The Pension Privatization Revolution

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Recently the Cato Institute held its second international conference on pension reform, this one in New York on March 9–10. Participants from 34 countries attended "Solving the Global Public Pensions Crisis II: The Privatization Revolution," cosponsored with The Economist. Among the speakers were former congressman Tim Penny, now a Cato fellow in fiscal policy studies; Michael Tanner, director of Cato's Project on Social Security Privatization; and Milton Ezrati, author of Kawari: How Japan's Economic and Cultural Transformation Will Alter the Balance of Power among Nations (1999).

Tim Penny: I look at my four children every day and realize the cliff that we're sending them over in terms of the Social Security system. What are we telling our children today? We're essentially telling them this: Here is a retirement insurance program for you. We take 12 percent of your income now and at least that much or more throughout your working lifetime and we spend it. In exchange you get at some future time (age 67 or possibly older) our promise to pay you an undefined rate of return. It may in fact be a negative rate of return. And you will get this money only if you live long enough to collect it. And when you die your heirs will not get a cent. And, by the way, we can raise your level of contribution by any amount at any time. That's essentially what we're saying with this current system, and clearly we ought to be able to do better for our children than that.

The numbers in this system are relentless. There are about 24 million Americans over 70 years old today; by the year 2030 when the baby boomers are fully retired there will be 48 million seniors over 70 years old. About 10 percent of our population were over 65 in 1970. That's up to about 14 percent today. It will reach 20 percent by the year 2030 when the baby boomers are fully retired. Life expectancy in 1965, when Medicare was enacted, was 70 years. It's now risen to 78. Today if you reach the age of 65 you can expect to live another 17 years, and those numbers will increase as time goes by.

Is it any wonder that Americans are becoming more and more dubious about the Social Security system? Sixty percent of Americans in a recent Gallup Poll said that the system needs either a complete overhaul or major changes. That's a pretty remarkable statistic. Seventy-five percent of Americans are comfortable with the idea of some degree of privatization so they can have more control over their Social Security investments. Only 12 percent of those under 30 years of age expect to receive all or most of their benefits from the system.

In other words, younger Americans really understand what's happening to them in a fundamental way. I think in some respects this is manifested in the increasing detachment that young people have from the political system. As a Democrat I think that detachment is contributing greatly to the degree to which my party is not resonating with younger voters because we essentially articulate the status quo when it comes to the Social Security system.

In Minnesota's most recent gubernatorial election, Hubert Humphrey, the son of Sen. Hubert Humphrey, was the Democratic candidate for governor and received 16 percent of the vote of those 30 and under. Jesse Ventura received 50 percent of the votes of that segment of the electorate and in fact inspired many, many young people who had not voted before to participate. Democrats who protect the status quo on Social Security and other social and domestic programs are losing touch with younger voters.

So the question is, why privatize Social Security? I guess the way I would answer that is to say because the alternatives are so bad. The alternatives are horrendous. I call the standard response to Social Security by many people in my party the Alfred E. Neuman School—"What, me worry?" It's to pretend that the problem isn't there. It's to pretend that the trust fund is real. But in doing so we obligate future generations to one of two realities. Either we will have to increase debt dramatically or we will have to raise payroll taxes significantly. We've been down that path before, and we're already at a point at which we're promising future retirees a negative return, so these are not options that resonate well with the average worker. But that's largely the response of my party, the Democrats.

There are others who say, "Well, maybe markets can help us through this problem, so let's just take the Social Security surplus and invest it in the markets." I don't want government bureaucrats sitting around deciding how to invest my Social Security money. We've seen states like Minnesota put a fence around public pension funds so that they can't be used for a variety of investments. You can't use them for investments that might somehow be tainted by tobacco money. You can't use them for investments that might somehow tie us to foreign nations that have bad human rights records. We don't need to go down that path.

The Clinton plan is, of course, to pay down debt with our current surplus, which on one level makes some sense, but he double counts the money. He first puts it in the trust fund, pretends again that the money will be there when we need it, and then pays down debt. He also talks about taking the interest saved by paying off debt and putting those savings into the trust fund, which is essentially a general fund transfer into the Social Security system, so it undercuts the basic premise of Social Security, which is a pay-as-you-go structure. Clinton also discusses creating new retirement funds—not allowing us to use payroll taxes for those retirement funds but giving us new money that we can invest for that purpose. None of this does anything to address the underlying problems with the Social Security system. Furthermore, none of this means anything to the poorest of the poor, because absent their Social Security payroll checks there is precious little money in disposable income that they can use to supplement that Social Security income.

