Social Security: Where’s the Real Risk?

Share

Not long ago, President Clinton went to Georgetown University tolaunch his campaign for Social Security reform. At that appearancethe president called for Americans to be "open to new ideas, not tobe hidebound and believe that we can see the future through theprism of the past." If the president is serious about fixing SocialSecurity's many problems, he should follow his own call for "boldexperimentation" and offer Americans a new Social Security systembased on individual ownership and private investment.

Social Security's problems begin with a looming financingcrisis. The date most often cited in public debate is 2029, theyear in which the Social Security trust fund will be exhausted. Butfocusing exclusively on that date is misleading. The implication isthat Social Security's financing is fine until 2029, at which pointbenefits will suddenly stop. The reality is much more complex.

Currently, Social Security taxes bring in more revenue than thesystem pays out in benefits. The surplus theoretically accumulatesin the Social Security trust fund. Beginning as early as 2012, thesituation will reverse. Social Security will begin paying out morein benefits than it collects in revenues. To continue meeting itsobligations, it will have to begin drawing on the surplus in thetrust fund. However, at that point we will discover that the SocialSecurity trust fund is really little more than a polite fiction.For years the federal government has used the trust fund todisguise the actual size of the federal budget deficit--borrowingmoney from the trust fund to pay current operating expenses andreplacing the money with government bonds.

Beginning in 2012, the Social Security Administration will haveto start turning in those bonds to the federal government to obtainthe cash needed to finance benefits. But the federal government hasno cash or other assets with which to pay off the bonds. It canobtain the cash only by borrowing and running a bigger deficit,increasing taxes or cutting other government spending. All thoseoptions pose obvious problems.

Even if Congress can find a way to redeem the bonds, the trustfund surplus will be completely exhausted by 2029. At that point,Social Security will have to rely solely on revenue from thepayroll tax. But that revenue will not be sufficient to pay allpromised benefits. Either payroll taxes will have to be increasedto at least 18 percent, a 50 percent increase over today's 12.4percent tax rate, or benefits will have to be slashed.

Social Security's financing problems are a result of itsfundamentally flawed design, which is comparable to the type ofpyramid scheme that is illegal in all 50 states. Today's benefitsto the old are paid by today's taxes from the young. Tomorrow'sbenefits to today's young are to be paid by tomorrow's taxes fromtomorrow's young.

Because the average recipient today takes out more from thesystem than he or she paid in, Social Security works only as longas there is an ever-larger pool of workers paying into the systemcompared to beneficiaries taking out of the system. However,exactly the opposite is happening.

Life expectancy is increasing, while birth rates are declining.As recently as 1950, there were 16 workers for every SocialSecurity beneficiary. Today there are only 3.3. By 2030 there willbe fewer than 2. The Social Security pyramid is unsustainable.

Those financial troubles are reason enough to reform socialSecurity. But focusing on the program's financing is to miss aneven bigger problem. Even if Social Security's financialdifficulties can be fixed, the system remains a bad deal for mostAmericans, a situation that is growing worse for today's youngworkers. Payroll taxes are already so high that even if today'syoung workers receive the promised benefits, those benefits willamount to a low, below-market return on payroll taxes. Studies showthat many young workers' benefits would amount to a real return ofone percent or less on the required taxes. For some, the realreturn would be zero or even negative. Those workers can now getfar higher returns and benefits through private savings, investmentand insurance.

Raising taxes or reducing benefits to keep the system solventwill only make the rate of return worse.

There is a better alternative. Social Security should be"privatized," allowing people the freedom to invest their SocialSecurity taxes in financial assets such as stocks and bonds.

A privatized Social Security system would essentially be amandatory savings program. Money would still be deducted from aworker's pay and matched by the employer, the same as it is today.But instead of sending that money off to Washington to disappearinto the black hole of Social Security, those workers who wish todo so could redirect their money into a personal retirement account(PRAs) of their choice.

PRAs would operate much like current individual retirementaccounts (IRAs)or 401(k) retirement plans. Individuals could notwithdraw funds from their PRAs prior to retirement, determinedeither by age or by PRA balance requirements. PRA funds would bethe property of the individual, and upon death, any remaining fundswould become part of the individual's estate.

PRAs would be managed by the private investment industry, andworkers would be free to choose the fund manager that best mettheir individual needs and could change managers whenever theywished. The government would establish regulations on portfoliorisk to prevent speculation and protect consumers. Reinsurancemechanisms would be required to guarantee fund solvency.

The government would continue to provide a safety net in theform of a guaranteed minimum pension benefit. If upon retirementthe balance in an individual's PRA were insufficient to provide anactuarially determined retirement annuity equal to the minimumwage, the government would provide a supplement sufficient to bringthe individual's monthly income up to that level.

Of course, some people might worry that allowing people toinvest privately is too risky. But that seriously misstates therisks of both privatization and of remaining with the currentSocial Security system.

Are stocks really risky? In any given year, stocks can go up,but they can also go down. For the last several years the stockmarket has been riding a wave of expansion. Undoubtedly, there willeventually be a correction.

But the year-to-year fluctuations of the market are actuallyirrelevant. What really counts is the long-term trend of the marketover a person's entire working lifetime, in most cases 45 years.Given that long-term perspective, there is no time in which theaverage investor would have lost money by investing in the U.S.stock market. In fact, taking just 20 years of stock marketreturns, the worst period in U.S. history, including even the GreatDepression and the 1929 crash, produced a positive real return ofmore than 3 percent. The average 20 year real rate of return hasbeen 10.5 percent.

As Sen. Robert Kerrey (D-Neb.) explains, "History showsconclusively that long-term investment in the stock market is safeand profitable."

By comparison, relying on the current Social Security system isextremely risky. Because Social Security is at its core a politicalsystem, future benefits are dependent on political decisions.Indeed, the Supreme Court has ruled, in Nestor v.Fleming that individuals have no right to Social Securitybenefits based on the taxes they've paid. Congress and thepresident can change or reduce Social Security benefits any timethey choose. A young worker entering the Social Security system isgambling on what benefits a Congress and president 45 years from now will decide to bestow. Given thealready low rate-of-return to young workers and the system's comingfinancial shortfall, the political risk of staying in SocialSecurity far exceeds the market risk of private investment.

The most difficult issue associated with any proposedprivatization of Social Security is the transition. Put quitesimply, regardless of what system we choose for the future, we havea moral obligation to continue benefits to today's recipients. Butif current workers divert their payroll taxes to a private system,those taxes will no longer be available to pay benefits. Thegovernment will have to find a new source of funds. TheCongressional Research Service estimates that cost at nearly $7trillion over the next 35 years.

While that sounds like an intimidating figure, it should beunderstood that this is not a new cost. It is really just makingexplicit an already existing unfunded obligation. The federalgovernment already cannot fund as much as $9 trillion of SocialSecurity's promised benefits. Privatizing Social Security,therefore, will actually reduce the amount of debt we owe.

Of course there will be a temporary cash flow problem while wemake the transition. We will have to find the revenues to paybenefits to current retirees. While any financing mechanism will bepolitical, involving some combination of debt, transfers fromgeneral revenues, asset sales and the like, the expected budgetsurplus offers a good place to start. President Clinton has calledfor using the surplus to save Social Security. If both parties arewilling to forgo new spending programs and junk tax cuts, we canbegin the transition to a new, improved Social Security system.

Social Security privatization may be an idea whose time hascome. For our children's sake, it can't come too soon.

Michael D. Tanner

Senate Special Committee on Aging
United States Senate Hearing Philadelphia