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Robert C. Pozen

Myth busters

The truth about Social Security reform

By Robert C. Pozen
December 12, 2010

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ERSKINE BOWLES and Alan Simpson, co-chairmen of the Budget Commission, have unleashed a storm of criticism by their proposal to reform Social Security. However, many of these criticisms are based on myths about the current state of Social Security or their proposal to reform the benefit program.

Myth #1: The current US system for retirement benefits subsidizes low-wage earners.

Most of the government subsidies for retirement benefits take the form of deferred taxation of contributions to private retirement plans and the earnings on such contributions. These contributions and earnings are taxed only when paid out to plan participants during retirement.

The value of this tax deferral is huge for participants in defined contribution plans such as 401(k)s and IRAs. Each year the federal government does not receive income taxes on over $100 billion of income related to private retirement plans. Most of these tax deferrals accrue to the benefit of workers earnings more than $30,000 per year. Few workers earning less than $30,000 annually participate in any type of private retirement plan.

Myth #2: The current structure of Social Security is progressive by income group.

Social Security is usually considered progressive because high-wage workers receive less in Social Security benefits than low-wage workers for every dollar contributed to the system. However, low-wage workers live on average two years less than affluent workers. These differences in life expectancy neutralize the higher ratio of benefits to contributions enjoyed by low-wage workers as compared to affluent workers.

Consider two workers both retiring at age 65. The first receives $20,000 per year and dies after 20 years. That means lifetime benefits of Social Security of $400,000. The second worker, by contrast, receives $22,000 per year and lives for 18 years. That means lifetime benefits of Social Security of only $396,000.

Myth #3: The Budget Commission’s proposal raises retirement age too quickly, especially for physical laborers.

Normal retirement age is currently scheduled to rise to 67 for those retiring in 2027. The proposal is to continue in 2027 by gradually raising the retirement age to 69 for those retiring in 2075. This is a much slower pace for increases in the retirement age than the projected increases in life expectancy. During the 48 years between 2027 and 2075, the normal retirement age will rise by only two years, but life expectancy in the United States will on average rise by more than 10 years.

In their proposal to reform Social Security, the co-chairs would allow physical laborers to claim half of their benefits early and the other half at a later date. Moreover, the proposal directs the Social Security Administration to develop a new and more flexible method for delivering retirement benefits for those in “physical labor jobs.’’

Myth #4: The proposal would constitute a large “cut’’ in Social Security benefits for American workers.

The proposal would actually increase the current schedule of Social Security benefits for low-wage workers. It accomplishes this result by expanding the concept of minimum benefits available to any worker.

The schedule of benefits for more affluent workers would be decreased as compared to the current schedule. But is this the proper comparison? The current schedule for Social Security benefits is not financially sustainable. Actuaries have estimated that the benefits for all workers will be reduced by almost one-fourth if we do not reform Social Security by 2038. And this estimate does not include the $120 billion in decreased payroll taxes during 2011-2012 — which Congress will probably approve before Christmas.

In short, to become progressive, Social Security needs to be reformed along the lines of the proposals by the Budget Commission. Viewed from the perspective of total lifetime benefits, the current system is neutral. Viewed from the perspective of government subsidies to all types of retirement plans, the current system is regressive.

Other aspects of the proposal are reasonable when put into a factually accurate context. The proposal moves back retirement age at a much slower pace than life expectancy, and it addresses the special problems of physical laborers facing later retirement dates. Most importantly, it is overly simplistic to say that the proposal “cuts’’ Social Security benefits because the current system has only enough money to finance three-quarters of scheduled benefits starting in 2038.

Robert C. Pozen is senior lecturer of business administration at Harvard Business School and chairman emeritus of MFS Investment Management.