David C. Dellinger, Ph. D.
January 2011


For about the same revenue increases and benefits reductions which would be required to extend the life of the current Social Security system, the current system could be phased out and replaced by a reformed, sustainable bipartisan system. A model for a bipartisan system is proposed which includes individual stock market accounts, all the safety net features of the current system and a retirement income insurance feature which guarantees a livable retirement income for American workers in a global economy.


Conservatives want to privatize the social security system so that retirees can enjoy the benefits of the higher returns available in the stock market, but retirees would have to accept the risks associated with poor market performance. Liberals want to maintain the safety net features of the current system through a guaranteed retirement income indexed to inflation. Both want a sustainable system which would operate on the OASI portion of payroll taxes and not add to the growing government deficit. Why not design a bipartisan Social Security system which meets the basic objectives of both sides?

Such a system would embed individual retirement accounts in a sustainable, reformed Social Security system which retains all the basic safety net features of the present system and operates on less than the present level of payroll taxes. The individual accounts would be used only to provide Social Security benefits. Benefits for spouses would be reformed to accommodate two-worker families. The new system would include a Stock Fund, a Bond Fund, and a new feature, Income Insurance, which would guarantee a minimum retirement income at a livable level regardless of stock market performance or lifetime earnings.

*    Bond Fund -- Basic Social Security benefits which would be determined as if they were bond fund investments paying interest at the rate used to calculate interest on the Social Security Trust Fund, would be included. Eventually, the trust fund would become the bond fund.
*    Stock Fund -- The stock fund would invest in a broadly based portfolio of US stocks similar to index funds. The US stock market as a whole has produced average returns of around 10% including inflation, and investments held for long periods, as Social Security investments would be, have shown very little variation from that average. The fund would be managed by the Social Security Administration either in house, by contract with an investment firm, or, as proposed by the administration, picking a set of existing funds. The method would be chosen based on minimizing administrative costs.
*    Income Insurance -- The distinguishing feature of this system, Income Insurance, is social insurance in its truest form. It insures against the loss suffered when retirement income falls below the insured minimum, a specified multiple of the poverty level. When losses occur, it compensates by paying the amount of the loss. It provides a guaranteed lower limit on retirement income for beneficiaries throughout their retirement years. No upper limit is imposed on Social Security benefits, so the maximum level is limited only by market performance and lifetime earnings. A portion of Social Security Contributions would be designated as an income insurance premium.

The reformed system would cover all new workers as they enter the workforce and any workers now covered by the current system who elect to switch to the new system. The adjustments in revenue and benefits which would be required to extent the life of the present system would be used to phase out the current system over a forty or fifty year period. Analysis indicates that the current system could be phased out with a .5% decrease in the rate of growth of benefits and a temporary .5% increase in payroll taxes along with a combination of several proposals to extend the life of the current system, provided that 20% to 25% of the workers covered by the current system elect to switch to the reformed system. Benefit reductions would be progressive in order to protect those retirees programmed for the lowest benefits and an increase in payroll taxes would be required only during the phase out of the current system.

Illustration of an Investment / Insurance Social Security System

In the following illustration, all interest rates are in current dollars (uncorrected for inflation). The 5% rate on bond fund investments is the projected interest rate in the SS Trustee's report used to credit interest payments to the Social Security Trust Fund. The assumed inflation rate of 3% is also taken from the Trustees report. The 10% return (including inflation) from stock investments represents the historical average return for the entire US stock market (Ref 3). The system is modeled after the TIAA/CREF retirement system for educators and historical returns from the CREF accounts are used in the illustrations (Ref 4).

