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Guest Article

(Reprinted from The 401(k) Handbook, published by Thompson Publishing Group, Inc.)

How Social Security Reform May Affect Your 401(k)


by Martha Priddy Patterson, Contributing Editor

Increasing life expectancies and low birth rates are combining to create a crisis for the Social Security system. To address this, the Bush Administration has put together a commission charged with making recommendations to cure the problem, including the creation of personal Social Security accounts that would supplement fixed Social Security benefits. But personal accounts alone will not fix Social Security's problems. So employers, especially 401(k) plan sponsors, should be especially watchful of the commission's recommendations.

Financial Status of Social Security Now

While most people only think about Social Security as retirement benefits, the system actually covers almost every worker during their working life with disability and survivor benefits coverage-- two benefits no one looks forward to using. Social Security largely is a "pay as you go" system in which workers' payroll taxes today are used to pay the benefits for current recipients, including retirees and their spouses, minor children whose parents have died and disabled workers. Once today's workers become retirees, their benefits will be paid by those who are then in the workforce.

During the early days of Social Security, about 42 workers were paying into the system for every one recipient of benefits, but today only 3.4 workers are paying for every recipient. According to projections regarding life expectancy, birth rates and workforce demographics, by 2050 only two workers will be paying for each recipient.

Translated into actual dollars, the 2001 Annual Report of the Social Security Trustees projects that in 2016, current tax revenue from Social Security taxes will exceed benefits paid out of the Social Security combined trusts (covering retirement, disability and survivors). Social Security combined trusts and funds will be fully drawn out by 2038. At that time revenue from Social Security taxes will be sufficient to pay about 73 percent of benefits due that year. By 2075 Social Security tax revenues for that year would be able to pay only about 67 percent of the benefits, leaving the remainder to be paid from general federal revenues, or requiring benefits to be reduced by 33 percent.

To place these projections in context, as recently as 1998, the Trustees estimated that benefits paid would exceed income into the trust as early as 2013 and that the fund would be completely drawn down by 2032. Although progress has been made in the last three years in forestalling the erosion of Social Security's trust fund, many would argue that Social Security's financial condition improved since that time due to relatively unique factors including a booming economy, increased number of workers (consequently, increased amount of Social Security taxes), reduced inflation, the federal government's annual surpluses for a few years and a reduction in the overall federal debt. As the economy begins to soften, unemployment rises, and the federal budget begins to run annual deficits again, it is unrealistic to imagine that the date for Social Security's deficits can be pushed out indefinitely.

The Social Security Trustees' 2001 report estimates the long-range actuarial deficit between future benefits payments and Social Security tax revenue to be the equivalent of an additional 1.86 percent of taxable payroll. So, an overall increase in current Social Security taxes of 0.93 percent paid by both employees and employers could maintain solvency, with immediate action. Obviously, neither employers nor employees are clamoring to pay higher payroll taxes, so other solutions must be created.

President Bush's Commission on Social Security

President Bush's Commission to Strengthen Social Security was organized in late May to last for approximately seven months. The Commission, chaired by former Senator and Chairman of the Senate Finance Committee Daniel Patrick Moynihan and by Richard D. Parsons, Chief Operating Officer of AOL Time-Warner, includes 14 other members, all pledged to support the creation of individual accounts as part of any recommended Social Security changes.

According to the Commission's Web site, its charter is to make recommendations to modernize and restore fiscal soundness to Social Security, using six guiding principles:

  • Modernization must not change Social Security benefits for retirees or near-retirees.
  • The entire Social Security surplus must be dedicated only to Social Security.
  • Social Security payroll taxes must not be increased.
  • The government must not invest Social Security funds in the stock market.
  • Modernization must preserve Social Security's disability and survivors insurance programs.
  • Modernization must include the establishment of individually controlled, voluntary personal retirement accounts, which will augment Social Security.

There is a real need to address Social Security financing and the sooner this happens, the cheaper any "fixes" will be. So at one level, the prompt appointment of the Commission could be a good step. But in reality, the Commission's charter and interim report are so focused on personal accounts, it seems unlikely any meaningful discussion of correcting the imbalances in the system can be maintained.

401(k) Plan Sponsors' Stakes in Social Security Changes

Both 401(k) plan sponsors and employers have an enormous stake in the debate about changes to Social Security for many reasons.

