Should Social Security be Privatized?
Many people don’t understand how the Social Security system really
works. There are no separate Social Security accounts set up for each
taxpayer to which he contributes his Social Security tax each year. Many
people believe these accounts exist, that the money they pay into their
accounts grows each year until retirement, and when they retire they get
back what they paid in with interest. This is not true. Most people are
unaware of the fact that our current Social Security system is a
pay-as-you-go program, which means that the revenue the federal
government raises each tax year for Social Security benefits is paid out
that same year to beneficiaries.
Many economists believe that our Social Security system is in need of a
major overhaul if today’s workers are to receive future benefits.
Thomas R. Saving, Director of the Private Enterprise Research Center at
Texas A;M University says, What is wrong is that the Social Security
system was never set up to be a sound investment-based retirement system.
Karl Borden, professor of financial economics at the University of
Nebraska recently wrote, Social Security is an unfunded pay-as-you-go
system, fundamentally flawed and analogous in design to illegal pyramid
schemes. Government accounting creates the illusion of a trust fund, but,
in fact, excess receipts are spent immediately.
Robert M. Ball, former commissioner of Social Security said, Some of
the trust fund money should be put into the stock market. I want to do it
to get a better return for the Social Security system. Historically,
long-term government bonds have had a real return, after inflation, of 2.3
percent a year, compared with 6.3 percent for stocks.
Paul W. Boltz, economist for the T. Rowe Price mutual fund said, When
we examine the pending financial crisis of our Social Security system, we
find, in effect, the characteristics of a government sponsored Ponzi-type
Michael H. Cosgrove, of the Dallas-based newsletter, The Econoclast
says, People need to take the responsibility of investing their own funds
for their retirement. The Social Security system assumes people can’t make
that decision and government can do it better. The result is a bankrupt
Social Security System.
These economists believe that by investing in the private market,
someone currently entering the labor force and retiring at age 65 can
expect to receive an inflation adjusted retirement benefit from 1.5 to 5.5
times the current social security benefit.
Increasing life expectancy and decreasing birth rates have combined to
create the crisis the system is now facing. For example, in 1950 there
were 16 workers for every social security retiree, while presently there
are only 3.3 workers for every retired worker drawing benefits. Estimates
are that by 2030 there will be fewer than two workers for every retiree.
Privatizing social security sounds extreme, but it has been done
successfully in other countries like Chile. Jose Pinera, who was Chile’s
minister of labor, privatized the state pension system in 1981. It is now
giving retirees generous pensions while fueling investment, growth and
improving living standards in that country.
The heart of the Chilean system is a mandatory savings plan. All
workers under age 45 contribute 10 percent of their monthly earnings in
special accounts, known as AFPs (Administradoras de Fondos de Pensiones).
Workers between ages 45 and 65 could shift to the new system at their
option. The funds in AFPs are professionally managed and invested in
stocks and bonds. The money may not be touched until retirement, at which
time the worker may begin phased withdrawals or purchase an annuity. At
the end of 1995 more than $25 billion was invested in AFP accounts. The
old Social Security system is being phased out. By 2030 Chile’s Social
security will entirely be privatized.
This system ensures the money a taxpayer pays for retirement goes to
helping that taxpayer retire (not others). It ensures the money paid in
taxes is invested and grows. It also gives taxpayers choices over their
plans and the age at which they want to retire.
If the US were to adopt a system like Chile’s, we could save our own
failed Social Security system and provide real security and peace of mind
to everyone. The money paid into these individual retirement accounts is
invested, meaning more capital is available to the business sector for
investment. An individual would have their very own pension, with their
name on it. The government would no longer control the money that the
individual paid in to it. It is the individual’s account, just like an
IRA. It is essentially a government mandated IRA. Only difference is your
tax payment goes into an individual’s account instead of going to the
government. Your income would not change because you already pay the tax.
You would simply redirect the payment into an IRA. People would be living
off their investment income and not a transfer payment funded through
economic growth-slowing taxes. The government would only need to cover
those people whose pension did not provide an adequate income. This would
be a much lower percentage than the current system of near 100 percent.
Politicians have been extremely reluctant to change Social Security
because any misstep could provoke explosive reactions from the program’s
43 million beneficiaries. Even Ronald Reagan at the peak of his popularity
pledged a defense of the present public system and in 1983 signed
bipartisan legislation to shore it up.
But this year the issue has surfaced in political debates. It provoked
a bitter exchange between the two candidates for the Republican
presidential nomination, Steve Forbes and Sen. Bob Dole.
When Forbes suggested that a part of younger workers’ payroll taxes go
into private retirement accounts, Dole ran television advertisements
denouncing the idea as a radical untested plan that would end Social
Security as we know it. But since then Dole has expressed interest in the
Since the creation of Social Security in 1935, money paid into the
program has been invested exclusively in interest-bearing government
securities, mainly long-term bonds. But you could obtain a higher return
on investment and increase retirement savings for the baby-boom generation
by channeling some of the money into the stock market.
