Social Security: Solvency Isn’t the Only Issue

This article appeared on on December 27, 1996.

Most of the calls for reforming Social Security have highlighted the program's looming insolvency. There is certainly good reason to be concerned about Social Security's financial health. The system will be running a deficit as soon as 2012. But focusing too narrowly on solvency invites cures that are as bad as the disease.

Social Security's failing finances are one reason why we need to update this outmoded New Deal legacy. But there is another, equally important, problem with Social Security.

Quite simply, Social Security is a bad deal for most Americans, a situation that is growing steadily worse for today's young workers. Payroll taxes are already so high that even if today's young workers receive the promised benefits, such benefits will amount to a low, below-market return on those taxes. Indeed, as the attached figure shows, most Americans working today will actually receive a negative return--less than they paid in.

If keeping Social Security solvent were the only concern, that could be done by raising taxes or cutting benefits. In fact, labor unions and the seniors lobby are already beating the drums for a tax hike. Meanwhile, in Congress, several benefit cuts such as raising the retirement age are being tentatively broached. Recent proposals for recalculating the Consumer Price Index are also being hailed as a way to preserve Social Security.

But raising taxes or cutting benefits would only make the return on Social Security even worse. For example, reducing the CPI by 1 percent will lead to a benefit reduction of more than $5,000 over a recipient's lifetime. Certainly, the CPI should be adjusted to ensure its accuracy, but such a change should never be confused with saving Social Security.

The only way to simultaneously solve Social Security's financing problems and provide higher benefits is to privatize the system, allowing young workers to redirect their payroll taxes to individually owned, privately invested accounts, similar to 401(k) plans or Individual Retirement Accounts. At the same time, the government should cut current spending and sell assets to guarantee benefits to those currently receiving benefits.

Privatizing Social Security in this way will end the current pyramid scheme and guarantee the system's future solvency. At the same time, by allowing workers to earn the high returns available from private investment, privatization will allow people to retire with much higher benefits. A 1995 study by William Shipman of State Street Global Advisors concluded that even if the financial markets’ performance is slightly worse than their historical average, today's young workers could expect to receive benefits three to six times greater if they were allowed to privately invest their Social Security taxes.

The poor return from Social Security leaves tomorrow's seniors at severe financial risk. Social Security accounts for nearly half of all retirement benefits. More than half of the elderly receive no private pension, and more than one-third have no income from assets. Clearly, millions of elderly people rely on Social Security to provide for their retirement. Therefore, the increasingly poor return from Social Security means that many elderly Americans will find their financial security at risk. In contrast, privatization would allow today's young workers to retire with the same financial dignity as their parents.

As we set out to fix Social security's financial problems, we should keep that in mind.

Michael D. Tanner

Michael Tanner is director of health and welfare studies at the Cato Institute.