America’s Social Security System: The Case for Privatizing

April 15, 1998 • Commentary
This article originally appeared in Vital Speeches, April 15, 1998.

I believe there is no economic issue facing the world today that is more important than converting public pension programs from pay‐​as‐​you‐​go government‐​run systems into individually capitalized privately owned retirement systems. Having just flown in yesterday from a two‐​day conference in London that the Cato Institute co‐​sponsored with The Economist at which no less than 38 nations were represented, I can personally attest to the growing international attention this crucial public policy question has been receiving of late.

The most successful example of Social Security privatization, of course, has been in Chile. So, you can imagine how very pleased all of us at my Institute are to have Jose Pinera as co-chairman of our Project on Social Security Privatization. That project was launched on August 14, 1995 on the 60th anniversary of the creation of the Social Security system in the United States. We made the point that at 60 it was perhaps time for Social Security itself to be retired.

As we all know, Social Security was the brainchild of German Chancellor Otto von Bismark in 1889. His motive for doing so, I believe, had little to do with compassion and much to do with buying votes and making citizens increasingly dependent on his militaristic government. In America the idea of what is essentially a socialized retirement system seemed inconsistent both with the Constitution's limits on federal power and with the average citizen's desire for personal independence. It took the Depression to change that view and it's interesting to note that one of the very first organizations to call for a national government retirement program was the American Association for Labor Legislation, an offshoot of the International Association for Labor Legislation, founded in Germany.

Whatever President Roosevelt's motives might have been when he signed the bill in 1935 creating the Social Security system, the German influence was there. He and his Democratic Congress borrowed heavily from Bismark's original plan.

In particular, the new public retirement program -- there hadn't been one previously -- was sold as an "insurance" program and financed out of payroll taxes rather than general revenues in order to suggest that "premiums" were, in effect, being paid for old-age insurance. As Roosevelt himself put it, "We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions... With those taxes in there, no damn politician can ever scrap my social security program." This official government deceit of describing Social Security as an insurance program continues to this day. I dare say that if private insurance company executives were to engage in such fraudulent activities they would end up in jail, as they well should.

The Problem

Social Security in the United States, as it is in most nations in the world, is a pay-as-you-go system and has been except for the first couple of years of its existence. As such, it is an intergenerational wealth transfer. Nothing less, nothing more. Its solvency, therefore, depends on demographic factors more than it does on economic factors such as productivity gains. Birth rate and longevity determine the solvency of pay-as-you-go retirement systems.

In the United States the birth rate at the time of the creation of Social Security was 2.3 but had risen to 3.0 by 1950 and continued to climb during that decade. Today it is 2.1. The average life expectancy in 1935 was 63 and today it is 75. That's good news for Americans, bad news for the Social Security Administration. As a result of these demographic factors, which are likely to stay the same in the case of the birth rate and to increase in the case of longevity, the number of workers paying Social Security payroll taxes has gone from 16 for every retiree in 1950 to just 3.3 for every Social Security beneficiary in 1997. That ratio is expected to decline to just 2 to 1 by the year 2025.

As one would expect under such demographics, the payroll tax has been increased continuously over Social Security's 62 year history. From an original tax of just 2 percent on a maximum taxable income of $300, the payroll tax has been increased more than 30 times and is now set at 12.4 percent of a maximum income of $65,400. To pay all promised benefits under the current program the payroll tax for Social Security will have to be raised to 18 percent, and if Medicare is included the tax will have to go to nearly 28 percent. Obviously, such a level of payroll tax will have a very negative impact on employment, as it as has in Europe.

Incidentally, those tax rates reflect the so-called realistic actuarial estimates of the Social Security system. Historically, the so-called pessimistic assumptions have proven to be the most accurate. Under those assumptions, the total payroll tax would have to go as high as 44 percent, or nearly triple what it is today.

To make matters worse, and as a consequence of Americans having fewer children and living longer, the Social Security system has developed an incredible unfunded liability of $9 trillion. Compare that to the total national government debt of $5.4 trillion. The growing awareness of the overwhelming insolvency of Social Security in America has led to a rather remarkable change in the political dynamics of the issue there. Until recently, Social Security was an overwhelmingly popular program and considered the "third rail" of American politics: touch it and your career was over. Indeed, Barry Goldwater's early support for privatizing Social Security in the 1964 presidential campaign is widely credited with having destroyed whatever slim hopes he may have had of winning that race. And one of Ronald Reagan's worst political missteps was a short-lived effort to cap the benefits of Social Security.

But that has all changed. A poll commissioned by the Cato Institute through the prestigious Public Opinion Strategies polling company showed that 69 percent of Americans favored switching from the pay-as-you-go system to a fully funded, individually capitalized system. Only 11 percent said they opposed the idea. Interestingly, the major reason people cited for wanting to switch to a private system was not the higher rate of return they surely would capture under such a system (and we'll get to that in a moment), but they pointed rather to the fact that they, and not the government, would be in control of their retirement income.

