President Bush is getting ready to reform Social Security -- and just in time. The oldest baby boomers will turn 62 in the final year of his next term. Bush is considering proposals to allow employees to put two to four percentage points of their 6.2% payroll taxes (which are currently matched by another 6.2% from employers) into their own private accounts each year. If he proceeds, the President should make sure he gets it right. Designing these accounts -- and paying for them -- is going to be tricky. If the President wants to build a better retirement system, he should follow key financial guidelines.
First, the President should insist that the private accounts be set up to maximize long-term returns. That means low administrative costs that don't erode investment returns. People who have 401(k) accounts today find it hard to get information about management fees. The new accounts should have transparent and low administrative fees.
The President should recognize that many workers using these new accounts will not be financially sophisticated. Some way must be found to ensure that their investments will be balanced and diversified. A limited number of such vehicles as no-load stock index funds and inflation-indexed Treasury bonds should be made available. Churning by brokers or putting investments into a single company or market segment could devastate returns.
Limits should be placed on withdrawals as well. Beneficiaries should not be able to raid their accounts imprudently -- for consumption, housing, or even emergency health reasons. The private accounts must only be used as financial vehicles for retirement.
Whoever manages the millions of new Social Security accounts will, in large part, determine their success. If individuals are allowed to put up to four percentage points of their payroll taxes into private accounts, about $175 billion a year would be freed up for stocks, bonds, and other investments. Wall Street contributed heavily to President Bush's campaign and expects to manage these new funds. It should, however, earn that right. The President should allow pension funds, such as CalPERS and TIAA-CREF and other money managers with good track records to compete.
The President would also do well to be honest about the cost of partially privatizing Social Security -- $1 trillion to $2 trillion over the next 10 years. This is what it will take to cover Social Security's obligations to current retirees and the boomers if some payroll taxes are diverted to private accounts. The President's advisers are telling him to borrow the money and add it to the budget deficit. A better way would be to combine borrowing with gradually raising the retirement age and shaving benefit payments.
President Bush is embarking on a radical reshaping of the most important part of America's safety net. He needs to get it right.