Privatizing Social Security: A Bad Idea Whose Time Will Never Come

Henry J. Aaron
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

June 1, 1997

Repeated often enough, even demonstrably false statements come to seem true. The assertion that Social Security faces enormous problems requiring large benefit cuts or tax increases is a case in point. Supposedly well-informed people have repeated this allegation so often that one risks losing credibility by challenging its accuracy. But it is false.

Sensible discussion follows from facts. The fact is that Social Security is adequately funded for 30 years and that its long-term financing problem can be solved by reforms that entail no serious modification of the basic structure of the program and no payroll tax increases.

How Big Is the Problem?

Between 1997 and 2035, the cost of Social Security is projected to rise 2 percent of gross domestic product. The increase, over nearly 40 years, is the same as that in the cost of Social Security from 1970 to 1982—just 12 years—and the drop in defense spending from 1989 to 1996—just 7 years. The point is not that any of these shifts is negligible. It is that the past changes in the costs of Social Security and national defense were as large as the projected change in Social Security costs and happened far faster, but without being seen as either a huge challenge or an enormous windfall. A little perspective is in order.

What about the projected decline in the ratio of workers to retirees—from roughly 3 to 1 in 1995 to roughly 2 to 1 by 2035? It looks as if each worker, who now takes care of one-third of a retiree, will have to take care of half a retiree in 2035—a 50 percent increase. But the real financial burden workers everywhere and at all times face is the need to support everyone who does not work, not just the elderly, as well as themselves. The total population per 100 workers (see figure), at a long-term high in 1960, has since fallen about 20 percent to a long-term low. The principal reasons have been a drop in the number of children per worker and, to a smaller degree, a rise in the proportion of women who work (hence, a drop in dependent non-aged adults). The number of elderly retirees per worker has risen, but not much. Over the next 45 years, it will rise rapidly. The number of dependent non-aged adults per worker is projected to stop falling, as a decrease in the share of men who work more than offsets some further increase in the share of women who work. Partially offsetting these trends, the number of children will keep dropping.

The total number of mouths each worker has to feed will rise about 6 percent over the next 45 years, not the 50 percent suggested by focusing only on retirees. Worker productivity growth of barely 0.1 percent a year would offset that burden. In 2040, the burden will be 16 percent lower than in 1960. But the elderly are supported publicly, children and dependent non-aged adults, mostly privately. Doesn’t the shift in who is dependent create serious stresses on public finances? Changing financial arrangements for a program as politically sensitive as Social Security is never easy. But the economic size of the problem is not large, and those who wish to see sober and sensible action must make this fact clear.

Solving the Problem in Six Steps

Even if costs are not rising as much as some have said, won’t it take heroic changes in Social Security to close the deficit? You be the judge. The program outlined below would not only close the projected long-term deficit, but create a surplus.

Reform 1 Under current law, government employees in a few states and localities are not covered by Social Security. Most, however, earn eligibility for Social Security through employment before, during, or after their government work—and they get far more in Social Security benefits than Congress intended. Social Security benefits are calculated based on average earnings in the 35 years of highest earnings. These state and local workers, who have considerable earnings during their years outside Social Security, are recorded as having none. Because their average Social Security earnings appear low, they get the relatively higher benefits intended for low earners as well as their state or local pensions. Legislation enacted in 1977 reduced, but did not eliminate, the problem.

The recent Social Security Advisory Council voted unanimously to bring all new state and local hires under Social Security. This reform eliminates 10 percent of the projected deficit.

Reform 2 In-creasing from 35 to 40 the number of years over which average Social Security earnings are computed would reduce benefits because the additional 5 years, by definition, would be lower than the highest 35. Most members of the Advisory Council embraced an increase to 38 years. Going to 40 years would close 21 percent of the deficit.

Reform 3 Contributory private pensions are subject to the personal income tax, unless the pension repays money that has already been taxed. In the case of Social Security, only the worker’s payroll tax has been subject to personal income tax. Making all Social Security benefits taxable would bring the tax treatment of Social Security in line with that of private pensions. It would eliminate 13 percent of the deficit.

Reform 4 In 1983 Congress approved a phased increase in the normal retirement age from 65 to 67—two months a year from 2003 through 2008, and from 2020 to 2025. This measured pace gives the word “leisurely” a whole new meaning. Avoiding abrupt changes for vulnerable older workers is compassionate, but the 12-year hiatus is surely over-cautious. Eliminating it would close 5 percent of the deficit.

