State sees burden in Bush funding idea

WASHINGTON -- President Bush is considering a controversial new source of revenue to help fix Social Security: shutting off the exemption from Social Security taxes of future state and local public employees who otherwise would be contributing to public pension plans.

For Massachusetts, where more than 300,000 public workers are exempt from the Social Security tax, the change could end up costing taxpayers billions of dollars, according to state officials.

One proposal under discussion at the White House would preserve the exemption from Social Security tax for state and local workers who do not have to pay it but would cut off the exemption for new workers.

If the proposal were enacted, state and local governments would have to compensate for the decrease in money flowing into pension plans from new employees. In addition, state and local governments would have to start paying millions a year as the employers' share of Social Security tax.

While Bush is considering many options in his drive to overhaul Social Security, his press spokesman, Trent Duffy, said in an interview last week that the idea of ending the exemption from Social Security for new public workers is on the table.

''To the extent that is an idea that may be part of a final solution, the president would be open to it," Duffy said. ''It is something that should be studied and be part of an overall discussion."

Massachusetts officials say their system works far better than the current Social Security system and indicate they will fight any proposal that attempts to alter it.

There are 106 public retirement plans in Massachusetts. Most of the public school teachers in Massachusetts, for example, contribute to a pension plan that pays an average annual benefit of about $27,000. State workers get an average pension payment of $20,513. By comparison, Social Security pays an annual average benefit of $11,400.

State Treasurer Timothy P. Cahill said that ending the exemption would be a ''disaster" for Bay State public workers and taxpayers, as well as for the Social Security system. One study indicated that Massachusetts taxpayers would have to supply $2 billion over a five-year period to compensate for the change.

''It would make more sense for the federal government to look at our system as a model, as opposed to opting into their model, which is clearly broken," Cahill said.

He said he is aware the idea of ending the exemption is attractive to some White House planners because it would bring in a ''huge infusion" of Social Security taxes, at least in the short term.

Notably, the AARP, which represents 35 million older Americans, endorsed the idea of ending the exemption for public employees in a Feb. 9 briefing paper. The AARP calculated that requiring new public workers to pay Social Security taxes would cut the program's shortfall by 9 percent in the short term, although some analysts say new revenue would be offset by the need to pay future benefits for new enrollees.

Nationwide, about 5 million public workers, or 25 percent of those in state and local public employment, do not pay Social Security taxes. The bulk of the exempt workers are in seven states: California, Colorado, Illinois, Louisiana, Massachusetts, Ohio, and Texas. The exemptions are allowed because Social Security originally covered workers only in the private sector. Many public workers were covered by pension plans before Social Security was created.

Several public pensions in Massachusetts, for example, began in the early 1900s providing a model for the federal system. The federal government eventually offered to provide Social Security to all public employees, but gave existing pension plans the right to opt out of the federal system. Massachusetts officials have chosen to remain out of the Social Security system for nearly all public employees.

Many of those fighting hardest against Bush's idea for private investment accounts in Social Security are labor unions that are also fighting to ensure that the 5 million public workers nationwide remain exempt from the Social Security system and can stay in public pension plans that invest in the stock market.

The American Federation of Teachers, for example, ''is a very strong supporter of the Social Security system but also a strong supporter of the existing plans outside the Social Security system," said the organization's chief congressional lobbyist, Bill Cunningham. He stressed that Bush's plan relies on private accounts managed by individuals, while the pension investments are pooled together and decisions are made by professional money managers.

Critics say the unions are trying to have it both ways: fighting the Bush plan on grounds that private accounts are too risky, while fighting to ensure that 5 million workers are exempt from Social Security and thus able to benefit from pension plans that rely on stock market investments.

''Clearly it is hypocrisy to have the security of private investment and then claim that this would somehow be risky if everyday people had that opportunity with their Social Security money," said Scott Hodge, president of the Tax Foundation, a think tank. ''If those [pension] funds did not grow in value over time, then they would not be able to pay their promised benefits."

The Massachusetts Pension Reserves Management Board, which controls the investments for most Massachusetts teachers and many state employees, puts far more money into stocks and potentially riskier investments than Bush has proposed be allowed in private accounts. Many city and town governments in Massachusetts also run separate pension plans for their employees.

It is difficult to compare Social Security and the public pensions because many of the pensions plans have different rates of contribution and benefits. But in general, the unions representing many of the 5 million workers in public pension plans nationwide say public workers prefer their system of benefits, which often are higher than Social Security, even if they have to contribute at a higher rate than the Social Security tax rate. Bush has proposed that all American workers be given the option of putting up to four percentage points out of the total 12.4 percent of Social Security tax paid by employees and employers into private accounts, with investments restricted to a small pool of relatively conservative mutual funds.

The Massachusetts plan for most teachers and state employees, by comparison, has 57 percent of its assets in equities, including 21 percent in international investments as part of an effort to diversify and lower the overall risk, state officials said. The fund also puts money into real estate, timber, and other investments. Last year, the state fund also placed 5 percent of its assets in hedge funds, which can bring higher returns than a more conservative investment like a stock index fund but also carry higher risks.

Before those moves, the fund had declined in value over a three-year period ending in 2002. After the investments were broadened, the fund had a return of 26 percent in 2003, followed by a 14 percent return last year. This two-year spurt helped increase the fund's assets from $26 billion to $36 billion. The fund has an average annual rate of return since 1985 of 11 percent. Unlike what Bush is proposing, the worker in the state plan gets a fixed, guaranteed pension that does not directly reflect ups and downs in the market; under Bush's plan, a retiree's pension would be affected by gains or losses in his investments.

''For Massachusetts, and the state's teachers, we have done very well in the markets and have moved to fiscal solvency with our retirement system," said Sean P. Neilon, assistant executive director of the Massachusetts Teachers' Retirement Board. He noted that teachers put 11 percent of their salary into the pension fund.

For comparison, the Social Security tax is 12.4 percent, divided evenly between employee and employer. If the comparison is viewed strictly as one solely involving employee contributions, the Massachusetts teachers pay a higher rate: 11 percent vs. 6.2 percent. But Neilon said the teachers like the higher benefits. And some longer-serving teachers paid contributions as low as 5 percent.

The state is now helping to make up for those lower contributions, with much of the $1.2 billion from general revenues going annually to support the fund that pays benefits to teachers and most state workers. But state officials said the fund should be financed through payroll contributions in about 20 years.

Bush has backed only the idea of private accounts controlled by individuals, and he has opposed suggestions that the trust funds -- currently invested in US Treasury bonds -- be put in the stock market in a manner similar to pension fund investments. The White House has noted that the Federal Reserve Board chairman, Alan Greenspan, who has been generally supportive of Bush's proposal for private accounts, has opposed investing Social Security trust funds directly in the stock market.

But to Massachusetts officials, the problems with Social Security have a familiar ring. In 1983, the state's public pension plans were run in a manner similar to Social Security, with the system rapidly going broke as it relied on contributions from younger workers to support a growing number of beneficiaries. Part of the solution was to allow public pension funds to be invested in the stock market.

Duffy, the White House spokesman, said one problem with the direct investment of Social Security trust funds in the market is the ''temptation and the risk of political manipulation in the markets buying and selling politically correct stocks and bonds." For that and other reasons, Duffy said, ''the president is dead set against the government investing directly in the markets."

The Massachusetts Legislature prevents the state pension funds from investing in tobacco stocks. The California Public Employees' Retirement System is famous for trying to influence the decisions of some corporations in which it holds stock. Proponents of investing the Social Security trust fund in stocks said that these problems could be eliminated by putting the money in index funds, which mirror broad stock categories without direct management.