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The Risks in Personal Accounts

Sunday, February 20, 2005; Page B06

NEWLY ELECTED to a second term and possessed of a mandate to cut the "nanny state," Margaret Thatcher set out in 1984 to privatize Britain's state pension system. The result stands as a warning to the Bush administration. The Thatcher reforms empowered unscrupulous salesmen to press inappropriate savings accounts on unsophisticated workers; regulators ultimately required payment of some $24 billion in compensation to the victims. Last year 500,000 Britons who had opted out of the government pension system in favor of private accounts returned ruefully to nanny.

Social Security reform, in short, is risky. Individual retirement accounts can suffer not only from aggressive salesmen but also from high management fees (Chile), disappointing investment returns (Sweden), irresponsible subsidization at the expense of taxpayers (Britain, again) and the danger that workers might seek early access to their money to meet medical emergencies or other expenses, leaving them impoverished in retirement (Singapore). So, despite the significant likely gains from investing in equities via personal accounts, reform doesn't cross the threshold of plausibility unless it is designed to avoid these pitfalls.

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The Bush administration appears to understand this. It says that workers would not be allowed to tap into their accounts before retirement; nor would they be permitted to borrow against them. Moreover, it has proposed a government-run personal account system, modeled on the Thrift Savings Plan for federal employees. The government, not private salesmen, would offer workers the option of a personal account, along with a short list of mutual funds to invest in. By cutting out private-sector marketing and advertising costs, the Bush plan would keep fees low -- to less than 0.3 percent of the savings in the system.

The administration also seems to want to avoid subsidizing private accounts, even though a subsidy might sweeten them politically. Under Mr. Bush's proposal, workers who opt to divert some of their payroll taxes into a private account must give up future government benefits worth the same amount, suggesting no taxpayer subsidy. However, it would still be true that account holders who die before retirement would be able to bequeath their savings; this would represent a "leak" of money from the system, which taxpayers would be required to plug.

What of the risk that the stock market investments in personal accounts could go bad? The nonpartisan Social Security actuaries have examined all the 22-year periods since 1925: Returns from the broad S&P 500 stock market index beat 20-year Treasury bonds in every one of them. Administration critics say these long-run numbers aren't everything: What if you retire the day after a crash and are forced to convert your savings into an annuity just when your account has tanked? But workers could avoid that danger by shifting their savings gradually out of stocks and into bonds in their last working years, thus insulating themselves from a collapse in equities. Equally, critics say that future investment returns may not be as great as the historical ones that guide the actuaries; the baby bust could hurt growth and hence also the stock market. But economists who've calculated this effect don't expect it to reduce equity returns by enough to undermine the promise of personal accounts.

So some oft-cited dangers in personal accounts may be overstated. But there are three that remain more worrisome.

The first is that, even though the average worker may gain, a minority will invest recklessly and end up impoverished. The admin- istration says it will reduce this peril by creat- ing a default "life cycle account": Workers who don't actively withdraw from this option would have their money shifted automatically from equities into bonds as they approached retirement. But this excellent provision won't prevent some workers from betting on the stock market up until the day that they retire and so risking real hardship. Unless the administration compels all workers to invest in life cycle accounts -- an illiberal but nonetheless sensible idea -- this particular danger cannot be eliminated.

The second risk in personal accounts is that their transition costs might scare financial markets. As we have argued before, investors shouldn't take fright. The transition borrowing merely swaps government debt to future retirees for government debt to bondholders. Indeed, if personal accounts are coupled with a benefit cut, as they should be, the government's total debts would fall; if anything, investors should be heartened. But financial markets are not perfectly rational. Coming on top of the president's irresponsible budget policies, a flood of new bond issues might possibly frighten investors, perhaps triggering a fall in the dollar and higher interest rates.

The last risk is that the traditional Social Security system, which has performed well for the past 65 years, might be weakened. The current system is attractively progressive; diverting some of its money into personal accounts would blunt that effect unless a compensating reform boosted the progressivity of the residual government benefit. The current system is also popular. But if better-off Americans come to like their personal accounts and to view the vestige of the old Social Security program as a welfare transfer to the elderly poor, the political foundations of a program that has greatly reduced old-age poverty could crumble.

To capture the high returns from equity investment without running these risks, the government could invest payroll tax revenue directly in the stock market, without personal accounts. This sensible idea was floated in the Clinton years and ought to receive serious consideration now. Another Clinton-era idea is to have personal accounts financed not by a diversion of taxes from the traditional Social Security program but rather by add-on contributions: This would reduce transition costs, protect the size and progressivity of the traditional system, and boost national savings. Short of these approaches, the Bush administration might consider limiting the size of private accounts, particularly for high-income workers. Under the president's current proposal, people earning more than the payroll tax cap, currently set at $90,000, would eventually have such big personal accounts that the compensating reduction in their traditional benefits would reduce them to zero. It's not clear that better-off Americans would continue to support a system from which they received nothing.

This is one in a series of editorials examining Social Security and its future. Others can be found at www.washingtonpost.com/opinion.

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