Committee on Economic Security (CES)
Volume II. Old Age Security
Papers in Support of Old-Age Provisions of Bill
MEMORANDUM ON PROPOSED AMENDMENTS PERMITTING
EMPLOYERS WITH PRIVATE PENSIONS PLANS TO CONTRACT OUT OF THE GOVERNMENT
SYSTEM
by
Murray Latimer
Chairman Railroad Retirement Board
Chairman Subcommittee on Old Age Security of the Committee on Economic
Security
I believe it would be inadvisable to amend the Social Security Bill so as to provide that employers who provided private pension and annuity schemes with benefits equal to or greater than those provided in the bill itself, would be relieved from the tax burden. My reasons are as follows:
(1) It would be difficult to guard against selection adverse to the old age fund. The first and most important form of this selection would be based on age. Employers would attempt to remove the young employees from the government system. When the total taxes stand at 5 or 6 per cent of the payroll, that will be more than enough to provide the annuities schedule in the plan for young insured persons. For example, a contribution of 2.5% paid by employees would provide 1% of the payroll of the persons affected. Thus there would be a considerable profit to the employer by insuring his employees outside the government old age insurance system up to say age 35, if the requirement for contracting out were the provision of equal or greater benefits.
The Social Insurance Board would presumably refuse to recognize a plan which contained such extreme elements of adverse selection; nevertheless, this gives an indication of how the selection might work. To whatever extent there is such selection, costs to the government fund would rise above the estimates.
Opportunity to contract out offers employers incentives to maintain low hiring ages, and to induce high turnover at the upper ages. The higher the rate of mortality among the employees of a given concern, the greater would be the incentive to contract out of the general government system. In other words, the profit motives under private plans run in directions directly contrary to the social welfare. The Social Insurance Board would necessarily have to devote a large portion of its time to examine very carefully the actuarial and other bases of every proposed private scheme in order to guard against such factors as these.
There are two ways by which this adverse selection could theoretically be overcome, in part though not entirely. First, the requirement might be that at the time any employee ceased to be covered by a private scheme, a payment be made to the old age fund equal to the taxes which would have been paid during the time when such employee was covered by the private fund, together with accrued interest. This method, however, would result in undesirable strains in periods of depression. This strain would come about by reason of the fact that when large numbers of employees would be laid off, securities would have to be liquidated by private companies in order to meet payments to the government. After 10 years of contributing at say a 5% rate, there would be a reserve per employee averaging probably $600. If employees covered by private plans numbered 3,000,000 at the start of a depression comparable to that of 1930-1933, it is possible that a half billion of securities would have to be liquidated by insurance companies, trustees, and other holders of old age funds rather rapidly in order to make payments to the old age fund. The possibility of such liquidation would in itself produce an undesirable effect upon the investment polices of the insurance companies and trustees, and the liquidation would unquestionably be a terrific strain on investment markets in a period when these markets would be least able to stand the shock. To allow the Social Insurance Board or the Treasury discretion as to whether or not the payments would have to be made to it seems undesirable. So to provide would subject the Board or the Treasury to enormous pressure from interested parties which might hamper the performance of other socially more important duties.
A second possibility would be to make private funds use the total contributions, which would not be less than that provided under the government plan, to purchase annuities of whatever amount such contributions would buy and upon the withdrawal of an employee from the private plan, fix his contributions and those of his employer so as to provide only the balance of the annuity benefits scheduled in the government plan. Such contributions would of course be less than normal, since the younger the employee, the more the contribution would buy. Merely to mention this possibility, however, shows its administrative impracticability, since there would soon be literally millions of rates at which employers and employees would be taxed under the government plan. The determination of the amounts of the changed rates would not be simple if the rate of annuity were not uniform for all levels of wages, and would require an individual calculation for each employee.
Another element of adverse selection lies in the fact that most of the employers who will wish to contract out will be those who now maintain voluntary plans, that is those who have large numbers of employees. The expense of collecting the taxes and maintaining records for those employers and their employees would almost certainly be considerably less than the corresponding expense for small employers. Thus, to permit contracting out of the government scheme would tend to increase the expense ratio of the government fund.
As has been stated, there is probably no way by which selection adverse to the old age fund can be completely eliminated. This would be particularly true if there is assessed against employers and their employees the cost of any unearned benefits paid at the initiation of the system. This will result, ultimately, of course, in all the plans which have been considered, in a payment in perpetuity equal to the interest on the amount of such unearned benefits accrued, with interest to the date when no further unearned benefits are paid. By contracting out under such circumstances, an employer whose employees had a relatively low age distribution, could provide benefits scheduled under the government plan and escape paying the pro rata share of the interest on the unearned benefits unless he were forced to pay to the government fund directly such pro rata part in excess of the cost of providing the benefits. None of the proposed amendments contain any such provision for that payment; and the collection of any such excess would involve administrative, actuarial, and probably legal problems of grave difficulty.