Reform 5 A quarter-century ago, conservatives, exasperated by liberals who regularly raised Social Security benefits in election years to offset inflation and then took political credit for it, persuaded Congress to make the inflation adjustment automatic. The reform assured the retired and disabled that their benefits would retain constant purchasing power. The principle has never been challenged, but many analysts believe that the price index used to adjust benefits greatly overstates inflation. If analyses by the Bureau of Labor Statistics reveal that the index should be lowered by 0.5 percentage point, less than half the change recommended recently by a commission chaired by former chairman of the Council of Economic Advisers, Michael Boskin, that change would cut the deficit by 32 percent.

Reform 6 It seems only fair that Social Security reserves be managed so that beneficiaries have the same investment opportunities as private savers do. It also seems fair that Social Security beneficiaries receive returns on their payroll taxes that reflect the benefits to society resulting from Social Security reserve accumulation.

Let’s be clear on one fact. Each extra dollar of saving earns the same return whether it is saved privately or through Social Security. Private saving makes that dollar available directly for private investment. The social gain is the private rate of return. Adding a dollar to Social Security reserves reduces federal borrowing from the public by a dollar, leaving an extra dollar of private saving for private investment. The social gain from adding to Social Security reserves is, again, the private rate of return.

Unlike private pension funds, Social Security reserves cannot be invested in private securities. The prohibition means that Social Security will pay smaller benefits than private pensions can pay for each dollar of tax or contribution although the social returns to both forms of saving are identical. The differential guarantees invidious comparisons with returns on private savings and thereby jeopardizes long-term public support of social insurance. Lifting the prohibition would close 37 percent of the deficit.

Some observers fear that lifting this prohibition would expose Social Security trustees to pressure to make politically motivated investments. But managers of the Federal Employees Retirement System and of the pension funds for the Federal Reserve System and the Tennessee Valley Authority, all of which invest in private securities, have remained entirely independent in their fund management. As an added safeguard, Congress could create an organization, modeled on the Board of Governors of the Federal Reserve System, to manage the Social Security trust fund and its investments. Members would be confirmed by Congress, appointed for lengthy, staggered terms, and removable only for criminal behavior. The record of the Board of Governors makes quite clear that such appointees are able to carry out their responsibilities without suffering political manipulation.

To be sure, Congress could direct such an organization to pursue politically motivated policies, just as it could force the Board of Governors to skew monetary policy for political reasons. It could also force private managers of federally approved private plans to follow mandated investment rules. But protection against such interference is political, not legal. Experience in other countries shows that governments can interfere with those who manage monetary policy and who supervise investment of public and private pension funds. But in the United States independent administrative frameworks have been sustained before and can be sustained in the future as long as the American people insist on it.

Even without investing Social Security reserves in private securities, the first five changes close more than four-fifths of the long-term deficit and would keep the Social Security trust fund solvent until well past mid-century. The six steps I have outlined may not be the best ways to restore long-term balance in Social Security, but they surely show that restoring the system to balance over the next 75 years requires no fundamental change in benefits and no increase in payroll taxes.

Privatization Plans

While the air of crisis around Social Security is bogus, it is surely legitimate to ask whether the welfare of the nation could be improved if all or part of Social Security were replaced with individual savings accounts. It is hard to address this question generally because the various “privatization” proposals differ so much. But all, including that by Laurence Kotlikoff and Jeffrey Sachs, raise two key issues. The first is who bears the risk? All savings plans carry risk. It may prove impossible to sustain deposits at planned levels. Investment returns may fall short of expectations. Who should bear these risks? All privatization plans put the risk on the individual. Each worker bears the full consequence of shortfalls in deposits or returns on his or her individual account, and the pension is reduced proportionately. This is an inescapable characteristic of “defined-contribution” plans in which the contribution rate is specified, but the amount contributed depends on earnings and the ultimate benefit depends on investment returns.

In contrast, social insurance is a “defined-benefit” plan that diffuses risks broadly among all workers and across generations. The benefit formula is fixed, and workers and their employers through payroll taxes or the government through other taxes must meet those commitments. The risk workers face is political: that elected officials will change benefits or taxes.

Herbert Stein illustrates the choice by asking which of the following two options is preferable for a basic retirement plan—one that guarantees a retirement income equal to 50 percent of average earnings or one that gives a 50-50 chance of 120 percent of average earnings or nothing? The latter has a higher expected value, 60 percent of income on average. But for the basic retirement program, the sure bet of social insurance is preferable. One should not subject the mass of the public, most with few assets and therefore little capacity to withstand financial reverses, to the uncertainties inherent in individual investment accounts.