Other polls confirm this attitude. A 1994 Luntz Research poll found that 82 percent of American adults under the age of 35 favored having at least a portion of their payroll taxes invested instead in stocks and bonds. In fact, among the so-called Generation Xers in America, by a margin of two-to-one they think they are more likely to encounter a UFO in their lifetime than they are to ever receive a single Social Security check. Even more remarkable, perhaps, was a poll taken just this year by White House pollster Mark Penn for the Democratic Leadership Council, a group of moderate Democrats with whom President Clinton was affiliated prior to his election. That poll found that 73 percent of Democrats favor being allowed to invest some or all their payroll tax in private accounts.

Now, this is a truly astounding turn of events, because Social Security has not only been very popular during all but the past few years of its existence, it has always been cited as the very essence the Democratic party. The most popular Democratic president in history was FDR, Franklin Roosevelt. Yet, recently the Democratic Leadership Council's magazine featured a picture of a smiling FDR seated in a car under the headline, "The New Deal: Time to Move On?" And that was an appropriately symbolic commentary because privatizing Social Security means privatizing 23 percent of the national government in America.

It also means changing the political dynamics of America in a very fundamental sense. For when members of labor unions, the average blue collar worker, blacks and other traditional constituencies of the Democratic party start investing in stocks and bonds that they own, rather than counting on government as a security blanket, their attitude toward the free enterprise system, toward corporate profits, and, indeed, toward big government itself is going to change. This dynamic has in fact already occurred in Chile. If the Democrats in the U.S. are going to be competitive in a post-privatized Social Security era, they're going to have to fundamentally alter their agenda.

And that is why the political stakes are so high with this issue. Thus far, it has been primarily Republicans who have ventured out to explore the political possibilities of Social Security privatization. There is in the U.S. House of Representatives a bipartisan caucus of some 80 members pursuing the idea of privatizing the system. The vast majority of them are Republicans. In the Senate, however, one of the leaders of the privatization movement has been Sen. Bob Kerry of Nebraska, a Democrat who some think may seek the presidency in 2000. Another Senate proponent of the idea is Republican Sen. Phil Gramm of Texas who is an economics professor by training and well-equipped to make the case for privatization to his colleagues.

At the presidential level, we know first-hand that Bill Clinton is aware of the Chilean success story and aware of the pending crisis in Social Security. We also know that Mr. Clinton is seeking his place in American history -- that he wants to make his mark on the American polity so he's remembered for something other than the Paula Jones episode. So, I don't think it's out of the question that in Clinton's State of the Union Address this winter he will make partial privatization of Social Security a major goal for the remainder of his administration.

Perhaps the most important new ally in the pension privatization movement is Federal Reserve Chairman Alan Greenspan. Ironically, he was the head of the Greenspan Commission that in 1983 claimed to have solved the Social Security system's financial problems all the way through to 2068. His commission did so by increasing taxes, reducing benefits, and extending working years prior to receiving benefits. Privatization was not even considered. To his credit, however, Mr. Greenspan now seems to realize that privatization, especially if it increases the savings rate, which it undoubtedly would, is the answer to the financial crisis of Social Security's huge unfunded liability.

In testimony before the Task Force on Social Security of the Senate Budget Committee on November 20, Greenspan said, "There are a number of broader reform initiatives that, through the process of privatization, could increase domestic savings rates. Given the considerable stakes involved, these are clearly worthy of intensive evaluation. Perhaps the strongest argument for privatization," Greenspan said, "is that replacing the current under-funded system with a fully funded one could boost domestic savings." Greenspan then spent the rest of his testimony discussing whether privatization should be phased in or done as "a 'big bang' one-shot transition," as he put it. Based on this testimony, just three weeks ago, it is clear that the chairman of the Federal Reserve System in the United States favors privatization of the Social Security system.

As all of this points out, I hope, popular support and political support for this idea is quite strong in the U.S. I don't mean to imply that we are on the verge of victory, because the opposition to Social Security privatization is intense and only now are opponents recognizing how much progress those of us in the movement have achieved. The battle is really only just being engaged.

Pension Benefits of Privatization

One of the reasons for the growing popularity of replacing a pay-as-you-go plan with an individually capitalized, fully funded plan is that Americans seem to intuitively know what is demonstratively true. Namely, that the returns from a privately invested retirement account will be significantly greater than the return one receives on one's alleged "investment" in Social Security. To repeat, in the United States the payroll tax is not invested, just as it's not invested in most Social Security systems around the world. It goes directly into payouts to current retirees, with whatever excess there may be going to help finance the federal government's deficit spending. The government leaves "Special Treasury Notes" in a so-called Trust Fund when it purloins these excess funds, but to see that the trust fund is a fraud, one need only consider the options facing the government whether these "bonds" are in the trust fund or not.

