For Social Security, Opt-outs Don’t Add Up

August 24, 2001

As President Bush enjoys his month-long vacation, the process he set up to reform Social Security is seriously off track. Critics have derided the commission he appointed to brainstorm reform proposals as stacked, charging its preliminary report was biased.

There is a more fundamental problem with Mr. Bush’s Social Security strategy. The mandate he gave the commission—to develop a proposal that would permit, but not require, workers to opt out and shift some of their payroll taxes to individual retirement investment accounts—is unworkable. Permitting, not requiring, sounds great. What could be more American? No one is forced to do anything, but everyone would enjoy increased choice.

But experience from Britain, the only other advanced industrial country that uses the opt-out in a major way, suggests that Social Security opt-outs have all of the problems associated with universal mandatory saving—notably high administrative costs and increased risk. In short, they’re a financial and administrative nightmare. One problem with an opt-out reflects the fact that the present system offers higher returns on contributions of low-wage workers to help provide them with a decent retirement income. If an opt-out were available, higher-income workers would be more likely to opt-out, seriously undermining the current Social Security system’s financing.

Conversely, opting out of Social Security wouldn’t make sense for many low-wage workers. But they’re likely to be the least sophisticated investors, so they might opt out when they would be better off staying in the current system.

A second major opt-out problem is the differing returns offered by contributions to an individual retirement investment account during a worker’s life. The earlier in one’s career these contributions are made, the likelier they are to generate higher pension value.

Contributions to Social Security of equal real value will provide relatively equal returns regardless of when they’re made.

As a result, many opted-out workers will find it advantageous to opt back into Social Security at some point. It’s unclear where that point is, however, given uncertainties about future returns on investments and prices for annuities.

In Britain, incentives to opt back into the state pension have been addressed through age-related rebates for National Insurance contributions. Older workers get higher rebates as an incentive to continue to opt out of state pensions. These age-related rebates make the British system complicated and expensive to administer.

Age-related rebates make even less sense in the U.S. system, in which there is a closer linkage between contributions and benefits. The absence of general revenue financing in Social Security means that more generous Social Security contribution rebates for older workers would further undermine the financing of Social Security.

An alternative solution would be to require young workers to make a one-time, irrevocable choice to opt-out of Social Security. But this option is almost certainly not appropriate and even less likely to be politically sustainable.

Problems concerning who should opt out and when to opt back in raise a third critical problem with opt-outs: To whom could workers turn for impartial advice on these issues? Not to pension fund providers or financial advisers; they have a vested interest in selling their products. And not to the Social Security Administration, which would be under intense pressure from the Bush administration, Wall Street and the pension industry not to weaken the message that privatization is a good thing.

Unfortunately, the result is likely to mirror the British outcome: Workers will respond to high-pressure sales practices by pension-providers who “mis-sell” pension products. In Britain, mis-selling in the late 1980s is estimated to have cost more than $15 billion.

Were this to happen in the United States, litigation surely would follow.

If the United States is to adopt a mandatory individual savings pension tier—and that’s a big if—it should be required for all workers.

Potential implementation problems with opt-outs could undermine the legitimacy of both Social Security and the private pension industry. Mr. Bush would be well advised to use some of his vacation to rethink both his objectives for Social Security reform and his strategy for getting reform enacted.

If he doesn’t, the problems with opt-outs mean that stalemate will surely follow.

R. Kent Weaver is a senior fellow in the Governmental Studies Program at the Brookings Institution and author of the forthcoming book Reforming Social Security: Lessons From Abroad.