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New Blood for Social Security

Friday, July 23, 2010

Should public-sector pensions shift their workers to Social Security?

This week’s New York Times discusses state governments that are thinking of shifting employees from their current pension plans into the federal Social Security program. Unlike private-sector workers, who are required to participate in Social Security, state and local governments have been given a choice. In a number of states workers aren’t enrolled in Social Security and instead rely on their own pension plans.

But as public-sector pensions have become more clearly underfunded, some policy makers are considering shifting workers into Social Security. According to the Times:

Maine legislators have prepared a detailed plan for shifting state employees into Social Security and are considering whether to adopt it. They acknowledge it will not solve their problem in the short term but see long-term advantages. Some variation on this idea could ultimately appeal to other states grappling with their own exploding pension costs and, in extreme cases, quietly looking for help from Washington. In troubled states, some employees have wondered whether they might be allowed to begin paying in and collecting from the federal system even before they have contributed a career’s worth of taxes.

If public-sector workers were shifted to Social Security, workers could expect to receive back only around 60 percent of the contributions they and their employers make to the system.

But is this a good idea? Will it help states fund their pensions and make state workers better off? As critical as I have been of public-sector pension financing, I suspect the answer to both questions is no.

First, will shifting state workers to Social Security reduce state pension underfunding? Probably not. State pension funding shortfalls—which the states themselves acknowledge to be around $500 billion, but which I estimate to be more than $3 trillion—represent the difference between what state pensions already owe and the assets they have on hand. Even assuming that a shift to Social Security would prevent the problem from getting worse—and it’s not clear it would, given that state workers would almost certainly try to retain some elements of their over-generous pensions—it wouldn’t solve the existing problem. States are $3 trillion in the hole and they’ll have to come up with that money, one way or the other.

But going forward, would a shift to Social Security make sense? Would it provide benefits more affordably than current state pensions or a reformed defined contribution approach might? Again, probably not. The reasoning is complex—which may explain why state lawmakers seem not to understand it—but worth figuring out.

To be frank, there’s a reason that many reform proposals would mandate that newly hired state and local workers enroll in Social Security. Whatever the merits of the Social Security program, these policies aren’t contemplated because they would be good for public-sector workers. It’s because, on average, these individuals will pay more taxes into the program than they’ll receive back in benefits.

This publication from Social Security’s actuaries measures the ratio of benefits received to taxes paid for a variety of worker types. This measure is called the “money’s worth ratio” and reflects how well a participant is treated by the program. If the ratio equals one it means that the person received benefits exactly equal to their taxes, plus interest at the trust-fund bond rate. A ratio of less than one means a bad deal for the workers, while a ratio greater than one implies a good deal.

Will shifting state workers to Social Security reduce state pension underfunding? Probably not.

According to the Social Security Administration’s actuaries, a medium-wage male worker born in 1985—meaning someone who might be entering the workforce around now—will receive Social Security benefits equal to around 84 percent of his lifetime taxes. For a medium-wage female the ratio rises to 0.94, due to women’s longer lives, but nevertheless remains under one. So these folks are losing money, even if the system were fully solvent.

But most public-sector workers are better classified as “high wage,” meaning someone who earns around 160 percent of the average wage each year. For these folks a male would receive a money’s worth ratio of around 0.70 and a female around 0.78.

All these figures assume that Social Security faces no solvency problem; but once we account for Social Security’s inability to pay the full benefits it promises, these money’s worth ratios for high earners fall to 0.56 and 0.62. In other words, if public-sector workers were shifted to Social Security, workers could expect to receive back only around 60 percent of the contributions they and their employers make to the system.

If, by contrast, state and local governments simply set up new defined contribution pension accounts, similar to a private-sector 401(k) plan, they could be assured of receiving back in benefits every penny paid into the new system for the simple reason that there’s no place else for the money to go.

I can see why, for reasons of fairness, everyone else would want public-sector workers to participate in Social Security—since it evenly distributes the costs of supporting larger populations of seniors—but there isn’t much reason workers themselves would want in.

The fact that some public-sector workers do want to enter Social Security—and the New York Times finds a few who do—simply shows how poorly these workers understand the generosity of their own pensions and the strong legal protections for benefits accrued under them. Public pension benefits are a massive financing problem, but given that in most states accrued benefits are guaranteed either by legal precedents or state constitutions, they’re a problem for everyone but the workers slated to receive them.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute. From 2008 to 2009 he served as principal deputy commissioner of the Social Security Administration and as secretary of the Social Security Board of Trustees.

FURTHER READING: Biggs most recently discussed public pensions in New Jersey as “No Garden-Variety Public Pension Crisis,” questioned whether we should “Tax to the Max?” on Social Security, and asked, “Should We Raise Taxes on the Middle Class? We Already Are,” and “Are Government Workers Underpaid? No.” His other work includes a look at “The Market Value of Public-Sector Pension Deficits” and a forecast for the “Entitlement Apocalypse.”

Image by Rob Green/Bergman Group.

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