Suppose we adopt an Investment/Insurance Social Security system which operates on only the 10.6% of payroll taxes currently dedicated to Old Age and Survivor Insurance. This excludes Disability Insurance which is assumed to continue to provide disability benefits as in the present system. Under the proposed system, individual contributions to OASI would be distributed as follows:

a. 25% would be invested in individual accounts in the Social Security stock fund, an index fund which invests in a broadly diversified portfolio of US common stocks.
b. 25% would be credited to individual accounts in the Social Security bond fund for calculating a portion of future benefits.
c. 15% would be credited to the bond fund as Income Insurance premiums. Ten percent would be for income level insurance which would be used to bring first-year retirement benefits up to the minimum guaranteed income level. Any excess funds would be used to pay dividends that would increase retirement benefits. The other five percent is for income maintenance insurance which would be used to maintain incomes no lower than the minimum guaranteed level throughout the retirement years.
d. The remaining 35% of OASI would be credited to the Social Security Trust Fund to fund survivor and dependent benefits not covered by investments, to serve as an insurance reserve fund and to generally back the entire retirement system. When the trust fund reaches the point where it can adequately serve as the bond fund and an insurance reserve fund, any excess can be used to reduce payroll taxes, enhance survivors and disability benefits, fund individual retirement accounts, etc.

To illustrate how such a system would operate, consider a hypothetical group of workers all of whom enter the work force in the same year, work for a period of forty years, retire at the same time, and live in retirement for twenty years. The income growth patterns were selected to demonstrate how workers with different income patterns would fare under the system. The workers are subdivided into five groups according to income earned during their forty years in the workforce. All workers within each group earn the same pay throughout the forty years. The numbers in the table apply to a single individual in each group.

Tables 1, 2, and 3 show how the system would operate for individuals over a period of sixty years, forty years of work and 20 years of retirement. Table 1 shows individual earnings and investments during the working years and how investments would grow under the assumptions. Table 2 shows how initial retirement benefits would be determined and the role income level insurance plays in those calculations. Table 3 and Figure 1 show how retirement income would be maintained at or above the guaranteed level by income maintenance insurance throughout the retirement years.

EARNINGS AND INVESTMENT PERIOD. Section 1 of Table 1 shows the life time earnings for the five groups. Section 2 shows the distribution of OASI contributions (which exclude contributions to Disability Insurance) for the first year: Insurance Reserve 35%, Stock Fund 25%, Bond Fund 25%, and Income Insurance premiums 15%. Section 3 shows the cumulative value of the investments after forty years. Stock fund investments accumulated at 10%, and bond fund investments at 5%, to represent the interest rate at which interest is credited to the Social Security Trust Fund. The last column shows the cumulation of the 15% Income Insurance Premiums and the portions designated to provide income maintenance insurance (5%) and Income level insurance (10%).

INITIAL RETIREMENT INCOME CALCULATIONS. Income Insurance covers only those workers who spend a substantial portion of their lives in the work force. The insured income level is defined in terms of the poverty level for a retired couple. To be eligible for insurance, workers must spend at least twenty years in the work force. The insured minimum income for those with twenty years of covered employment is set at 100% of the poverty level in the year of retirement. The insured level increases with additional years worked to 150% of the poverty level at forty years. The poverty level is expected to increase with inflation during the retirement years. Those workers who would have spent less than twenty years in the workforce would receive benefits based only on their investments in the Social Security stock and bond funds and the cumulative value of their income insurance premiums. The retirement age in the reformed system is set at an arbitrary sixty years since, in this defined contribution system, age has no effect on the solvency of the system.

When workers decide to retire, they would have the option of converting the accumulated value of their funds into various types of lifetime annuities. These include fixed and graded annuities based on the bond fund and variable annuities based on the stock fund. Both graded and variable annuities are designed to increase during the retirement years to counter inflation, assumed to be 3%. (See Appendix C -- Annuities and Inflation.)

The minimum income is set at $18,000, assumed to be 150% of the property level for older Americans. If first-year benefits calculated as the annuity value of accumulated bond and stock funds fall below this $18,000 level, funds from Income Level Insurance would be used to make up the difference.