  • Currently, the employer pays Social Security taxes of 6.2 percent of wages and withholds another 6.2 percent from the employee's wages. Any solution that increases payroll taxes will increase costs to the employer and reduce the take-home wages of employees, thus increasing pressure for additional wages.
  • If Social Security is changed to include personal investment accounts, 401(k) sponsors could see profound changes in the level of participation. Some workers may see the Social Security account as an alternative to saving in the 401(k), which may significantly affect nondiscrimination rules, resulting in lower contributions by all 401(k) participants.
  • Most employer pension plans whether explicitly, through benefits integrated with Social Security, or implicitly by setting the payment goals for these plans, assume the worker as a retiree will receive additional retirement income from Social Security. Reductions in benefits or reductions in or elimination of inflation indexing could increase existing pension plan costs or force material changes to employer plans.
  • Since 1990, more retirement benefit dollars have been paid from employer retirement plans than Social Security. Any law changes that discourage or limit private retirement plans will, in effect, reduce many future retirees' incomes and ultimately only increase the political and economic pressure on Social Security to supply higher retirement benefits.
  • Given that U.S. workers are now competing globally, any government-imposed tax or requirement that raises the cost of U.S. labor does not uniformly affect all employers. Any additional labor expense makes U.S. labor and goods less competitive for those employers engaged in international trade. In general the U.S. employment taxes and the social insurance programs funded by those taxes are far lower than in other industrialized nations. Changes to Social Security are not likely to reduce our competitive position with other industrialized countries, but may increase the existing gap in labor costs with less industrialized nations.
  • Changes in the Social Security retirement age will profoundly affect the demographics of the workforce. Raising Social Security retirement ages beyond the currently scheduled increases will keep older workers in the work force longer, which may be a real bonus for some employers-- and a problem for others-- as the work force ages. It may also limit opportunities for younger workers who expect rapid promotions and increasing responsibility and who may be frustrated if those expectations are not met.
  • Changes in the level of Social Security payments will affect the demographics of the workforce, although perhaps to a lesser degree than changes in the retirement age. Some people may continue to work well after their Social Security retirement age because they cannot afford to retire under the changed Social Security structure.
  • If the 20 percent of Americans who will be over age 65 in 2020 do not have secure, adequate incomes, those Americans will be forced to reduce both their consumption and their investment, which will have profound direct effects on every employer's core business profitability.
  • Regardless of any Social Security change proposals or alternatives adopted, the burden of collecting, transmitting and initially reporting Social Security taxes will remain with the employer.

How Much Investment Risk Is Too Much for Employees?

Establishing personal accounts raises a number of issues, not the least of which is how they could be financed without incurring additional federal debt or further shrinking the Social Security trust fund. But for 401(k) plan sponsors, the largest issue in Social Security personal accounts may be the most difficult to assess. Will the employee view the risk of investment burden imposed by Social Security personal accounts combined with the risk of investment burden under the employer-sponsored 401(k) plan as simply too much risk?

Under the current system, the individual knows that his or her Social Security benefit is dependent upon salary earned and years in the workforce, but that benefit is not dependent on investment risk. The full Social Security benefit is also guaranteed for life and indexed for inflation. Consequently, under today's Social Security program, the individual may be willing to bear the 401(k) plan risk of investment and to be a bit more aggressive-- or in some cases a great deal more aggressive-- as an "investor" of his or her 401(k) money, knowing that a significant portion of retirement income will come from Social Security, which in the individual's benefit is: (1) not linked to risk in investment; (2) guaranteed for life; and (3) indexed for inflation. As the individual bears more risk in Social Security, he or she may push for less risk and higher guaranteed benefits from employers, which may raise retirement plan or other labor costs for employers.

Of course, Carol may not be able to save the extra $5,000 each year and many "Carols" might not be able to annually sacrifice that much in savings each year. But Carol and many of her colleagues, both male and female, would like to try. Because a person is willing to sacrifice to save for retirement does not necessarily mean that he or she is rich, but it may mean that he or she may want to be.

Martha Priddy Patterson is the director of employee benefits policy analysis with Deloitte & Touche LLP's Human Capital Advisory Services in Washington, D.C. Patterson is the contributing editor of The 401(k) Handbook.
Reprinted with permission from the September 2001 supplement to The 401(k) Handbook, ©Thompson Publishing Group, Inc., 2001. All rights reserved.

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