Social Security

Are private accounts a good idea?

To give America's struggling seniors a lifeline out of poverty, Franklin D. Roosevelt 70 years ago established the Social Security system. The program was never intended to be particularly generous -- and even after increases over the decades, the average check totals just $14,000 a year. Yet Social Security remains a mainstay for America's 36 million seniors; two out of three of them count on it for half their income.

Now, a cash squeeze endangers Social Security's future, as the huge Baby Boom population heads into retirement. If nothing is done, the system may only have enough money to pay today's young workers about two-thirds of their benefits when they retire. So President Bush and other free-market advocates are suggesting the most sweeping change to this core social program since its inception, based on a simple premise: Let the stock market help fix it.

On Jan. 11, Bush kicked off his new campaign by telling a town hall meeting that younger workers should be able to take some of their payroll tax and "set it aside in the form of a personal savings account." Social Security only provides returns of about 2% a year after inflation, and private accounts, says the President, could top that easily if they were invested even partially in stocks. Explained Bush at a press conference back on Dec. 20: "Over time, that rate of return would enable that person to...make up for the deficiencies in the current system...and more likely get that which was promised."

Is he right? Are private accounts really a good idea? The short answer is, they could be -- but only if Americans are willing to wait several generations for the higher returns to make up for Social Security's expected shortfall. The gap is so large -- $3.7 trillion in today's dollars -- that even if the stock market matched its historical average, private accounts wouldn't fill the gap for something like 90 to 100 years. And that doesn't even count the extra $1 trillion to $2 trillion in transition costs required to set up such accounts.


Still, private accounts have their appeal. They could be a way to encourage savings. They could partially prefund a system that is now pay-as-you-go. Another plus: the nest egg that builds up, something older Americans may be able to pass on to their heirs.

The details of the plan that the President will ultimately ask the country to consider are very much in flux. Now that Bush has put fixing Social Security at the top of his domestic agenda, there's a profusion of proposals across the political spectrum, and horse-trading between Republicans and Democrats over the coming year will certainly influence the shape of the final program. For now, Social Security reform is a moving target.

Even so, the President has pointed repeatedly to the suggestions of his 2001 Commission to Strengthen Social Security. Because that group's blueprint contains the rudiments of just about any of the private-account schemes out there, it's a good starting point to assess how a partially privatized system might play out over the long haul. Its primary plan calls for allowing workers under 55 to divert four percentage points of their 12.4% annual Social Security payroll tax into private accounts, up to a maximum of $1,000 a year. It also slashes the future growth of Social Security benefits to wipe out the shortfall -- relying on the accounts to make up what amounts to only a portion of the difference. Indeed, today's 20-year-olds would see their promised benefit cut nearly in half, leaving them a check equal to just 15% of their annual income when they retire.

Of course, no politician wants to be the first to deliver bad news, so Bush hasn't yet indicated that his plan might involve reducing benefits from today's promised levels. But now, some Administration officials are starting to concede that private accounts can't earn enough to fix all of Social Security's ills. White House adviser Peter H. Wehner made the point explicitly in a memo widely circulated in early January.

If Americans go for private accounts, then, it won't be so they themselves receive the retirement Social Security currently promises. Instead, those working today would be accepting smaller benefits, as would their children when they join the workforce, so that their grandchildren could count on a fully funded system. Says David C. John, a research fellow at the conservative Heritage Foundation who is a leading advocate of private accounts: "It's wrong to say that private accounts can fill Social Security's shortfall. They're not a magic bullet. But do you want to leave the world better for your grandchildren or just tell them to make do?"


Of course, politics weighs just as heavily as economics in the great Social Security debate. Bush's desire for personal accounts is part of his larger vision of an "ownership society," in which the power of the market is unleashed to better the lives of average Americans. This view motivated the savings- and investment-oriented tax cuts of his first term. It drives his enthusiasm for such ideas as health savings accounts, with their tax incentives aimed at giving Americans more control over a basic aspect of their lives. And it's at the core of his desire for partial privatization of Social Security.

Democrats, deeply at odds with Bush's sweeping ownership agenda, largely oppose schemes featuring private accounts. Instead, they're expected to push for a hike in payroll taxes along with some benefit cuts, though smaller ones than Bush's plan would entail. Of course, there would be no stock-market offset, either. "Maybe we don't have to solve the whole problem right now, since it's still so far off," says Alicia H. Munnell, director of the Center for Retirement Research at Boston College. "But we've got to make a start with some combination of small tax hikes and benefit reductions." Even larger problems loom, she notes, such as Medicare's huge deficit, which is twice as large as Social Security's.