Actually, Stein’s example unduly favors plan two, at least as embodied in most privatization proposals. If both plans invest in the same assets, the returns potentially available under social insurance are higher, not lower, than under private plans. If, under the private plans, each person is free to choose among funds, and the incomes of fund managers hinge on that choice, selling and administrative costs will be high. Under the much-vaunted Chilean privatized pension system, such costs have averaged 20 percent of fund incomes, about the same as for U.S. life insurance companies. Based on Chilean experience, and adjusted for population, sales staffs would total some 450,000 in the United States.

The plan proposed by Kotlikoff and Sachs is not as bad as other privatization plans in saddling workers with risks. It reduces the loss workers would suffer from a drop in wages by stipulating that the government should match workers’ contributions “on a progressive basis.” But they do not explain exactly what this means. They would also restrict the frequency with which workers could move their accounts. But no privatization plan can escape the central reality: if workers can shift accounts, private managers will spend money to induce them to do so. And no matter how much managers spend, workers as a group cannot earn more than the economywide average return on investments, less selling and administrative costs. They can earn the same return without the extra costs through social insurance.

I Asked for Ice, But This Is Ridiculous

This remark, attributed to a man standing at the bar in the Titanic, might stand for the reactions of many to the tax increase that Kotlikoff and Sachs propose. A 10 percent sales tax would generate between $300 billion and $500 billion in 1997, depending on whether all consumption was taxed or major exemptions, such as for education and hospital care, were allowed. Now that is a tax increase! This tax would come on top of the contributions workers would have to make to their personal security accounts. Kotlikoff and Sachs are quite vague on just what the various magnitudes would be.

Their reticence is understandable, because they face a problem that advocates of all privatization plans have to solve but few like to highlight. Social insurance operates on the principle that today’s workers pay for today’s retirees. In return, today’s workers expect their retirement to be paid for by tomorrow’s workers. Recently the United States edged away from this principle by requiring today’s workers to pay more than is necessary to support the retired roughly $60 billion a year more now, growing to more than $100 billion a year over the next decade. The intent was to ease the burden on tomorrow’s workers and make today’s bumper crop of workers pay in part for their own retirement.

Under privatization, today’s workers would pay for all of their own retirement, as well as the full cost of pensions for today’s retirees. That is why a big tax increase is necessary. In the Kotlikoff-Sachs plan, the payroll tax would be replaced by payments workers would make into personal accounts. The effect of the contribution on a worker’s current disposable income, however, is the same as the payroll tax. The 10 percent sales tax would be an added burden. Without it, the Kotlikoff-Sachs plan collapses.

The real function of any tax is to discourage consumption, thereby boosting national saving. Many people now agree that the United States saves too little. In confronting proposals to boost saving, one has to ask two questions. How much? Is this the best way?

U.S. families now save 4-5 percent of disposable income and consume the rest, most of which would be subject to the 10 percent sales tax. If all consumption were covered, the sales tax would triple the proportion of their disposable income not available for consumption. If half of consumption were exempt, the proportion would double.

Forced saving of this size is unlikely to be acceptable in any form. But if the nation is to save so much, one is entitled to ask who is to consume less. In this case, it is the poor and middle classes, who consume most of their income. High-income families might not have to cut consumption at all. They could reduce voluntary saving to offset the new mandate. Most middle- and lower-income families do not currently save enough voluntarily to do so. Surely it is worth asking whether those who must consume all their modest income should be forced to contribute a larger proportion of that income to boosting national saving than those whose income now permits them to save a good share of it.

America’s Best Antipoverty Program

Social Security faces a modest long-term deficit that Congress should address immediately. The system can and should be fixed, not scrapped. It is possible to do so without raising taxes or materially changing the program. Social Security has served the nation well and promises to continue doing so. It provides more than 80 percent of income to the lowest-income 40 percent of the elderly and disabled. For all but those in the highest-income 20 percent, it provides more than half of income. It is far and away the most important U.S. antipoverty program. It lifts 6 percent of the population out of poverty, double that of all other cash and in-kind assistance combined. Privatization is a bad idea because it places risks on individual workers that they should not be expected to shoulder and that Social Security now spreads broadly among all workers. It would create costly and needless administrative burdens. One can understand why large financial enterprises are spending millions to fund studies of privatization. They would gain enormously, but the rest of us would lose.