As the debate over Social Security reform begins its escalation, I hope (but don’t expect) that liberals, instead of just shrieking, will bear in mind that the program’s current design was not the product of careful ratiocination based on progressive principles. FDR’s brain trust simply copied the features that were most common in private pension plans of the 1920’s. Hence, the system is a defined benefit plan based on career average compensation and funded on a pay-as-you-go basis by both employer and employee contributions. The main reason why it did not include individual accounts is that plans of that sort were extremely rare at the time. The best known was the Sears Roebuck plan, which invested only in employer stock. “Privatization” was not an option that was analyzed and rejected; it was never on the table.
Pension plan design concepts have advanced since 1933. Individual capital accumulation is rapidly becoming as important as employer promises, for reasons that are not completely different from those that impel Social Security reform: Offering a guaranteed lifetime income to retirees becomes a risky business as life expectancy lengthens and the ratio of active to former employees shrinks.
The way that Social Security is set up makes the effects of demographic change particularly acute, for it promises more than most other plans: a lifetime retirement income indexed to current workers’ wages. A corollary is that a decline in the number of workers per retiree necessarily increases the percentage of the workers’ income needed to support the program; higher wages stemming from improved productivity don’t fully mitigate the burden, because the wage rise increases benefits.
Reform would, in broad outline, refashion the present structure in this manner: Nothing would change for current retirees and workers within a few years of retirement. For younger workers, a share of current FICA taxes (12.4 percent of wages up to an inflation-indexed maximum ($90,000 in 2005)) would be deposited in individual accounts, which could be invested in an array (but not an infinite array) of mutual funds and insurance company pooled investment accounts. The individual account portion would be larger for younger workers. The remaining taxes would be applied, as at present, to pay current benefits. Future entitlements would be reduced by the economic equivalent of the private accounts’ anticipated future value, using reasonable actuarial assumptions. Eventually, government promises would be eliminated, except perhaps for a “longevity insurance” benefit beginning at, say, age 85, to reduce the risk that account owners will outlive their capital. Once the transition is complete, no generation will rely primarily on the generosity of the next as support for its old age.
The reason why Social Security needs repair is not that it faces an imminent threat. The current scheme can lumber along for another generation or so before it grows as costly as some of the European systems are today. But, barring a halt to current longevity trends, it is not self-sustaining in the long run. At its inception, the U.S. had 41 workers per retiree. Today there are three; 25 years from now, there will be two. Roughly speaking, people working in 2030 will have to shell out 50 percent more per capita for Social Security, in some combination of payroll taxes, income taxes, federal spending reductions and borrowing, than we do today.
There is no way to avoid coping with that burden, and reform advocates don’t pretend otherwise. Their goal to prevent Social Security’s relative cost from rising indefinitely as the worker-to-retiree ratio spirals toward one-to-one or less. The problem is so large and long-term that any solution has to begin now. If we wait until, say, 2050, the only options will be breaking commitments to newly retiring workers, stripping the active cohort of a huge share of its earnings or stopping medical progress. Liberals who coo over “the children” might want to think about those choices.
The preference of most left-of-center commentators so far has been not to think but to engage in misdirection, often tinged with hysteria. Four lines of mal-argument (as an Austrian economist might style it) are prominent:
1. Most people will invest their individual accounts poorly and wind up impoverished. There are two bases for this fear: First, the stock market fluctuates. Second, most investment professionals don’t think much of the way the employees invest their section 401(k) accounts. These are, however, phantom worries.
The market does indeed go down as well as up, but there has never been any stretch of American history as long as a working lifetime in which equity investments did not produce a substantial real return. Furthermore, retirees do not need all of their savings at once. When a man builds up capital over 30 or 40 years, then draws it down over 20 or 30, what happens in a particular year or five is not of crucial importance.
While past performance is no guarantee of future returns, as investment advisors’ ad have to remind us, it is instructive to look at what would have happened if the transition to a Social Security system based on individual accounts had begun in the Eisenhower or Kennedy Administration, when a 1,000 Dow seemed impossibly far away. With all that has happened over the past 45 years, there is no doubt that someone entering the labor force then and retiring about now would be far better off today if his payroll taxes had been invested for his own benefit, and Social Security would be a solved rather than a future problem. Alas, neither progressive Republicans nor liberal Democrats had that much foresight and imagination.
What about the possibility that individuals will spoil this scenario through poor investment choices? Critics of reform like to note that individuals have not, according to various studies, invested their 401(k) accounts in a manner that has kept up with major market indices. That is true enough, but the reason is not that 401(k) holders pick stocks badly. Rather, they tend to invest very conservatively, preferring GIC’s and money market funds to equities. That phenomenon, in turn, is largely explained by the fact that older workers are the heaviest 401(k) contributors. Because of their relatively shorter investment horizon, these investors tend to be risk averse. Even they should probably be more aggressive, but, in any event, comparing their returns to the market as a whole gives no indication of how individual Social Security accounts would perform over time.
