US Should Study Swedish and German Social Security Reform

7/30/2019 US Should Study Swedish and German Social Security Reform

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U.S. Should Study Swedish and

German Social Security Reforms

by James C. Capretta

Reprinted from Tax Notes Intl, October 23, 2006, p. 289

Volume 44, Number 4 October 23, 2006


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U.S. Should Study Swedish and GermanSocial Security Reforms

by James C. Capretta

In recent weeks, both U.S. President George W.

Bush and new Treasury Secretary Henry Paulsonhave made it clear they are planning another effortto rein in future spending on the highly popular, butexpensive, federal entitlement programs: Social Se-curity, Medicare, and Medicaid.

That is good news for the country, if not for anadministration already stretched by its currentagenda. Projections show that, left unchecked, thosethree programs alone will swallow up every avail-able tax dollar and then some.

Unfortunately, the time available for reform isrunning short, as the baby-boom generation is onthe verge of joining the ranks of Social Security and

Medicare beneficiaries in large numbers. Accordingto the U.S. Census Bureau, in 2005, 2.2 millionAmericans turned 65. In 2015 the cohort of new65-year-olds will be more than 50 percent larger at 3.4 million. And in 2025 the number of peopleturning 65 will be 4.2 million. The population aged65 and older will nearly double in 25 years, from 37million in 2005 to 70 million in 2030.

The unprecedented aging of the U.S. populationwill put tremendous pressure on the federal budget.

According to the Congressional Budget Office, be-tween 2010 and 2030, spending on the big threeentitlements will go from 9.2 percent to 15.2 percentof gross domestic product using intermediate as-sumptions a 6 percentage point increase in just 20years.

Bushs attempt in 2005 to start the entitlementreform process with Social Security showed just howsteep the hill is for would-be reformers. It is no

accident that Social Security hasnt changed in anysignificant way in more than two decades. With noimminent crisis, U.S. politicians have found it rela-tively easy to delay the tough decisions on entitle-ments even as the budget crunch draws near.

Thats not the case for most of Europes statepension programs. With plummeting birth rates,rapidly aging populations, and expensive benefitformulas, governments throughout Europe havebeen forced to act some more decisively thanothers to head off the financial train wrecks thatwere, and in some cases still are, already upon them.

Usually, U.S. policymakers look to Europe to

determine what not to do when it comes to socialwelfare policy. And, in fact, most of Europe remainsin a deeper hole than the United States in terms ofthe long-term fiscal implications of populationaging, as their state pension programs remain fartoo expensive, even after implementation of somefar-reaching reforms. Nonetheless, as the sayinggoes, when you are in a hole, the prudent first stepis to stop digging, and the United States can indeedgain insight into how to stop digging the entitle-ment hole by studying the reforms some of their

James C. Capretta is a fellow at the Ethicsand Public Policy Center and was an associatedirector in the Office of Management and Bud-

get from 2001 to 2004.

Viewpoints

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European counterparts implemented to cut theirlong-term pension commitments.

In particular, Swedish and German pension re-forms deserve careful attention.

In the 1990s, facing steep tax hikes necessary topreserve the status quo, Sweden adopted a radicalnew approach to pension financing. The multipartycoalition embracing reform chose to design the newpension system within a budget fixed at 16percent of covered wages. To hit that target, Swedenchanged the pension entitlement from a definedbenefit to a notional defined contribution. Workerspayroll tax contributions are treated like contribu-tions into an investment fund even though theactual tax payments are used to finance benefits forcurrent retirees. The contributions are tracked sepa-rately and credited with a default rate of returnequal to growth in average wages in the economy.

To keep actual pension payouts within available

revenue, Sweden has incorporated two self-adjusting features into the notional accounts.