In the year 2010 or sooner, by our estimates, the cash flow from payroll taxes will be insufficient to meet the benefits due current retirees. Assuming the government will live up to its obligations (there is good reason to believe it will not, but for the sake of argument we will give it the benefit of the doubt), once the system's cash flow turns negative and the Social Security Administration turns to the national government for help, the government can come up with the necessary funds by: 1.) increasing taxes; 2.) increasing borrowing; 3.) reducing benefits; or 4.) reducing other government spending. Now suppose the Special Treasury Notes are presented to the national government by the Social Security Administration for redemption to make up for the shortfall. The government, in order to raise the funds to redeem the bonds is faced with precisely the same four options as if there were no trust fund at all.

Thus, when the American government officials smugly point to the approximately $2 trillion in accumulated Special Treasury Bonds that are expected to be in the trust fund by 2010 and tell us that this will help finance the system until 2029 and that therefore there is no crisis, they are being disingenuous, to put it kindly. There is no trust fund in the United States and the crisis is at hand, particularly for younger workers who face the prospect of negative rates of return on their payroll taxes over their entire working lives.

Which brings us back to the intuitive notion that a private account will, in fact, do much better than what Social Security promises, not to mention what it will be able to deliver. One of the best ways to see what an incredibly bad investment Social Security is compared to various alternative investment portfolios is to look at the Cato Institute's Social Security Web site at That site has an interactive calculator prepared for us by KPMG Peat Marwick which allows the user to assume whatever rates of return on stocks or bonds he projects, what percentage of each asset he'll have in his portfolio, and what the expected inflation rate will be. The opportunities to accumulate significant retirement assets and income, using very conservative assumptions, are clear from the calculator. While the comparison to Social Security won't be meaningful to a French user, the exercise with respect to what it takes to accumulate desired retirement assets is quite enlightening and I would invite you to visit our Social Security Web site.

To be more specific, the other co-chairman of our Project on Social Security Privatization, Bill Shipman of State Street Global Advisors, has done a study for us that compares various age groups and various investment alternatives. To cite just one analysis in the study for workers born in 1950, using prospective rates of return on stocks and bonds that are lower than the actual returns thus far during their working lives, a low income worker can expect $631 per month from Social Security. Had he instead invested his payroll tax in a 50-50 mix of government and corporate bonds, his monthly income would have been $1,069. Had he invested in a stock portfolio of 75 percent large capitalization companies and 25 percent small capitalization companies he would have received a monthly income of $2,419.

For high income workers the results are even more dramatic. Social Security would provide $1,562 a month, a bond portfolio $4,585 a month, and a stock portfolio $9,972 a month -- that is about $120,000 a year. Plus, the investor in the private accounts owns the corpus of the money paid in, which is not the case with Social Security. In other words, the private option is clearly the preferable option.

Critics, of course, speak of the market risk of a fluctuating stock market. It's worth noting, therefore, that for all 30 year periods in the United States dating back from 1802 until the present, stocks have outperformed bonds 99.5 percent of the time. And overlooked in the discussion of market risk is what seems to me to be the much greater political risk of increased taxes, delayed retirement, and reduced benefits. With a private system, the citizen controls the assets. With a public system, the politicians are in control, and I know of no country where that is not a risk.

Economic Benefits of Privatization

As Alan Greenspan has pointed out, the economic benefits of privatization of Social Security are potentially enormous. In Chile, as Dr. Piñera has noted, there has been real economic growth of 7 percent a year over the past decade, energized by a savings rate in excess of 20 percent.

We asked the noted Harvard economist Martin Feldstein to undertake a study for us that would estimate the economic impact of privatization in the United States. Feldstein, who was formerly Chairman of the Council of Economic Advisors under President Reagan, concluded that the present value to the U.S. economy of investing the future cash flow of payroll taxes in real assets would be on the order of $10 to $20 trillion. That would mean a permanent, significant boost to economic growth.

I would add that in the world economy of the Twenty-First Century, those nations that choose to adopt a fully funded private retirement scheme are going to be in a much more competitive situation than those that choose to stay with the government-run pay-as-you-go system. It is particularly significant both from the standpoint of geopolitics and the international economy that China is giving serious consideration to adopting a Chilean-like private Social Security system as we meet here today.

Funding the Transition

If privatizing Social Security is good for the workers and good for the economy, how do we actually go about doing it? The unfunded liability of France's system is more than twice that of the United States'. Even if it can be done in the U.S., isn't it too late to save the day here? The answer is no. And for the very reason that Alan Greenspan gave at a small dinner Jose Pinera and I were fortunate enough to attend a few months back. Dr. Piñera's presentation at that dinner, I should say, undoubtedly influenced Chairman Greenspan's change of heart on the privatization issue.