(2) Since the government is forcing all employers and employees who are affected by the government plan to provide old age annuities, and since any contracting out would involve sales commissions or fees to actuaries or investment counsel and the like, such action would be equivalent to encouraging people to pay something to someone for selling them a service which must in any event be bought. This seems to be economically unjustifiable.
Such does appear to have been the experience in workmens' compensation. Insurance companies incur high sales expenses to compete among themselves for business, even in states where the state itself maintains the compensation insurance fund. The social insurance measure it seems to me ought to be regarded as a public utility of prime importance. As such the element of private profit, whether it goes to stockholders, or salesmen, or actuaries, ought to be rigidly excluded.
(3) If the government contributes to the old age fund sums raised by progressive taxation, and firms which contract out pay the whole of the cost of the benefits by contributions paid by the employer and employees, regressive taxes are being substituted for a progressive tax. This is socially undesirable.
It may be pointed out in this connection that even under the so-called self-supporting plan there is an element of government contribution if a rate of interest is guaranteed, certainly above 2.5% and probably above 2%. It may also be pointed out that the interest on the reserve would be raised by taxation in so far as such reserves are used to purchase government securities which do not represent revenue producing investments. It seems likely that in the future as in the past this interest will be raised to a large degree by progressive forms of taxation.
(4) The tax sections of the Social Security Bill (Title III) contain no reference to benefits. This is presumed to improve the chances of the statutes being held constitutional. I can think of no way by which contracting out may be permitted except under Title III, and if the contracting out is permitted under Title III, it must necessarily contain reference to the benefits schedule under Title IV. This will probably take away whatever advantage there is in the separation of the tax and benefit provisions. I append a memorandum on this point written by Mr. L. P. Schoene, an assistant counsel of the Railroad Retirement Board, in response to my request that he comment on this point.
(5) Providing for contracting out would add appreciably to the administrative burden of the Social Insurance Board. It would have to inspect contracts with insurance companies, probably keep track of all types and varieties of rate schedules; and probably exercise a certain casual jurisdiction over investments with some chance that investments would prove faulty and employees covered by private schemes receive inadequate benefits. In such event, there is a grave question relating to where liability would lie for the payment of benefits. It is probable that many employees would not wish to contribute to an outside agency, but would elect to remain in the state plan, in which event both the employer and the Social Insurance Board would be put to considerable trouble in checking up on what taxes were due to the outside agency. Insofar as contracting out results in selection adverse to the old age fund, estimates of cost for that fund will be less dependable and more difficult to calculate.
In considering the advisability of permitting employers to contract out of the government system the present status of employer pension systems should be borne in mind. Most of theses systems are now maintained by industrial companies, municipalities of state governments (which are not affected by the present legislation), churches, and private educational and eleemosynary institutions, and trade unions. The largest single group of industrial pension plans, those which have been maintained by the railroads, are not affected by this legislation. There are probably about four hundred other companies which maintain pension plans, employing at the 1929 level about two and one-half million persons. Of these plans, to my knowledge, and I am familiar with most of them, none are satisfactory as social insurance measures and all would require revision, drastic in practically every instance, before the Social Insurance Board could possibly approve them. Either employees under those private industrial plans lose all rights to annuities upon withdrawal for any cause, or the division of costs between employer and employees is inequitable, or employees withdrawing or dying are deprived of the interest on their contributions. The church and private educational institution plans are probably more adequate and more equitable than the plans of private industry, though practically all of them would need some revision before they could be regarded as satisfactory. The trade union plans have always been technically bankrupt and several have already been discontinued and probably the union would be very glad to get entirely out of the field.
The benefits under the proposed Social Security Bill are admittedly inadequate as retirement incentives for several years. It would probably be desirable for employers to provide supplemental benefits which would when added to the government annuities be equal to or greater than the annuities now being paid under private plans. All the arguments for the group who advocate contracting out come down to one essential point--that if contracting out is not permitted, employers will, generally speaking, do nothing other than what is required by the government.
I am unable to agree with this view. If in the past there were good reasons for employers to maintain pension plans for the purpose of maintaining compulsory retirements, to provide disability benefits and to attract superior personnel, it will be good business to do so in the future. The benefits under the government plan of course would become more adequate after twenty years than they were initially, but nevertheless there will always be room for employers who wish to maintain for one reason or another working conditions which are more favorable than the average. There will also be a large field for annuity systems among the groups which are not covered by the insurance. I am unable to see that the maintenance by employers of plans supplemental to the government old age insurance system involves operating problems of any particular difficulty.
MEMORANDUM: for Mr. Latimer:
You have referred to me three suggested amendments to the old age insurance
provisions of the Social Security Bill, differing considerably in form
and particularity, but each designed to permit operation of private annuity
plans partially in lieu of the old age insurance plan established in the
Bill. I have made no attempt to judge the constitutionality of the entire
Bill, nor, more particularly, to judge the constitutional advantage of
separating the tax provisions from the appropriation provisions as the
Bill does. I understand, however, that it is considered that the measure
is easier to sustain against attack on constitutional grounds as a result
of this separation, and I have therefore examined the proposed amendments
on the assumption that separation of tax from appropriation is a constitutional
advantage which should not be jeopardized.
