In Us We Trust: Take The System Private
By Michael Tanner
If the president is serious about fixing Social Security's many problems, he should follow his own call for "bold experimentation" and offer Americans a new retirement system based on individual ownership and private investment.
Social Security's problems begin with a looming financing crisis. The date most often cited in public debate is 2029, the year in which the Social Security trust fund will be exhausted. But focusing exclusively on that date is misleading. The implication is that the system will be fine until 2029, at which point benefits will suddenly stop. The reality is much more complex.
Currently, Social Security taxes bring in more revenue than the system pays out in benefits. The surplus theoretically accumulates in a trust fund. Beginning as early as 2012 as the first wave of baby boomers confront retirement the situation will reverse and the government will begin paying out more in benefits than it collects in revenues. To continue meeting its obligations, it will have to begin drawing on the surplus in the trust fund. At that point we will discover that the fund is little more than a polite fiction. For years, the federal government has used the trust fund to disguise the size of the federal budget deficit borrowing money from the fund to pay current operating expenses and replacing the money with government bonds.
Beginning in 2012, the Social Security Administration will have to start turning in those bonds to the federal government to obtain the cash needed to finance benefits. But the federal government has no cash or other assets with which to pay off the bonds. It can obtain the cash only by borrowing and running a bigger deficit, increasing taxes or cutting other government spending.
Even if Congress can find a way to redeem the bonds, the trust fund surplus will be exhausted by 2029. At that point, the government will have to rely solely on revenue from the payroll tax. But that revenue will not be sufficient to pay all promised benefits. Either payroll taxes will have to be increased to at least 18 percent, a 50 percent increase over today's 12.4 percent tax rate, or benefits will have to be slashed.
These problems are a result of Social Security's fundamentally flawed design, which is little more than a government-sponsored pyramid scheme. Today's benefits to the older are paid by taxes from the younger, who are still working. Tomorrow's benefits to today's young are to be paid by tomorrow's taxes from tomorrow's young. Because the average recipient today takes out more from the system than he or she pays in, Social Security works only as long as there is an ever-larger pool of workers paying into the system compared with beneficiaries taking out of the system.
The opposite is happening. Life expectancy is increasing, while birth rates are declining. As recently as 1950, there were 16 workers for every Social Security beneficiary. Today there are 3.3. By 2030, there will be fewer than two.
But focusing on the program's financing misses an even bigger problem: The system remains a bad deal for most Americans. Payroll taxes are already so high that even if today's young workers receive the promised benefits, those benefits will amount to a low, below-market return on payroll taxes. Studies show that many young workers' benefits would amount to a real return of 1 percent or less.
Those workers can now get far higher returns through private savings, investment and insurance. Raising taxes or reducing benefits to keep the system solvent will only make the rate of return worse.
There is a better alternative. Social Security should be privatized, allowing people the freedom to invest their payroll taxes in financial assets such as stocks and bonds.
A privatized system would essentially be a mandatory savings program. Money would still be deducted from a worker's pay and matched by the employer. But instead of sending that money into the black hole of Social Security, those workers who wish to do so could redirect it into a personal retirement account (PRA) of their choice.
PRAs would operate much like current individual retirement accounts (IRAs) or 401(k) retirement plans. Individuals could not withdraw funds prior to retirement. PRA funds would be the property of the individual and, upon death, any remaining funds would become part of the individual's estate.
PRAs would be managed by the private investment industry, and workers would be free to choose the company managing the fund that best meets their individual needs and could change whenever they wished. The government would establish regulations on portfolio risk to prevent speculation and protect consumers.
Re-insurance mechanisms (such as those that protect insurance policy holders in the U.S. against the collapse of insurance companies) would be required to guarantee fund solvency. For those who don't earn enough in a new system to provide a decent level of old age support, the government would continue to provide a safety net in the form of a guaranteed minimum pension benefit. If upon retirement the balance in an individual's PRA were insufficient to provide an actuarially determined retirement annuity equal to the minimum wage, the government would provide a supplement sufficient to bring the individual's monthly income up to that level.
Of course, some people worry that allowing people to invest privately is too risky. Are stocks really risky? For the past several years, the stock market has been riding a wave of expansion. Undoubtedly, there will be a correction. But what really counts is the long-term trend of the market over a person's working lifetime. Given that perspective, there is no time in which the average investor would have lost money by investing in the U.S. stock market. Looking at the worst 20-year period of stock market returns (1929-1948), which includes the Great Depression and the 1929 crash, shows a positive real return of more than 3 percent. The average 20-year real rate of return has been 10.5 percent.
By comparison, relying on the current Social Security system is extremely risky. Because Social Security is at its core a political system, future benefits are dependent on political decisions. Indeed, the Supreme Court ruled in Nestor v. Fleming (1960) that individuals have no right to Social Security benefits based on the taxes they have paid.
A young worker entering the system is gambling on what benefits a Congress and president 45 years from now will decide to bestow. Given the already low rate-of-return to young workers and the system's coming financial shortfall, the political risk of staying with the current system far exceeds the market risk of private investment.
The most difficult issue associated with any proposed privatization of Social Security is the transition. Put quite simply, regardless of what system we choose for the future, we have a moral obligation to continue benefits to today's recipients. But if current workers divert their payroll taxes to a private system, those taxes will no longer be available to pay benefits.
The government will have to find a new source of funds. The Congressional Research Service estimates the cost at nearly $7 trillion over the next 75 years. While that sounds like an intimidating figure, it should be understood that this is not a new cost. It is really just making explicit an already existing unfunded obligation. The federal government already cannot fund as much as $9 trillion of Social Security's promised benefits. Privatization, therefore, will actually reduce the amount of debt.
We would have to find the revenues to pay benefits to current retirees. While any financing mechanism will be political, involving some combination of debt, transfers from general revenues, asset sales and the like, the expected budget surplus offers a good place to start. President Clinton has called for using the surplus to save Social Security. If both parties are willing to forgo new spending programs and junk tax cuts, we can begin the transition to a new and improved system that will serve everyone better.
Michael Tanner is director of health and welfare studies at the Cato Institute in Washington and the co-author, with Peter Ferrara, of "A New Deal for Social Security," forthcoming from Cato.
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