The Region

Paying for Retirement: A Global Template

Key changes to a mandatory saving-for-retirement plan could smooth a transition for retirees and workers

Ann Harrington | Senior Writer

Published October 19, 2016

How do you solve a problem like Social Security? The pay-as-you-go system used in the United States, in which workers’ payroll deductions support those who have already retired, seems headed for demographic disaster as fewer and fewer workers are available to support ever-increasing numbers of retirees.

Social Security is already the single biggest item in the federal budget, and Medicare is not far behind. Both entitlements are now paying out more than they are taking in from payroll taxes, and the surge of baby boomer retirees will draw down reserves. Social Security’s trust fund is expected to run out by 2035; Medicare’s reserves are projected to last only until 2028.

The situation has generated much hand-wringing and a few proposals, but little action by policymakers.

Some argue that rather than try to shore up the existing system, the United States should replace it with a mandatory individual savings program akin to those in Australia, Britain and New Zealand. While the change could be beneficial in the long run, critics note that making the transition could be a sticking point: If payroll deductions ended, where would the money come from to support those already retired?

The complexity of forecasting outcomes of various options paralyzes analysts and politicians who try to solve the transition. And it’s a problem that confronts nations globally where, just like in the United States, fewer workers are supporting retirement for more retirees.

Path to a solution

A Minneapolis Fed staff report (SR 472) earlier this year, “On Financing Retirement with an Aging Population,” tackled that transition problem and found a path to a solution. Consultant Ellen McGrattan, a professor of economics at the University of Minnesota, and Senior Monetary Adviser Edward Prescott, the W.P. Carey Chair in Economics at Arizona State University, came up with a plan that with a few key adjustments allows for a smooth transition to an individual savings program. They concluded that their plan significantly improves the welfare of all current and future generations across different levels of productivity, as measured by income.

Ellen McGrattan

A plan that makes everybody better off sounds good, of course. But McGrattan and Prescott weren’t satisfied. Realizing that the complexity of their model made it cumbersome for policymakers to use, they decided to see if they could get similar results with a simpler model. Their new staff report (SR 534), “An Aggregate Model for Policy Analysis with Demographic Change,” is the result. In this simplified model, participants differ only by age; the more complex earlier model included different levels of income as well. Once again, the economists found that a move to mandatory individual retirement accounts produced robust positive outcomes for all generations. The key advantage to this model, however, is that the streamlined framework is easier for policymakers in the United States and other countries to match to data from their national accounts.

McGrattan and Prescott propose a mandatory retirement savings program that could be implemented in the form of an annuity or by other methods. They construct their model based on data from the U.S. economy between 2000 and 2010, keeping all federal spending percentages constant except for Social Security and Medicare, which phase out. Their simulations incorporate a demographic change in the number of workers per retiree falling from 3.93 (the level in 2005) to 2.40 by the end of the changeover.

Smoothing the transition

To smooth the transition to a saving-for-retirement system, the economists propose three key adjustments. First, they suggest phasing out payroll deductions faster than payments to retirees. This provides an immediate benefit to workers—lower payroll taxes—while maintaining benefits for those who are no longer working. So where will the money to pay retirees come from? The answer is another adjustment: Broaden the tax base by suspending the deductibility of certain fringe benefits employers pay, such as insurance, at least temporarily. A third key adjustment: Lower marginal tax rates (again, at least temporarily), thereby removing a disincentive for workers to earn additional income.

A move to mandatory individual retirement accounts produced robust positive outcomes for all. The key advantage to this model, however, is that the streamlined framework is easier for policymakers to use.

The economists assume that if the United States continues with its current system, taxes would have to be raised to pay increasing obligations to retirees. Under their proposal, by contrast, tax revenues would decline substantially. Of course, that’s no longer a problem if Social Security and Medicare are eliminated.

The calculations depend in part on a more expansive definition of capital than is commonly used. It includes consumer durables, inventories, land and intangible capital, resulting in a productive capital estimate of 5.8 times gross national product (GNP)—roughly twice the estimates typically found in such analyses. But by incorporating these elements into their framework, McGrattan and Prescott say, they are able to measure the broader welfare gains from reform.

Better off

The authors calculate that the nation as a whole, across all age groups, would be dramatically better off if their proposed reforms were enacted. By comparison, economic forecasts are dire if the United States keeps its existing entitlement system. For example, McGrattan and Prescott figure that under the current system, GNP would fall 6.3 percentage points below current trend. But if their proposal were enacted permanently, GNP would rise 13.2 percentage points, for a total gain of 19.5 percentage points compared with the current system.

Edward Prescott
Edward Prescott

Similarly, household net worth would drop 4.5 percentage points under the current system, but rise 21.2 percentage points under reform, for a total gain of 25.7 percentage points.

Those are eye-popping numbers, but this may be one instance where the numbers are not the most important part of the model.

The economists built this aggregate model to see if they could produce good results similar to their earlier study using a simpler framework. They succeeded. The simpler model provides a close substitute that is much easier to use.

And that, after all, is the point: McGrattan and Prescott want their model to be used. The paper concludes: “Our hope is that its simplicity can be exploited by policymakers who need timely analysis.”

If ever there were a case for timely exploitation, Social Security is it.