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Time to Privatize Social Security

by Ryan Sager

This article appeared on cato.org on March 5, 1998.

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By now, we have all heard the statistic that more young Americans believe in UFOs than believe they will collect Social Security. Young people, unlike Agent Mulder from the X-Files, cannot make themselves "want to believe" in the UFO that is our nation's Social Security system. As a freshman in college, I face the prospect of paying taxes far in excess of current levels into a system that may no longer exist when I retire. However, that does not have to be the case. Given the current budget surplus, and given Washington's newfound willingness to discuss reform, my generation may still have a chance. If the politicians can forgo a "quick fix" and realize that Social Security will have devastating effects on today's young people, there may be hope.

The first step is to acknowledge that our current system is fundamentally unsound and is eventually going to collapse. A giant pay-as-you-go system, with taxes on current workers paying benefits to current retirees, was workable in 1950, when there were 16 workers paying taxes to support 1 recipient. However, by 1996 there were only 3.3 workers supporting every recipient, and by 2030 there will be only 2 workers per recipient.

Since the system was instituted over 60 years ago, Social Security taxes have been raised more than sixfold to keep up with demographic changes. However, with the impending retirement of the baby-boom generation, even the Social Security Administration predicts that the system will become insolvent by 2029 at the latest, and possibly as early as 2016.

Thanks to the baby boomers, we can allow young workers to open PRAs and at the same time pay benefits to those already in the old system. We have a window of opportunity, but this window could be missed if the politicians take the easy way out.

Ryan H. Sager is a George Washington University student and an intern at the Cato Institute.

So, what does that mean for people my age? First, it could mean exceedingly high taxes. Payroll taxes would need to be as much as tripled to meet future payments. Second, it could mean raising the retirement age. Workers would have to work more years and receive benefits for fewer years. Third, it could mean a reduction in benefits. Any of those changes would make Social Security an even worse deal for my generation. However, there is one reform that would give my generation a smaller tax burden and higher returns while not affecting those already in the current system: privatization.

Under a privatized system, workers would contribute a percentage of their income to a private retirement account (PRA). PRAs would function much like IRAs and be managed by the private investment industry. Individuals would have freedom to choose the managers of their accounts, and there would be regulations on portfolio risk to guard against unsound investment.

Adopting such a system would accomplish three important goals. First, it would increase the rate of return on each worker's contribution. Today, the average return on Social Security is 2.2 percent -- in 20 years, the rate of return will be negative. Compare this to the 9 percent average return historically achieved by funds that invest in stocks and bonds. Second, it would reduce payroll taxes. Given the higher rate of return on PRA contributions, benefits equivalent to those provided today could be financed with a payroll tax one-fifth the size of the current one. Third, a privatized system would boost the economy. The immense flow of capital into private markets that would be unleashed by a privatized system would create new opportunities for investment-hungry entrepreneurs.

Although many people are concerned about switching to a private system, it is not an untested idea. Chile privatized its government-run pension system in 1981 and has since achieved a 12 percent return on contributions and a growth rate in real gross domestic product averaging over 7 percent. And Chile is not the only country that has switched. Many countries in Latin America and Eastern Europe, as well as Great Britain and even communist China are abandoning the American model of Social Security in favor of market-based approaches.

Now is the time for America to privatize Social Security. Thanks to the baby boomers, the system currently runs surpluses from $25 billion to $50 billion a year. Given that, and given the budget surplus, we can allow young workers to open PRAs and at the same time pay benefits to those already in the old system. We have a window of opportunity, but this window could be missed if the politicians take the easy way out. Few people my age want to be forced into a failing system -- and there is no reason for that to happen. There is a viable and tested alternative -- privatization.