From this point of view, it seems fairly clear to me that any amendment along the lines of those which you have referred to me would jeopardize this advantage. When provisions such as these, allowing either exemptions from or credits against the proposed taxes, are incorporated, a distinction is introduced which must be justifiable by reference to some standard or purpose that makes a distinction reasonable; otherwise the tax is invalid as being discriminatory. For instance, it would probably not be doubted that gradations or exemptions in the tax based on size or physical characteristics of employees would make the tax invalid. I understand the tax itself to be justified on the ground that it is an excise upon maintenance of the employment relationship, and as such it must operate uniformly except as departures can be justified upon reasonable ground. The departures proposed in these amendments cannot be justified by reference to anything within the tax provisions themselves. In order to find the justification for them it is necessary to refer to the appropriation provision and to the scheme of benefits there established. Such a cross-reference necessarily destroys the plan of separation.
It seems to me that the loss of advantage of separation which is thus brought about is not confined in its effect to the particular amendments proposed. That is to say, if the court is called upon to determine the constitutionality of the tax, say upon an employer maintaining no private annuity plan, and it is argued in support that the tax is simply an excise and must be judged without reference to the appropriation measure, the court would be likely to reject the argument on the ground that the tax contains discriminatory features which find their basis and justification only in the accompanying appropriation measure, and that therefore the entire scheme can be supported only if some power can be found in Congress to provide social security.
As between the three proposed amendments, there are, of course, great differences in definiteness of the standards established. That dated February 4, and attached to Mr. Forster's statement before the House Committee provides the most definite standards and leaves least to the discretion of the Board. In view of the decision in the oil case, it is of course highly important that care be exercised to avoid any such wide discretion as might be invalidated on the ground of delegation of legislative power. This seems particularly important where the function of the Board is, as under these proposed amendments, that of determining the incidence of a tax.
L. P. Schoene.
Memorandum on Standards Necessary if Private
Pension Plans Are Permitted to Contract Out of the Government System
Prepared by Maurray Latimer,
Chairman Railroad Retirement Board
Chairman Subcommittee on Old Age Security of the Committee on Economic
Security
If it is deemed necessary, despite the grave difficulties, outlined in
a separate memorandum, to permit private employers to contract out of
the government old age insurance system, the following minimum standards
should be included in the provisions:
(1) Benefits in the private plan must be not less than those called for under the government system.
(2) Contributions to be not less than those of the government system.
(3) No compulsion direct or indirect shall be exercised to induce employees to participate in the private system, and all announcements to employees shall emphasize the fact that such employees will be protected by the government system if they elect not to participate in the private system. The privilege of participating in the private plan shall not be denied to any employee eligible for insurance under the government system by reason of his age.
(4) If benefits larger than those under the government plan are provided, employee contributions shall be no larger a proportion of the total cost than is the corresponding proportion under the government system.
(5) Benefits provided under the private schemes shall be non-forfeitable in event of the withdrawal of the employee; provided, however, that the death benefit may be the employee's own contributions with interest compounded annually at a rate not less than three per cent; and provided further, that the liability for payments of benefits equal to those under the government system shall be transferred to that system upon making the payment as specified in (6).
(6) Upon the withdrawal of an employee from the private system there shall immediately be paid to the old age fund the taxes which would have been paid to such fund on the earnings and payroll of such employee during the period in which he was a member of the private system, together with the interest which would have accrued had payments been made currently to the old age fund.
(7) If the cost, under the private plan, of providing that part of the benefits equal to those specified in the government system is less than the earnings taxes and excise taxes which would be paid to the government under Title III, the difference shall be paid as an excise tax under Title III.
(8) In calculating the cost of benefits under (7) no allowance will be made for sales, administrative and other costs in excess of a ratio to the earnings and excise taxes which would otherwise be paid under Title III greater than the corresponding ratio for the government old age system. Reserves shall be calculated on the basis of interest at the rate of not less than 3 per cent per annum and mortality at a rate not less than the standard table for annuities under the applicable state laws. An allowance for a contingency reserve not greater than 2 percent of the net reserve on the above basis may be made in computing cost.
(9) The liability in respect to benefits provided in excess of those specified by the government system shall be funded currently except that the liability for such excess benefits in respect of service prior to the inauguration of the plan may be amortized within a period not to exceed 20 years.
(10) Funds to meet the liabilities shall be placed with an insurance company, or with a trustee, and shall be invested in funds which are legal investments for insurance companies, trustees and savings banks. Contracts between the employer and the insurance company or trustee shall be executed only after approval by the Social Insurance Board as meeting all the prescribed standards.
(11) Guarantee of payment of benefits shall be made both by the insurance company or trustee and the employer.
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