Some critics even argue that stronger economic and demographic growth alone could solve the problem, so we should wait a while longer before taking drastic steps. After all, the $3.7 trillion shortfall occurs in part from the looming Baby Boom retirement wave and in part from pessimistic projections of a steep slowdown in economic and population growth. But if the U.S. matched its growth rates of the past 75 years for the next 75, there would be no shortfall at all, according to projections by the Social Security Administration (SSA). Paradoxically, "if the pessimists are right, and there's a shortfall, you can't [also] have 7% returns in stocks, so private accounts can't solve the problem," says Jeremy J. Siegel, a finance professor at the University of Pennsylvania's Wharton School.

The Social Security system is facing today's conundrum as a result of its initial design. Because Social Security was set up with no up-front funding, retirees back then began receiving benefit checks even though they hadn't paid any payroll tax. Ever since, the system has run on a pay-as-you-go basis.


The official fiction is that workers' payroll deductions plus employers' contributions go into a trust fund that builds up savings for retirement. But in reality, the trust fund is filled with government IOUs, while workers' and employers' taxes go right out the door to pay the Social Security checks of today's retirees. Currently, with most boomers still in the workforce, there's a surplus in the SSA accounts (although Congress spends every penny of it each year on other federal programs).

By 2018, however, Social Security's surplus could disappear as rising numbers of boomer retirees demand more cash from the system. After that, Social Security still can pay all promised benefits with payroll taxes until about 2042, according to the SSA's Office of the Actuary. (A separate analysis by the Congressional Budget Office puts the date at 2052, largely because of different economic and demographic assumptions.)

But if the crisis actually hits, the payroll tax will cover only about two-thirds of the promised benefits. An average retiree in 2042, one of today's twentysomethings, would get a Social Security check for only $1,080 a month in today's dollars, 27% less than the $1,478 he or she is currently slated for, according to the Actuary. The drain on Social Security's coffers would continue to mount, and by 2075, the average retiree would collect $1,362, or 33% less than the $2,032 now scheduled.

Virtually none of the private-account plans would try to make up this difference. Instead, they eliminate it by switching the way retirees' initial benefits are calculated. Right now, the SSA adjusts the benefit level future retirees will receive each year according to the change in average U.S. wages. Although pay often lagged inflation in the 1970s and '80s, over the long term it has outpaced consumer prices by roughly 1% a year. That's why today's Social Security check of $1,184 a month is projected to jump to $2,032 after inflation over 75 years.

The Bush Commission would switch the formula so that benefits keep pace with prices instead of wages. Sounds reasonable. But if wages grow faster, then over the decades the average Social Security check would shrink as a share of future workers' pay. Right now, that $1,184 works out to nearly 42% of the average worker's pay, a ratio that would remain if wage indexing is kept in place. But price indexing would gradually reduce benefits to the vanishing point as wages outpaced prices. Seventy-five years from now, the average retiree would still get roughly $1,184 in today's dollars. But with wages running 1% a year ahead of inflation, it would come to less than a fifth of what the average worker would earn by that time.

If Social Security checks had been adjusted for inflation ever since the program started in 1935, retirees today would take home only $425 a month. "Price indexing may not be sustainable when retirees in the future see that they have the same purchasing power as 50 years ago," says Kent Smetters, a Wharton insurance professor who as a U.S. Treasury official helped the President's Commission crunch all these numbers.

What's more, the result of price indexing is so extreme that it would wildly overshoot the shortfall, transferring more than $1 trillion in surplus taxes to federal coffers, according to Stephen C. Goss, the SSA's chief actuary. Even some commission members concede that this would be unsustainable. "It's true that with price indexing, Social Security benefits would keep falling while the revenue to the government keeps rising, but we said at that point a future Congress can change it," says Olivia S. Mitchell, a public policy professor at Wharton who was a Democratic member of the President's Commission.

Higher returns from private accounts wouldn't offset these lower benefits for well over 75 years, even in the best-case scenario. To see why, take a look at the analysis Goss did of the commission's primary plan, the one that allows 4% of payroll to go into individual accounts. (The commission suggested three plans, but the Bush Administration has embraced the second, more moderate one.)

Goss assumed, as most privatization proponents do, that the stock market would average 6.5% a year after inflation for the full 75 years. He also used their assumption that most workers would participate and would invest prudently by splitting their account 50/50 between stocks and bonds. They would use their earnings to buy an annuity when they retire, leaving a net return of 4.25% a year. (At that rate, the private account of a young worker today would be worth $149,000 at age 67.) Goss found that average workers after 75 years would wind up with the equivalent of $1,615 a month in today's dollars, leaving them 20% short of matching the promised $2,032 benefit. "You can't use private accounts to make up the Social Security shortfall; the hole is just too deep," says Michael Tanner, director of the Project on Social Security Choice at the libertarian Cato Institute in Washington, who nonetheless supports private accounts.