But there are many questions such as: How much Social Security revenue
should be invested in stocks? Who would manage the investments? How many
private investment options should be allowed?
Economists also disagree on how stock markets might be affected by the
infusion of huge amounts of money. The financial services industry would
presumably benefit, but banks, mutual funds and insurance companies have
just begun to study the issue.
In a Ponzi scheme, money from new investors goes out to satisfy claims
of early investors. What else can you call Social Security? The current
retirees are paid much more than they put in, so the younger generation
has to pick up the tab. The system’s funds are invested in low-yielding
Treasury securities. Over the last 50 years, such investments have
returned 5.8 percent a year, while the Standard ; Poor’s 500 has provided
In 1994, a poll was published indicating that more people in their
twenties believed in UFOs than in Social Security. Many simply do not
believe there will be anything in Social Security when they retire. A Wall
Street Journal/NBC News poll showed that 29 percent of all Americans now
expect to receive nothing from Social Security when they retire. Another
37 percent expect to get sharply reduced benefits. Among those under age
35, nearly half expect nothing whatsoever from Social Security.
Unfortunately, there is good reason for skepticism. According to the
latest report from the Board of Trustees of the Social Security Trust
Funds (OASDI), Social Security tax revenues will be insufficient to pay
current benefits as early as the year 2013. By 2020 tax revenues plus
interest on the Trust Funds will no longer be adequate to pay for promised
benefits. As more and more of this generation reaches retirement age,
Social Security expenditures rise sharply. By the year 2030, Social
Security outlays will have completely exhausted the Trust Funds and
current revenues will be short of expenditures by about 2 percent of the
annual gross domestic product. In order to meet such expenditures without
cutting benefits, the Trustees estimate that the payroll tax would have to
rise from the present 12.4 percent (half on employer and employee) to 19
In a recent Cato Institute paper, William Shipman of State Street Global
Advisors estimates that a worker born in 1970, investing all of his or her
payroll taxes in stocks, would be able to retire in 2035 on $11,729 per
month (in 1995 dollars), compared to an estimated Social Security benefit
of $1,908. For this reason, there is a growing consensus that at least for
younger workers there needs to be an alternative to Social Security. This
would necessarily require some movement in the direction of privatization.
Rep. John Porter, R-Ill., and Sen. Bob Kerrey, D-Neb., have suggested
partially privatizing Social Security by cutting the payroll tax rate by
1.5 to 2 percentage points and requiring that the tax savings be invested
in a form of individual retirement account.
The World Bank now urges developing countries to adopt Chilean-style
pension systems. In a 1994 report, Averting the Old Age Crisis, the bank
noted the positive impact of private pensions on saving, capital
formation, investment and economic growth. Also, by shifting from a
pension system in which people had no confidence to one that is fully
funded, the effect is to actually reduce the burden of payroll taxes. Two
recent studies have looked at the potential gains to the United States
from switching to a private system. Harvard University Professor Martin
Feldstein estimates that the value of future pension benefits would rise
by 60 percent, from $11.3 trillion to $18 trillion. Boston University
Professor Laurence Kotlikoff also found large potential gains in output
and living standards from privatization.
While everyone would be better off in the long run from a privatized
Social Security system, it would cost several trillion dollars to, in
effect, buy out the current generation of retirees. Thus while a private
Social Security system would clearly make sense if we were starting from
scratch, the cost of switching today may be too great. While the American
Association of Retired Persons will no doubt fight to the death to stop
privatization, in the long run its position is untenable. Social Security
is going broke and will eventually be replaced with a private pension
system. The sooner we at least start moving in that direction the better
it will be for future generations as well as today’s economy.
Privatization does contain pitfalls. The present Social Security system
is pay-as-you-go. It uses the receipts from today’s payroll taxes to
finance the checks for today’s retirees. If those tax receipts were
diverted to a new, privatized system, there would be an immense shortfall.
The loss would have to be made up either by hiking taxes, increasing
borrowing or drastically cutting benefits to current retirees. The
present Social Security system faces a long-term shortfall of between 1
percent and 4 percent of total payroll, depending on your projections of
future economic growth. But the existing pay-as-you-go system could be
rendered solvent by a judicious combination of increasing the retirement
age by two or three years and slightly
Also there is the question of whether to privatize the whole system, or
whether to add a second tier. We might keep the basic system but
with self-directed IRA-like funds. The basic tier would be redistributive
and pay-as-you-go. The supplementary layer would be private and based on
A further question is who bears the risk when investments go sour.
There is no such risk under the current system. The stock market looks
like a great retirement vehicle in the 1990’s, but it wasn’t so reliable
in the 1970s and 1930s. The program was deliberately designed as a social
guarantee of retirement income, not a system of government-mandated