A Way Out of the Social Security Squeeze

Franco Modigliani: Our solution may be labeled 'partial privatization,' or risk-sharing through a common portfolio

By Franco Modigliani

Despite the hard criticism of the President's Commission on Social Security for overdramatizing the retirement fund's plight, one can only agree with its conclusion: In the absence of reforms, the system is heading for insolvency -- in the foreseeable future. It will be unable to pay the promised benefits while maintaining current contributions. That conclusion is the unavoidable consequence of 1) the present pay-as-you-go financing, whereby pensions are paid by the current contributions of those working, and 2) the generalized expectation that the ratio of workers to pensioners will decline dramatically in the decades to come.

One can similarly sympathize with the commission's suggestion that the financing gap can be reduced by investing all pension reserves in the private securities market, rather then in low-yielding government securities, as in the past. But there is more than one way to achieve this change in composition. One way, favored by the commission in line with their Presidential directions, is so-called privatization, a radical innovation that consists of diverting the contributions to Social Security into individually managed accounts to be invested in the capital markets.

The common account would be placed under the supervision of a blue-ribbon board

We offer instead a more conservative solution between the two extremes of do nothing and individual accounts, or privatization. Our solution may be labeled "partial privatization," or risk-sharing through a common portfolio. In this approach, all reserves are again invested in the capital markets, not in individual accounts but rather in a common fund, managed by the trust funds that will continue to receive all future (net) contributions.

The common account will be protected from political interference by placing it under the supervision of a blue-ribbon board (as has been done successfully in Ireland and Canada, for example) and relying on indexing to a highly diversified benchmark. From the point of view of financing, this solution can accomplish whatever privatization can, but in other respects it is vastly superior.

Complete privatization, in contrast to partial privatization, exposes participants, including the poorest, to unacceptable and totally unnecessary risks. Pooling, by ensuring the same return -- the average market return -- to all participants, provides the basis for maintaining the most valuable features of the current Social Security system -- defined benefits -- in which mandated contributions related to "life" earnings result in a predictable pension guaranteed by the state.

Privatization would transform Social Security into a compulsory gambling institution

In privatization, defined benefits are replaced by defined contributions, in which the same contributions are mandated, but the pension depends on the performance of one's portfolio of securities through the date of retirement. This will result in artificial and capricious inequalities in the distribution of pension income. Some will beat the return from the common fund, but the average return cannot be very different, so about half will do worse. Social Security is transformed from an old-age insurance scheme to a compulsory gambling institution.

These "capricious inequalities," reflecting market gyrations, will be intensified by a systematic tendency of the Bush plan to enrich the well-to-do at the expense of the rest in two ways: 1) by terminating one of the most important social features of the existing system, namely, its redistributive feature, whereby the poorest participants enjoy a replacement rate distinctively higher than the richer; and 2) because the portfolios of the well-to-do and well-connected will tend to enjoy higher returns, through better management and the ability to bear risk.

Managing small, individual portfolios will be far more expensive than managing a common indexed portfolio, with a huge impact on the terminal pension. For example, if the portfolio returned 5 1/2% and the average management cost was 1 1/2% -- a conservative estimate by Latin American experience -- the effect would be to reduce the net rate of return and the terminal pension by about 40%. This loss is the gain of portfolio managers, to the tune of billions of dollars per year. It is not surprising they are so enthusiastic about privatization.

Individuals should have complete freedom in saving outside Social Security

Supporters of privatization claim their approach has two advantages over the common fund, but neither turns out to have any substance. The first amounts to scare tactics, that a common account can be more easily "raided" by Congress than an individual account. But this is naive. A common account can be protected by popular sentiment and legislation (e.g., statutory prohibition against investing in government debt). On the other hand, a Congress looking for cheap funds to finance a deficit can easily order individual accounts to invest in government bonds, as has happened extensively in South America.

The other highly sophisticated objection is that people have different risk preferences, which they can satisfy only by choosing their own portfolios. But this reasoning ignores the fact that Social Security is designed to provide only a floor to retirement resources, in the interest of the individual and society. A person who can count on only this minimum should not be allowed to put it at risk. And where there are other retirement resources, they can be used to craft a portfolio satisfying risk preferences. We are in favor of allowing individuals complete freedom in savings outside Social Security.

We still have to contend with the fact that privatization or partial privatization can contribute to but cannot provide a complete solution to the problem of maintaining benefits in the face of a massive reduction in the ratio of workers to retirees. Our analysis leads us to the conclusion that a solution exists, and it consists in accumulating additional reserves -- whether in trust funds or in individual accounts -- large enough for returns from extra accumulation to cover the gap created by the insufficient contributions by the working population.

Our "risk-sharing solution" preserves the key aspects of the existing system

Those additional reserves can be provided by a large injection of government subsidies (of the size of the surplus once pledged to Social Security by President Clinton with the support of Congress). But the subsidies could be achieved only by rescinding much of the promised tax cuts. The alternative is a rise in individual contribution rates that could be kept modest -- around 5% -- if enforced immediately but would gradually increase to 50% if concentrated on future workers. Thus, to preserve the key aspects of the existing Social Security system, Congress would have to opt for our "risk-sharing solution" and, in addition, will have to face the unsavory choice between voiding much of the tax cut for the rich or financing it with the most regressive levy in our arsenal, the Social Security tax. But in this case, the time is now.

Modigliani is Institute Professor Emeritus at the MIT Sloan School of Management and recipient of the 1985 Nobel prize in economics

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