As Bob Kerrey, a senator from Nebraska, has said about his ideas for partial privatization of Social Security, he believes in the dignity, not the density, of the American people. In other words he trusts them with the truth. He doesn't insult them and doesn't believe we ought to insult them with nostrums like "save Social Security first" and "pay down the debt." He's content to let the people decide whether they can better invest a portion of their Social Security taxes in a system that will give them a far better return and a far more secure retirement than will the government system. And I'm convinced that if the American public sees this sort of debate and if more of our political leaders are willing to put these options on the table, those leaders will find resonance within the electorate. I'm encouraged by this election cycle in which a variety of candidates, including the apparent nominee of the Republican Party, George W. Bush, are willing to talk about this sort of a fundamental change in the Social Security system.

Winston Churchill said that you can trust the Americans to do the right thing after they've tried everything else. Well, we've been talking about a lot of other options that will take a bad situation and make it worse. But the right thing is to move in the direction of private investments to the benefit of the American worker, and I think the American public is ready for that alternative.

Michael Tanner: The reasons for privatizing Social Security are much more fundamental than just financial issues. First, even if Social Security were solvent, it is a bad deal for most young workers. The return will be abysmal for most people, even if Social Security pays every penny promised.

In addition to losing money in real and actual dollars, there is the huge opportunity cost. People could be earning a higher rate of return elsewhere if they weren't forced to put their money in the Social Security system. With Social Security you're lucky if you can get a 1 or 2 percent rate of return. The real before-tax rate of return to capital in this country is about 9.3 percent on a real basis, and that's what you're not able to invest in.

Orlando and Leah, a couple I recently met in south central Los Angeles, illustrate this point. Orlando works part-time helping to put together pegboards for computers, and Leah is a waitress. They each earned about $20,000 last year. Right now they are paying over $5,000 a year in Social Security taxes.

If they invested that $5,000 in real assets and it earned the historic rates of return—7 percent or so a year—for the next 45 years, when they retired they would have more than $1.5 million in the bank. The interest payments on that amount would be more than what Social Security paid, and when they died they could leave that money to their son, little Orlando. That is the loss they're suffering under the current Social Security system—and that's the reason to privatize Social Security even if Social Security were solvent and even if it could pay every dime in benefits that it has promised. The RAND Corporation has concluded that Social Security actually transfers money in the United States from the poor to the rich, from blacks to whites, and from men to women. Poor black men end up supporting rich white women on Social Security, and I suspect that is not the type of system we intended.

The World Bank has concluded that most pay-as-you-go social security systems around the world are actually regressive and that, despite progressive benefit formulas, those systems actually all end up transferring money from the poor to the rich because the poor start work earlier and don't live as long. Likewise, the system penalizes working women; because of the interaction between spousal benefits and the benefits women earn on their own, they receive exactly the same benefits they would receive if they hadn't worked outside the home and hadn't paid any Social Security taxes. All the tax money they paid their entire life is just lost.

Another problem with the current Social Security system is that it doesn't allow for the accumulation of wealth. I am deeply concerned about a society in which there are savers and investors and other people who do not get to participate in savings and investment. The people who can save, invest, and accumulate money can pass it on to their heirs. The people who have nothing but Social Security cannot.

Harvard University's Martin Feldstein estimates that the privatization of Social Security would result in a 50 percent reduction in the disparity of wealth in this country—that is, the gap between rich and poor in this country would close by almost half.

Finally, it's a simple question of dignity. In a pay-as-you-go social security system in the United States and around the world there is no legal right to your social security benefits. It's entirely a matter of politics and whether the politicians want to give you retirement benefits. Twice, in Flemming v. Nestor and Helvering v. Davis, the Supreme Court ruled that Social Security is a tax-and-spending program. The government determines your Social Security benefits and is free to cut them and take them away any time it wants. Someone entering the workforce today is gambling. What will the president or Congress decide to give me for retirement 45 years from now? In many countries around the world it is even worse. There are countries in Eastern Europe and elsewhere where the government made explicit promises to provide pensions and retirement benefits, and the checks aren't coming. That's the problem when you have to depend on politicians for your retirement instead of owning your retirement benefits.

Social Security was invented in the 19th century in Prussia. Here we are in the 21st century, and a lot has changed in the world. It's time we change Social Security as well and had a 21st-century Social Security system—one that is based on savings, investment, personal property rights, ownership, and the ability to pass the savings on and to accumulate wealth from generation to generation.