First, the account balances are converted intobenefits by way of an annuity divisor effectivelydividing the notional account balance into monthlybenefits over the expected life span of the retiree.Importantly, the divisor is updated each year to staycurrent with measured advances in longevity. So, asretirees live longer, the monthly annuity paid outfrom a fixed notional balance will automaticallydecline with successive cohorts unless the pension-ers choose to begin taking their benefits later in lifethan those who retired before them. An increase in

the retirement age for benefit eligibility bringsimportant economic benefits that the annuity divi-sor lacks such as stronger incentives for contin-ued work. Nonetheless, with the annuity divisor,Sweden no longer has to worry about adjustingbenefits to offset the added costs of increased lon-gevity it happens automatically.

Second, Sweden adopted an automatic balancemechanism. Each year, the government determineshow much interest earnings can be applied to thenotional balances without exceeding available pay-roll tax revenue. The critical demographic and eco-nomic factors such as the size of the workforce,

total payroll tax payments, and the age of workersrelative to pensioners are then combined into asummary measure of the systems assets. If assetsfall below projected liabilities, the default rate ofreturn earned in the notional accounts is automati-cally cut to keep the system in balance. If, forinstance, fertility continues to trend downward, theaverage age of workers will eventually creep up-ward, reducing the value of the systems measuredassets, which will, in turn, force a lower return onthe notional balances.

The government projects that updating the annu-ity divisor annually will cut average monthly ben-efits for those continuing to retire at age 65 by 14percent by 2055 which is equivalent to a delay intheir retirement of 26 months. It also projects thatthe automatic balance mechanism will be triggeredonly a few times in coming years. Under more

pessimistic assumptions, however, the automaticbalance mechanism would be triggered more or lesscontinuously beginning in 2008, automatically driv-ing down the replacement rates for retirees forseveral decades. Either way, however, the systemwould remain financially solvent at the 16 percentpayroll tax rate.

Germany has been less aggressive than Sweden,and the system remains far too expensive. Nonethe-less, in 2004 the government took an important stepby establishing a link between annual pension in-dexing and changes over time in the ratio of pen-sioners to workers supporting the system the

so-called sustainability factor. All German pensions for new retirees and those who retired in earlieryears are tied to the same basic pension valuecomponent, which in turn is indexed to annual wagegrowth. Adjusting the pension value component bythe sustainability factor will have a powerful stabi-lizing effect on the pension system because it willlower pension payouts for all German retirees as thepensioner-to-worker ratio increases over time. Thesustainability factor is expected to cut the necessarypayroll tax by 4 percentage points in 2040, from 28percent of wages to just under 24 percent.

U.S. policymakers should look to build similar

automatic adjustment mechanisms into Social Secu-rity. For instance, the age at which full benefits arepaid should be automatically adjusted to reflectongoing improvements in average life spans. WhenSocial Security began, men retiring at 65 couldexpect to get benefits for 12 years. Today, a maleretiree at 65 will get benefits for 16 years, andfurther improvements in longevity are expected inthe years ahead. It should be obvious that everlonger periods of retirement will eventually becomeunaffordable (without more robust populationgrowth), and automatic adjustment provision for thefull benefit retirement age is a simple recognition ofthat fact.

The United States should also consider buildinginto initial benefit payments a German-style sus-tainability factor. As the ratio of beneficiaries toworkers increases, a new dependency ratio factorcould be applied to the benefit formula, effectivelyreducing benefits payable to new retirees to keepthem in line with the level that can be supportedwith the current payroll tax rate. Once in paymentstatus, beneficiaries would get full inflation protec-tion with annual cost-of-living increases.

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Building automatic adjustment mechanisms intoSocial Security has important advantages over moredirect benefit cuts and tax increases. First, if currentprojections are wrong as they inevitably will be the automatic provisions are self-correcting. Thatshould be attractive to both optimists and pessi-mists. Second, it may be easier for Congress to pass

mechanistic provisions with more uncertain impli-cations for future benefits than changes that moreclearly and directly cut benefits.

No one should be under the illusion, however, thatany version of Social Security reform will be easy topass. But it is almost certain that a reform will pass eventually. The disruptions caused by the statusquo will become unbearable at some point. Whenthat time comes, the United States could steal apage from the Europeans who have been there.

Viewpoints

Tax Notes International October 23, 2006 291

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US Should Study Swedish and German Social Security Reform