In any event, Greenspan made clear that in his view there is no net cost in a transition to a fully funded system. The reason for that being the fact that an unfunded liability is a liability, just as direct national debt is a liability of the government. Whether that liability is implicit or explicit should really not make a difference.

Under the private option promoted by the Cato Institute, workers would have the option of staying in the current system or instead paying into a private stock and bond account managed by a professional, qualified investment company. Contributions would be tax-deductible and matched by the employer, who would expense his contribution. Withdrawals at retirement could begin at any age once assets had grown to the point that a minimum standard annuity could be purchased. For those who choose the private option, zero-coupon recognition bonds would be issued by the government to reflect past payroll taxes paid. Because of the higher return expected from the private option, less than 100 percent of past taxes would be reflected in these recognition bonds given to younger workers. For instance, those in their twenties might receive no bonds, those in their thirties might receive 25 percent of their past taxes in the form of recognition bonds, those in their forties 50 percent, and so on. In this manner the $9 trillion unfunded liability could be reduced by as much as $3-4 trillion, a significant fiscal benefit of privatization.

There are several options available to policymakers responsible for funding current Social Security retirees, those who stay in the system (new workers, incidentally, would not be given the option to stay in the government-run system), and for redeeming the recognition bonds of older workers as they retire.

From my standpoint, by far the best way of funding the transition to a private system is by cutting government spending. In the U.S. we spend, as an example, more than $70 billion a year on what we call corporate welfare, subsidizing giant corporations at taxpayer expense. Then, too, there are many departments of the national government, ranging from education to commerce to energy, that are simply not a national responsibility in America's federal system of government. Eliminating just one-quarter of the activities the national government should not be engaged in would finance the transition.

Second, the national government has many other assets that should be privatized, as was done in Chile to help finance their transition. AMTRAK, the money-losing national rail system should be sold to private investors. The government owns 50 percent of the land west of the Mississippi River and much of that should be sold to private investors who would likely manage it in both a more productive and ecologically sounder manner than do the bureaucrats in Washington, D.C.

Another means of smoothing the transition would be to invest privately only ten percentage points, leaving the remaining 2.4 percent to help fund current retirees. Extending the retirement age by six months a year up to age 70 for those who stay in the system would also provide substantial revenue relief while reflecting the increased longevity of the population.

It turns out that there is tremendous revenue generated for the transition by the privatization itself. The tax revenues generated from the net increase in investment alone, according to a Cato study by scholar Peter Ferrara, would be about $150 billion in the tenth year from the start of the transition, and it would continue to grow as private investments accumulated each year. Ferrara estimates that this effect, combined with modest spending cuts of about $60 billion a year and modest increased borrowing of about $50 billion a year, would yield a positive cash flow for the remaining Social Security system, requiring no further spending cuts or borrowing by the fifteenth year after privatization. And his analysis makes no allowance for increased revenues from improved economic growth, even though that will undoubtedly occur.

I'll conclude with an anecdote from a conference the Cato Institute held in Shanghai last June. We received a telephone call from a senior official in Beijing, Sun Jianyong, who is leading the project to establish a national public pension system in China. The current system there is chaotic and ineffective, to put it mildly. Sun wanted to meet with Jose Pinera, who was speaking at our conference. We met with him in the lobby of the Peace Hotel in Shanghai and as we approached, Dr. Piñera, noting that Sun Jianyong was a young man -- he is 38 -- said, "But I expected someone much older!" Sun replied immediately through his interpreter, "But you were only 30 when you privatized Social Security in Chile!" And so it turned out that Sun was a great admirer of Dr. Piñera and of the Chilean system.

When Jose Pinera had finished his presentation to Sun Jianyong, this high-ranking Chinese official said, "I agree with everything you have said, and here are six reasons why." He then proceeded to list six solid reasons why Social Security privatization is a good idea, including such things as a higher savings rate, greater retirement income, and the ability to leave significant assets to your children. But what struck me the most was his remarkable point that under a privatized system the average citizen has the dignity of not having to depend on the government in his old age.

That, it seems to me, is ultimately why we should privatize Social Security in the United States, and why you should do the same here in France. Not for the higher income and improved economy that would undoubtedly result, although those are clearly things to be desired. But more for the reason of expanding civil society and reducing political society -- for the dignity of the individual human being. The Twentieth Century has been a century of big government, but I am encouraged, as we look toward entering the Twenty-First Century, by the trends in nations all over the globe -- by the 38 nations represented at our conference in London a couple of days ago -- nations that are rejecting the myth of the omnipotent state and instead looking toward legal and economic structures that recognize and protect the dignity of the individual. Thank you very much.

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