Privately owned accounts produce retirement income that is far superior to the Social Security system, and die-hard defenders of Social Security know it. So they've taken to arguing that the personal retirement account alternative is just "too dangerous to test in the real world."
But the fact is that, in the real world, some 5 million workers employed by state and local governments are already outside the Social Security system, and a very fortunate subset of this group has exactly the sort of private account alternative that Congress should be aiming for.
The personal retirement account system for government employees in Galveston, Tex., is the one that has drawn most of the media's attention. News organizations such as ABC News and USA Today have told the impressive story of 1,500 Galveston employees and the much greater retirement benefits they get from a rather conservative, low-risk investment plan. But there is an even better example of the benefits a system of personal retirement accounts can provide in San Diego, where some 8,000 city employees receive even greater choice and higher returns — and therefore greater retirement benefits — from their personal accounts.
How did Galveston, San Diego and many other cities escape the "black hole" of Social Security? When the system was created in 1935, coverage was not offered to state and local government employees; at the time, Congress was concerned about the constitutionality of the federal government taxing state governments. In the 1950s, however, the law was changed to give state and local governments a chance to go into Social Security — or remain outside, if they wished. Then in 1983, the law was changed again to prevent any more from leaving.
In 1981, just two years before that last change in the law, the city of San Diego decided to opt out. The city's administrators believed that they could provide a better deal for their workers with an independent retirement plan. The city created the Supplemental Pension Savings Plan (SPSP), a mandatory defined-contribution plan. While this program replaces Social Security, city workers can, of course, participate in other retirement vehicles, just like employees in the private sector. For example, while city workers are automatically covered by San Diego's defined-benefit pension plan, they have the option of investing in a 401(k) plan as well as a separate deferred compensation plan.
In the SPSP program, participants like Bob Tilaro, a 43-year-old senior utility supervisor, are required to contribute 3 percent of their salaries. They can go beyond the minimum requirement and put as much as 7.5 percent of their salaries into their accounts. The city matches employees' contributions dollar for dollar, which provides an additional incentive to save.
When Tilaro began working for the city of San Diego in 1986, he was skeptical about the plan and contributed only the minimum. After a year of watching the growth of his account, fueled by the returns on his investments, he decided to contribute the maximum. His decision to go beyond the minimum is not unusual; more than 85 percent of the plan's participants take advantage of the additional savings option.
When the program began, all assets in San Diego employees' accounts were invested by the city treasurer in lower-risk securities, which averaged between 5 percent and 8 percent return a year. In 1996, San Diego restructured the program, giving its employees greater control over their accounts and greater freedom to invest. Instead of being restricted to investments in low-risk securities, they may now choose from among four mutual funds as well. San Diego workers have shifted close to 50 percent of the program's assets into mutual funds; since 1996, a booming economy has helped these funds post an average annual rate of return of more than 14 percent.
When Tilaro stops working at age 65, he will use the assets in his account to provide income for his retirement. Assuming his annual salary remains at about $44,000 per year and his investments earn a 7 percent real rate of return, his account will be worth approximately $630,000 in 1999 dollars by the time he retires. According to estimates provided by the benefits administrator, an asset of this value could purchase an annuity with a monthly payment of approximately $4,200 today.
If Tilaro instead had to participate in Social Security, he would be eligible to receive a monthly payment of about $1,300 starting at retirement age. Of course, by that time baby boomers will be moving out of the work force, and Social Security is likely to be in serious financial trouble. Unlike San Diego's program, Social Security uses "pay-as-you-go" financing, which means payroll taxes are immediately spent as benefit payments. No real assets are reserved for future benefits. As the ratio of workers to retirees dwindles, payroll taxes will become insufficient to pay all currently legislated benefits. By 2034, according to the Social Security Administration, taxes will have to rise from the current 12.4 percent to almost 18 percent of payroll, or benefits will have to be cut by at least 25 percent.
State and local retirement plans fund future benefit payments, a fundamentally different approach than the pay-as-you-go Social Security system. The additional revenue generated by investing at least a portion of workers' contributions allows state and local retirement plans to offer higher benefits and more flexibility than Social Security.
State and local retirement plans vary when it comes to who controls the programs' assets and who makes investment decisions. There are two main types of state and local retirement programs: defined-contribution plans, like the city of San Diego's, in which individuals own and invest their contributions; and defined-benefit plans, in which funds are pooled and invested by pension fund managers and benefits are determined by a set formula.
While state and local defined-benefit plans are a big improvement over Social Security since their funds are invested in real assets that appreciate in value, they also exhibit an important flaw. The Institute of Fiduciary Education estimates that 42 percent of such pension systems are required to allocate a portion of investment funds to projects that are supposed to support a local economy. Other pension systems prohibit investing in tobacco companies, or in firms that produce music or art deemed objectionable, making investment decisions political rather than economic. Not surprisingly, their returns tend to be more modest than those of systems where individuals own the accounts and invest in ways that are designed to maximize their retirement income.
Tilaro, who is married and has three children, sees the ownership of his account as a benefit in its own right: "Ours is a real retirement program, where you watch your account grow and know it's going to be there. I hear talk about Social Security — about whether or not there is going to be enough money in the future — and am glad I'm not a part of it. There is no guarantee with Social Security like there is when you actually own your money."
Those with a vested interest in maintaining Social Security's status quo malign proposals for personal retirement accounts as impossibly complicated and risky. But the real-life, ongoing program in San Diego proves just the opposite: A universal system of personal retirement accounts is not only feasible, but provides participants with real security grounded in personal ownership of investment accounts.