Table 2 illustrates how first year benefits are calculated for the five groups of workers. Section 1 shows the annuity values of the bond and stock funds for each group. The last column shows the annuity value of the Income Level Insurance which will be used to augment annuities if necessary. (It is assumed that these workers elect to invest bond fund returns in the bond annuity and stock fund returns in the stock fund annuity.) The bond fund annuity is a graded annuity which begins as if the annuity paid only 2% interest but is increased each year at about 5% so as to increase over the lifetime of the retiree. The stock fund annuity is a variable annuity which begins as if it were a 5% fixed annuity but is adjusted each year by the actual stock fund rate of return expected to average around 10%. Line 1c shows the value of the sum of the two annuities which would be the first year benefit without income insurance. Since Group 1 benefits are less than the guaranteed $18,000, a $3,789 annuity is added to the bond fund annuity to make up the difference. The annuity value of the remaining Income Level Insurance fund, $9,201, is awarded as dividends to the five groups based on their income insurance payments. Line 2c shows the resulting first year benefits. Line 3 illustrates the redistributive properties of income insurance.

ANNUAL RETIREMENT INCOME. Table 3 shows the annual retirement income for the five groups as it would vary if actual yearly returns were as shown in the third column. (These yearly returns were taken from a period of actual returns from the CREF stock fund. The equivalent twenty-year annual return, the constant return which would have produced the same results as these actual returns, was 7.7%. This period of unusually low returns was selected to demonstrate how income maintenance insurance operates, not as the expected rate of return. See Appendix A -- The CREF Stock Account.)

Note that the incomes of both Groups 1 and 2, shown in red, fall below the increasing minimum insurance level during the last half of the twenty-year period and that income maintenance insurance is necessary to make up the difference. Note also in the last column of the table that the 5% income maintenance insurance was more than adequate to meet these payments. The excess $189,059 would be added to the insurance reserve fund. Projected retirement income levels for other stock fund interest rates are provided in Appendix B.

Figure 1 shows the sources of the retirement income for Group 1. The green bars show the increasing graded bond fund annuity. The blue bars show the returns from the stock fund variable annuity. The red bars show how income insurance keeps the retirement income no lower than the increasing guaranteed minimum.

BASIC RETIREMENT BENEFITS would be determined and funded by the cumulative value of the stock and bond funds as shown above. So would most of the other benefits now paid by the current system. In cases where both spouses have separate Social Security accounts, the couple would have the option of pooling their accounts when converting to annuities or taking individual benefits. Retirees could elect joint life annuities which pay benefits until the second spouse dies. Spouses of workers who die before retiring are entitled to the same benefits the worker had acquired. Retirees' spouses who did not have Social Security retirement benefits of their own would be paid half of the retiree's benefits to assure that benefits are shared with the spouse. Disability Benefits would be funded by the Disability Insurance contributions as in the present system. Other benefits of the current system, such as dependent benefits, would be funded by a portion of the 35% of OASI set aside for that purpose.

Phasing Out the Current System

The reformed system and the current system would operate in parallel during the phase-out of the current system. Those in the new system would have 25% of their OASI contributions invested in the Social Security stock fund. Benefits to those remaining in the current system would be paid from the remainder of all OASI contributions and funds from the Social Security Trust Fund. In order to avoid insolvency during the phase-out, some reductions to benefits and/or increases in revenues to the system would be required.

The magnitude of the benefit reductions and revenue increases can be decreased by encouraging workers in the current system to switch to the new system. Those workers who switch would give up their claim to benefits under the current system, thereby reducing the cost of phasing out the old system. (Judging from the popularity of the administrations proposed personal accounts among younger workers, these workers would be especially likely to switch.)

In order to adopt this approach to reforming Social Security, policy makers would have to agree on the appropriate balance between benefit reductions and revenue increases, how to implement the reductions and increases, and how to create incentives to encourage workers in the current system to switch to the new system.

ADJUSTING REVENUES AND BENEFITS. Diamond and Orszag, in Saving Social Security, A Balanced Approach, have proposed several ways to adjust revenues and benefits in order to extend the life of the present system. Among them are:

*    Adjustments to normal retirement age for increasing life expectancy be made annually on the basis of contemporaneous estimates of life expectancy. Their recommendation would adjust both benefits and revenue and have the same effect as a .55% increase in payroll taxes.

