per year would be reached for workers reaching 65 after 2015. The delayed retirement credit applies for those months between NRA and age 70 in which no retired worker benefit is received. 

| Age 65 in:  | 2008-09 | 2010-11 | 2012-13 | 2014-15 | 2016 & later |
|-------------|---------|---------|---------|---------|------------------|
| Present Law | 8       | 8       | 8       | 8       | 8                |
| Model 3     | 8       | 8.5     | 9       | 9.5     | 10               |

This provision alone would increase the size of the long-range OASDI actuarial balance (reduce the actuarial deficit) by an estimated 0.28 percent of taxable payroll.

c.1) *Enhanced Benefit Level for Low Earners*: This provision would gradually raise the PIA starting 2009 with an ultimate increase for 2018 and later of 12 percent (relative to the level provided under provisions 1 and 2 above) for 30-year minimum wage worker.1   The combined effect of provisions a.1 and c.1 on such workers is expected to be a PIA equal to 100 percent of the aged poverty level for 2018. Thereafter, the PIA would increase from one generation to the next at a rate that is expected to be about 0.5 percent per year faster than the growth in the CPI and the poverty level. Thus, PIA levels for such workers would be expected to rise to levels above 100 percent of the aged poverty level after 2018.

The following table illustrates the effect of the benefit enhancement for workers with low earnings.

| Number ofYears ofWork | Quarters ofCoverage(QCs) | **Average Earnings Level in Years Worked (2002 wage levels)** |
|-----------------------|--------------------------|---------------------------------------------------------------|
||