What's more, over time, private accounts would eclipse traditional Social Security. Just look at what average workers would collect. The $1,615 would come from two sources. The 4% of payroll they had diligently invested in personal accounts would yield $989, according to Goss. Meanwhile, the 8.4% workers and employers had continued to fork over to the traditional Social Security fund would pay the remaining $626.

At the same time, the stock market can't provide enough extra returns for private accounts to close the entire gap within 75 years. Look at what would happen to Social Security in the aggregate, rather than from the perspective of an individual. If all workers 55 and younger invested 4% of their pay into a private account, that would create a $4.6 trillion hole over this time. Assuming a 6.5% annual stock market return on that 4%, however, about $8 trillion would pile up after 75 years, according to calculations by Dean Baker, co-director of the Center for Economic & Policy Research, a liberal think tank in Washington that opposes personal accounts. Net it all out, and that would still leave the system $300 billion shy of plugging the $3.7 trillion hole. "You can't solve the shortfall without slower benefit growth or some source of added funds," agrees Harvard University economics professor Martin S. Feldstein, a leading privatization proponent.

Remember, too, that none of this includes the $1 trillion to $2 trillion in transition costs that would be required to set up private accounts. Because Social Security is a pay-as-you-go system, allowing workers to divert 4% of their pay into private accounts would leave the SSA short of funds to cover current retirees' benefit checks. This cost is by definition transitory, since the diverted money eventually would be put back into the system. After all, as workers with private accounts retired, their check from the traditional Social Security system would be lower, to offset the money that went into their account. However, that wouldn't happen for several decades, forcing the government to borrow the difference to keep the system afloat in the interim.

The true nature of this cost has ignited an almost theological debate. The Bush Commission plan would require Washington to borrow at least $160 billion a year in the early years. Since the federal government is already running a $400 billion-plus deficit, the central question is what the economic impact would be of jacking up Uncle Sam's indebtedness by 40%. The traditional view: The bond market would hike interest rates, slowing U.S. economic growth. Higher deficits or national debt also could weigh down a weakened dollar. "If you pile on another $1 trillion to $2 trillion to the national debt we've already got, it could trigger an economic crisis," warns Massachusetts Institute of Technology economics professor Peter A. Diamond.

Recently, though, Administration officials have begun to argue that since the borrowed money eventually would be paid back, it shouldn't count as an increase to the deficit. Backed by economists such as former Council of Economic Advisers chief R. Glenn Hubbard, now dean of Columbia University's Graduate School of Business, private-account advocates point out that any transition costs would be offset by a corresponding reduction in the U.S. government's long-term debt -- leaving no net change in its borrowing. "This is different than normal deficits, because the money is saved, not spent, so the effect on the financial markets would be very small," says Feldstein.


While the debate may seem abstract, the answer matters. If Washington can sell up to $2 trillion worth of bonds at essentially no economic cost, leaving them off the federal balance sheet, personal accounts would be much easier to sell politically. But if the money must be accounted for in the federal budget, Bush would have to retreat from his pledge to slash the deficit in half. Either that, or slice other social programs -- or hike taxes, which Republicans won't touch.

By contrast, one liberal proposal that has received much attention, from MIT's Diamond and Brookings Institution economist Peter R. Orszag, would make tax hikes its centerpiece, combined with benefit cuts in roughly equal proportions. They suggest raising the cap on the payroll tax, currently set at the first $90,000 of income (it increases with average wages each year). The reason: Affluent people are more likely to live longer than Social Security intended. So they're getting more out of the system than they pay into it. They would also lift the 12.4% payroll tax for everyone starting two decades hence. Benefits would come down, though by much less than what price indexing would do. A 25-year-old, for example, would get an 8.6% reduction in the growth of promised benefits.

The most audacious position may be to do nothing at all, at least for a decade or so. The $3.7 trillion shortfall that has spurred Bush into action is based on Goss's projections that the U.S. economy will grow at a slower rate over the next 75 years. Inflation-adjusted GDP gains will drop to 2% a year, he projects, vs. the 3% average that has held for the past 75 years. And the labor force will inch up at a mere 0.35% a year, vs. an historic average of 1.4%. But the SSA has adjusted these numbers every year since the mid-1990s economic and immigration booms, lowering the shortfall and pushing back the crunch date each time.

Goss's reliance on conservative assumptions is perfectly reasonable, especially since no one can really project anything over 75 years. But his more optimistic scenario, based largely on historic growth rates, shows no shortfall at all. Since the U.S. economy has produced pleasant surprises for nearly a decade, little might be lost by waiting to see if those trends continue. For those unwilling to wait, private accounts will help -- eventually. "It's all a matter of patience," says Diamond. "It could take many years for stocks to pay off, and the question is, does anyone really want to wait that long?" The challenge for private-account advocates is to convince Americans that reinventing Social Security for their grandchildren is the right thing to do.

By Aaron Bernstein

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