Milton Ezrati: Japan is about to enter an age of deregulation and privatization that will extend beyond the pension area. I'm not going to forecast that Japan will adopt a Chilean privatized scheme, but a market-oriented one is not out of the question. My confidence comes from two sources. One is the demographic issue. By 2020, one person in four in Japan will be over the age of 65. As a consequence the nation will have fewer than two workers and possibly only one worker for each retired person. In economic and financial terms, that situation is about twice the burden that will face the United States. It will be impossible to maintain the present system, and Japan will have to change.

There is also a growing awareness in Japan, even among the government bureaucracy, that the situation is critical. That awareness is a basis for my rather optimistic view that Japan will change from an extremely statist approach to a more private approach in the future. Japan's unfortunate luxury, much like the United States, is that it is an extremely rich country. This has allowed procrastination. The demographic pressure, however, will make that procrastination impossible. Japan will change or it will sink, and I don't think the Japanese will choose the latter path.

Despite being statist, the Japanese pension system is actually better suited to privatization now than is the system in the United States. The Japanese system has a two-tiered approach: One, the basic structure is effectively a redistribution, or a welfare safety net—a set rate is applied to everyone who is working. It's a minimal amount and is purely a safety net. Then on top of that the Japanese have what they call their employees' pension scheme, which looks a lot like Social Security in the United States.

This two-tiered approach separates the welfare redistributive function of the retirement system from the actual pension plan. And that is something that has muddied the debate in the United States.

What also helps the Japanese is the opt-out option for corporations or multiemployer groups who can reduce their contributions if they provide a pension scheme that is at least as good as that offered by the state. To help compete for better workers, corporations can, for no or little more cost, offer superior retirement benefits to employees.

As the demographic pressures build, Japan will be able to quickly move toward a privatized scheme. Recent surveys reveal that one-third of new workers are refusing to enroll in even the basic plan because they don't expect to get their benefits. This is tax evasion in a country that is renowned for its discipline and law-abiding nature. The old expression that more American youth believe in UFOs than believe they're going to get their Social Security benefits was alluded to in Japan as applicable there as well.

One ironic blessing for Japan is that, unlike the United States, Japan does not have a budget surplus. In fact, Japan is running a huge budget deficit, so it cannot kid itself that it can fund one government obligation with another. The Japanese cannot pretend that the surplus can fix their system, and that is a benefit.

The pension system is officially under-funded by half of gross domestic product. The Keidanren, Japan's major employers group, estimates that underfunding is actually about equal to GDP. Put another way, the Ministry of Health and Welfare (which oversees social security) has indicated that, to fund the social security system as it is currently structured, 30 percent of GDP will have to be devoted to that particular activity by 2025. Currently, it is 16 percent, already a large figure. Again, Japan's wealth is allowing procrastination.

According to the Ministry of Finance and the Ministry of Health and Welfare, payroll taxes would have to be 34 percent to keep the system as currently structured. The employee system would need to be funded by a hike in the consumption tax of an additional 3.7 percent. Overall, the average tax rate would be about 60 percent. Even the most docile population could not stand for that.

There have been the standard reform proposals: delay the retirement age, reduce spousal benefits, and index to inflation instead of wages. Fortunately, some groups have proposed some form of privatization. The Keidanren has proposed a system similar to the Chilean one that would end the current employee system while maintaining the basic system as a welfare safety net. The Keidanren would amortize the implicit debt of the existing public system over a long period of time and set up a private system with individual accounts. As an alternative the group has proposed a similar ending of the system with amortizing the burden and a 401(k) approach.

These proposals are truly remarkable, when you consider that the Keidanren is part of the "iron triangle" of government, business, and bureaucracy that is said to run Japan. Yet, sometimes when I read the Keidanren's material I think I'm reading Cato's stuff. Of course, it's more guarded and doesn't inspire me the way José Piñera's work does, but nonetheless it has the same flow to it. For an organization like the Keidanren to propose this in Japan today suggests to me that we are not very far from a turn in Japan and that the demographic pressure is tremendous not only for the pension system but also for the whole economy.

The reality of having fewer than two people working for every retiree is going to force Japan to change its entire economic model. That radical change is going to make privatization in public pensions an easy step compared with the other radical economic and financial changes that are going to have to take place in Japan.

This article originally appeared in the May/June 2000 edition of Cato Policy Report.