All reform proposals are designed to reinforce the essentials of prudent saving: long-term perspectives, regular deposits and diversification of investments. The actual stock picking, under any realistic proposal, will be left to professional money managers at mutual funds and insurance companies, not to amateurs trying to assemble their own portfolios. There is one unavoidable risk: The whole U.S. economy may sink into a decades long, EU-like torpor. Should that occur, retiree-investors will not be in an enviable position. On the other hand, counting on a stagnant economy to transfer ever larger shares of income from workers to non-workers is not a brilliant strategy either. It isn’t obvious that the elderly will then be better off without than with reform.
The proper comparison is not “risky” investment returns against unfunded promises whose fulfillment is taken for granted. It is the accumulation of individual capital against promises that can be met only if conditions exist that will make investments profitable and that are exposed to repudiation in case of a permanent economic downturn.
2. Individual accounts will pay billions of dollars in investment management fees. This canard, ancillary to shibboleths about investment risk, aims to prey on atavistic suspicions of Wall Street. Of course professional investment management costs money, just like any other service. That the service is worth the cost is shown by the fact that very rich, sophisticated people gladly pay for it.
The market for investment management is also among the most competitive that has ever existed. It’s a business with minimal barriers to entry and low start-up costs. The notion that it is overpriced is one that can be conceived only by minds imbued with an unshakeable conviction that all private enterprise is exploitation.
3. The President’s plan really hinges on cutting benefits. Private accounts are just an ideologically driven flourish. The anti-reformers’ key misdirection is their failure to distinguish between the two separate challenges that Social Security faces: first, closing the gap between future benefit promises and the revenues that will be produced by projected FICA taxes; and, second, adjusting to the steady reduction in workers per retiree. Private accounts may help with the first problem. Young workers could prove willing to accept fairly optimistic estimates of future investment, increasing the revenues available to support their elders, but we shouldn’t count on any “bonus” from that source. Structural reform aims to deal with the second problem. The first will have to be addressed whether or not the structure changes a whit.
Unfortunately, the stream of revenues dedicated to Social Security will, in less than 15 years, produce less money than will be needed to pay benefits. At that point, the deficit will have to be closed by increasing FICA taxes, using other government revenues to make payments (entailing either raising taxes or reducing other spending), borrowing money or cutting benefits. Those are the only options. A transition to private accounts will not make them easier or harder.
The Bush Administration has given some indication of what it prefers. The President has ruled out higher payroll taxes and has more than hinted that he is leery of both further expansion of the federal deficit and reliance on general revenues (beyond the extent to which that recourse is already contemplated by Social Security’s fictional “trust fund” mechanism”). Benefit reductions are what is left. The ideas being floated – principally increases in the age at which full benefits would commence and indexation linked to cost of living rather than wage increases – have frequently been advanced by experts from across the political spectrum. Whether they are good or bad is not pertinent here. The point that I wish to emphasize is that they have no bearing on the desirability of private accounts.
Incidentally, Michael Kinsley’s much publicized “logical proof” that reform cannot succeed relies on confusion between the two Social Security problems. His contention is that private accounts won’t make the economy richer and therefore won’t produce the funds needed to close the actuarial gap between revenues and benefit promises. Others, Don Luskin, for instance, have questioned the merits of his argument in what I regard as a convincing fashion. (His claim that increased saving cannot create increased wealth is certainly novel, to say the least.) But the merits of Kinsleyan economics really don’t matter. He is contending that private accounts won’t solve the problem that they aren’t designed to attack, while ignoring their actual purpose.
4. The transition to private accounts will lead to vast new government borrowing. Analysis of the consequences of reform for government finances is muddied by the fact that Social Security liabilities are currently off the Treasury’s books. Failing to report them does not, needless to say, make them any less real, and, unless the investment community is stupid, they have the same impact on financial markets as recorded debt.
For an interim period Social Security will have to meet its commitments to current and near future retirees even as all or part of younger workers’ payroll taxes are deposited into their personal accounts. The system’s net financial position will not change as a result. The taxes allocated to the defined benefit portion of the program will be lower, but so will defined benefit obligations, since private accounts will replace promises of equal value. What will change is the timing of the liabilities. Under the current setup, active workers are offered unfunded benefits post retirement; the reformed one will replace those distant liabilities with immediate contributions to personal accounts. Borrowing funds to finance that acceleration will leave the government’s real deficit unchanged: Reported debt will be higher, off-books Social Security debt lower by an equal amount.
In summary, if an intellectually coherent case exists that unfunded promises are a better retirement vehicle than individual capital accumulation, the defenders of the present system have yet to make it. The shrillness of their attacks is a measure of their inability to cope with a proposal that many, I suspect, regard as undesirable for noneconomic reasons: Senior citizens who rely on their own investments for retirement income will be immune to demagoguery about how “evil Republicans are plotting to take away your Social Security”. Instead, they will be vigilant in defense of private property and pro-growth economic policies. That isn’t a happy prospect for some political factions.
Further reading: David C. John, “The Top Ten Myths About Social Security Reform”
Arnold Kling, “Economics of Social Security Privatization”
Tim Worstall, “The Social Security Debate’s Red Herrings”
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