Not long ago, President Clinton went to Georgetown University to launch his campaign for Social Security reform. At that appearance the president called for Americans to be “open to new ideas, not to be hidebound and believe that we can see the future through the prism of the past.” If the president is serious about fixing Social Security’s many problems, he should follow his own call for “bold experimentation” and offer Americans a new Social Security system based on individual ownership and private investment.
Social Security’s problems begin with a looming financing crisis. The date most often cited in public debate is 2029, the year in which the Social Security trust fund will be exhausted. But focusing exclusively on that date is misleading. The implication is that Social Security’s financing is fine until 2029, at which point benefits will suddenly stop. The reality is much more complex.
Currently, Social Security taxes bring in more revenue than the system pays out in benefits. The surplus theoretically accumulates in the Social Security trust fund. Beginning as early as 2012, the situation will reverse. Social Security will begin paying out more in benefits than it collects in revenues. To continue meeting its obligations, it will have to begin drawing on the surplus in the trust fund. However, at that point we will discover that the Social Security trust fund is really little more than a polite fiction. For years the federal government has used the trust fund to disguise the actual size of the federal budget deficit—borrowing money from the trust fund to pay current operating expenses and replacing the money with government bonds.
Beginning in 2012, the Social Security Administration will have to start turning in those bonds to the federal government to obtain the cash needed to finance benefits. But the federal government has no cash or other assets with which to pay off the bonds. It can obtain the cash only by borrowing and running a bigger deficit, increasing taxes or cutting other government spending. All those options pose obvious problems.
Even if Congress can find a way to redeem the bonds, the trust fund surplus will be completely exhausted by 2029. At that point, Social Security will have to rely solely on revenue from the payroll tax. But that revenue will not be sufficient to pay all promised benefits. Either payroll taxes will have to be increased to at least 18 percent, a 50 percent increase over today’s 12.4 percent tax rate, or benefits will have to be slashed.
Social Security’s financing problems are a result of its fundamentally flawed design, which is comparable to the type of pyramid scheme that is illegal in all 50 states. Today’s benefits to the old are paid by today’s taxes from the young. Tomorrow’s benefits to today’s young are to be paid by tomorrow’s taxes from tomorrow’s young.
Because the average recipient today takes out more from the system than he or she paid in, Social Security works only as long as there is an ever-larger pool of workers paying into the system compared 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 Social Security beneficiary. Today there are only 3.3. By 2030 there will be fewer than 2. The Social Security pyramid is unsustainable.
Those financial troubles are reason enough to reform social Security. But focusing on the program’s financing is to miss an even bigger problem. Even if Social Security’s financial difficulties can be fixed, the system remains a bad deal for most Americans, a situation that is growing worse for today’s young workers. Payroll taxes are already so high that even if today’s young workers receive the promised benefits, those benefits will amount to a low, below-market return on payroll taxes. Studies show that many young workers’ benefits would amount to a real return of one percent or less on the required taxes. For some, the real return would be zero or even negative. Those workers can now get far higher returns and benefits through private savings, investment and insurance.
Raising taxes or reducing benefits to keep the system solvent will only make the rate of return worse.
There is a better alternative. Social Security should be “privatized,” allowing people the freedom to invest their Social Security taxes in financial assets such as stocks and bonds.
A privatized Social Security system would essentially be a mandatory savings program. Money would still be deducted from a worker’s pay and matched by the employer, the same as it is today. But instead of sending that money off to Washington to disappear into the black hole of Social Security, those workers who wish to do so could redirect their money into a personal retirement account (PRAs) of their choice.
PRAs would operate much like current individual retirement accounts (IRAs)or 401(k) retirement plans. Individuals could not withdraw funds from their PRAs prior to retirement, determined either by age or by PRA balance requirements. PRA funds would be the property of the individual, and upon death, any remaining funds would become part of the individual’s estate.
PRAs would be managed by the private investment industry, and workers would be free to choose the fund manager that best met their individual needs and could change managers whenever they wished. The government would establish regulations on portfolio risk to prevent speculation and protect consumers. Reinsurance mechanisms would be required to guarantee fund solvency.
The government would continue to provide a safety net in the form of a guaranteed minimum pension benefit. If upon retirement the balance in an individual’s PRA were insufficient to provide an actuarially determined retirement annuity equal to the minimum wage, the government would provide a supplement sufficient to bring the individual’s monthly income up to that level.
Of course, some people might worry that allowing people to invest privately is too risky. But that seriously misstates the risks of both privatization and of remaining with the current Social 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 stock market has been riding a wave of expansion. Undoubtedly, there will eventually be a correction.
But the year-to-year fluctuations of the market are actually irrelevant. What really counts is the long-term trend of the market over a person’s entire working lifetime, in most cases 45 years. Given that long-term perspective, there is no time in which the average investor would have lost money by investing in the U.S. stock market. In fact, taking just 20 years of stock market returns, the worst period in U.S. history, including even the Great Depression and the 1929 crash, produced a positive real return of more than 3 percent. The average 20 year real rate of return has been 10.5 percent.
As Sen. Robert Kerrey (D-Neb.) explains, “History shows conclusively that long-term investment in the stock market is safe and profitable.”
By comparison, relying on the current Social Security system is extremely risky. Because Social Security is at its core a political system, future benefits are dependent on political decisions. Indeed, the Supreme Court has ruled, in Nestor v. Fleming that individuals have no right to Social Security benefits based on the taxes they’ve paid. Congress and the president can change or reduce Social Security benefits any time they choose. A young worker entering the Social Security system is gambling on what benefits a Congress and president 45 years from now will decide to bestow. Given the already low rate-of-return to young workers and the system’s coming financial shortfall, the political risk of staying in Social Security far exceeds the market risk of private investment.
The most difficult issue associated with any proposed privatization of Social Security is the transition. Put quite simply, regardless of what system we choose for the future, we have a moral obligation to continue benefits to today’s recipients. But if current workers divert their payroll taxes to a private system, those taxes will no longer be available to pay benefits. The government will have to find a new source of funds. The Congressional Research Service estimates that cost at nearly $7 trillion over the next 35 years.
While that sounds like an intimidating figure, it should be understood that this is not a new cost. It is really just making explicit an already existing unfunded obligation. The federal government already cannot fund as much as $9 trillion of Social Security’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 we make the transition. We will have to find the revenues to pay benefits to current retirees. While any financing mechanism will be political, involving some combination of debt, transfers from general revenues, asset sales and the like, the expected budget surplus offers a good place to start. President Clinton has called for using the surplus to save Social Security. If both parties are willing to forgo new spending programs and junk tax cuts, we can begin the transition to a new, improved Social Security system.
Social Security privatization may be an idea whose time has come. For our children’s sake, it can’t come too soon.