*    Increasing the taxable earnings base. Their recommendation would increase revenues by .25%.

*    Retaining the Estate Tax in its 2009 form and dedicating the revenue to the Social Security system. This suggestion would increase revenues by .60%.

These three adjustments, if adopted, would have the same effect as increasing revenues by 1.4%. (Some of these adjustments may have to be accelerated.) If, in addition, the payroll tax rate were temporarily increased by .5% from 12.4% to 12.9%, and the rate of increase in benefits were reduced by .5%, the phase out of the current system could be accomplished without becoming insolvent, while maintaining the Trust Fund Ratio (the ratio of the Trust Fund Balance to total expenditures) at a minimum of 125%. The increase in payroll taxes could be covered by either a tax credit or a tax deduction to reduce the negative effect on workers, and the reduction in benefits in benefits could be applied progressively to protect workers with low lifetime earnings. The Operations of the OASI Trust Fund during the phase out with these adjustments are projected in Figure 2. (A 1% increase in revenues and no reduction in benefits would accomplish the same result.)

These projections are based on data from Table VI.F8 of the 2005 Trustees Report. Projections are in current dollars for OASI (Old Age and Survivors Insurance) operations and exclude both Disability Insurance income and benefits. It is assumed (worst case) that the 25% of workers switching are all those in their first ten years of their forty years of work, hence the decrease in benefits beginning in year 30 as the last of those remaining in the current system retire. Benefits from Social Security funds for those switching in their first year of work are included beginning in year 31.

Reduced Benefits as Percent of Programmed Benefits
  Year 5 10 15 20 25 30
  Reduced .5% 100.0% 98.1% 95.9% 93.6% 91.4% 89.3%
Progressively Reduced Benefits
Lowest Benefits Group 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Below Average Group 100.0% 99.1% 97.9% 96.8% 95.7% 94.6%
Average Benefits Group 100.0% 98.1% 95.9% 93.6% 91.4% 89.3%
Above Average Group 100.0% 97.2% 93.8% 90.5% 87.2% 83.9%
Highest Benefit Group 100.0% 96.3% 91.7% 87.3% 82.9% 78.6%

PROGRESSIVE BENEFIT REDUCTIONS. Figure 3 shows the projection of a .5% reduction in the rate of increase in first-year benefits over the thirty years during which those remaining in the current system would retire. As shown by the blue line, the reduction begins after the fifth year and gradually reduces first-year benefits to 89.3% of programmed benefits in the thirtieth year. This means that 89.3% of programmed benefits would be available to distribute among all those retiring in the thirtieth year. One way to distribute the reduction is a flat reduction in which the programmed benefits of each retiree is reduced by 10.7% to 89.3% of his or her originally programmed benefits. But such a reduction in benefits could be very damaging to those programmed to receive small benefits.

Progressive benefit reductions would spare those programmed to receive the smallest benefits the full impact of the reduction. One way to make such reductions is to divide all those eligible for first-year benefits in any one year into five groups, each of which is programmed to receive one-fifth of the total benefits programmed for that year. The first group would be made up of those programmed to receive the smallest benefits. The next group, those programmed to receive the next lowest benefits, etc. Each group would be assigned a different portion of the total reduction, with the lowest benefit group absorbing the smallest portion of the reduction and each group progressively absorbing a larger portion.

In this illustration, the group programmed for the lowest benefits would not have their benefits reduced at all. To balance this allocation, the group programmed for the highest benefits would have their benefits reduced by two times the flat reduction rate. Similarly, the group programmed to receive the second-lowest benefits would have their benefits reduced by one-half the flat reduction rate balanced by a reduction for the second highest benefit group of one and one-half times the flat reduction rate. For the 10.7% reduction in total benefits (to 89.3%) for those retiring in thirty years, the lowest benefit group would receive 100% of programmed benefits, the next higher group, 94.6% of programmed benefits, the average group 89.3%, the next highest, 83.9% and the highest group 78.6% as shown in the table under Figure 3.

Under this arrangement, an individual in the lowest benefit group, retiring in thirty years, programmed for first year retirement benefits of $500 per month would receive $447 under a flat reduction and $500 under the progressive reduction. An individual in the highest benefit group programmed for $1500 would receive $1340 under the flat reduction and $1179 with progressive reductions.

INCENTIVES TO ENCOURAGE WORKERS TO SWITCH SYSTEMS. As noted earlier, the youngest members of the work force were enthusiastic about the administration's proposal to add Social Security funded personal accounts to the American retirement system, and they would probably elect to switch to the new system. The assurance of a guaranteed livable retirement income regardless of market performance, the prospect of no limit on how large their retirement income could grow, and all the benefits of the current system should increase their desire to switch. But older workers who have fewer working years before retirement might be less likely to switch. There would be fewer years for their investments to grow and they might be cautious about giving up guaranteed benefits in the current system, even with the minor reductions in programmed benefits, for the uncertain prospects for investment growth. Several incentives which could encourage those at the margin include:

*    Allowing full credit in the bond fund for the years already worked under the current system.

*    Allowing full credit for years worked in calculating eligibility for income insurance.

*    To partially compensate for the fact that they will have fewer years for investment in the stock fund to grow, allow for additional investments in the stock fund covered by tax credits or deductions.

With incentives such as these, it is highly likely that 20% to 25% of the workers in the current system would switch to the new system. This is especially true for those who expect to have higher than average lifetime earnings since their higher Social Security contributions would result in larger investments in the stock fund and greater retirement benefits than those expected from the current system. Moreover, when these higher earners switch systems, a greater reduction in the liabilities of the current system results.


*    Provide a permanent solution to the long range solvency problem by replacing the current unsustainable system with a sustainable one.
*    Allow Social Security beneficiaries to enjoy the higher returns available through investments in US stocks.
*    Increase national savings.
*    Continue all the safety net features of the current system.
*    Provide a guaranteed livable retirement income for American workers in a global economy.


Appendix A -- The CREF Stock Account. Describes the performance of the CREF Stock Accounts from 1953 to 1999. CREF returns are used to illustrate the performance of the proposed Investment/Insurance Social Security System. Reference 4.

Appendix B -- Other Projections. Shows the projected performance of the Investment/Insurance Social Security System for assumed Stock Fund returns of 7%, CREF Returns, 12%, and 10% with twenty years of work.

Appendix C -- Annuities and Inflation. Describes graded and variable annuities which are used in the Investment/Insurance Social Security system and how they are designed to counter inflation. Reference 4.

Appendix D -- The Transition Model. Shows spread sheets used to make projections of the operations of the OASI Trust Fund during the transition.

Appendix E -- The Present System. Describes the present Social Security System and the long range solvency problem. Reference 1.

Appendix F -- Market Performance, 1802-1999. Reviews the performance of the US stock market from 1802 to 1999 with special attention to the stability of returns for long periods of time. References 3 and 4 .


1. Privatizing Social Security: The Troubling Tradeoffs. Brooking Institution Policy Brief #14, March 1997, by Gary Burtless and Barry Bosworth

2. The 2005 Annual Reports of the Board of Trustees of the Social Security and Medicare Trust Funds, OASDI Trustees Report

3. John Bogle on Investing, The First 50 Years, by John Bogle, 1998. McGraw Hill, ISBN 0-07-136438-2.

4. The following TIAA-CREF publications. TIAA-CREF, 730 Third Avenue, New York, NY 10017-3206.
       4a. Evaluating Your Retirement Income Portfolio, The TIAA-CREF Accounts, 2000
       4b. Choosing Income Options, 2001
       4c. How TIAA-CREF Variable Account Units Work, 1998

5. Saving Social Security: A Balanced Approach, by Peter A Diamond and Peter R. Orszag, 2004. Brookings Institution Press, Washington, DC.

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