How should Social Security be reformed?
August 5, 1998
in this forum:
Is there really a social security crisis? Is privatizing the only alternative we have to raising Social Security taxes? What risks do you see with privatization? What are the advantages of privatization? What happened to all of the money collected in the past?
Shane Smuin of San Francisco, CA, asks: Is privatizing the only alternative we have to raising Social Security taxes?
Carolyn Weaver of the American Enterprise Institute responds:
Privatizing social security--meaning moving toward a system of personal retirement accounts, buttressed by a government safety net--is not the only option, it's just the best option. Conventional reforms involving tax increases or benefit reductions would not ensure solvency--any more than they did in 1977 and 1983; they would not enhance the value of social security for younger workers; and they would not boost the confidence of workers in the long term viability of the program.
While critics of personal accounts decry the riskiness of stocks, they don't deny the benefits of stock market participation. In fact, many critics, including Henry Aaron, now endorse having the government invest in the stock market, just not workers. Over the long-term, stocks have yielded an annual return of 7%, after inflation. A mixed portfolio of stocks and bonds has yielded an annual return of 5%-6%, which is substantially higher than the 1%-2% younger workers are projected to earn under social security--before factoring in the benefit reductions or tax increases needed to close the long-range deficit by conventional means.
Henry Aaron of the Brookings Institution responds:
Privatization does exactly nothing to close Social Security's projected long term deficit.
There are only three ways to close the projected deficit—raise taxes, cut benefits, or shift investments held by the retirement fund to higher yielding assets than the government bonds in which Social Security reserves are now invested.
Each of these steps can be taken within a system of individual defined-contribution accounts or within a system of defined-benefit pensions, such as Social Security.
[Defined-contribution pensions fix the amount that is contributed. The pension you get depends on the size of the contributions and the investment returns earned on the assets in which the contributions are invested. Defined-benefit pensions fix the size of the pension and contributions have to be set so that they and investment returns cover projected costs. Privatization plans all rely on defined-contribution accounts. My answer to question 3 contains a description of their risks, relative to those under Social Security.]
The mere act of converting Social Security from a pooled, defined-benefit program to an individual, defined-contribution program would do nothing to affect the taxes necessary to cover promised benefits. To deliver a pension of a given size under either sort of system requires exactly the same taxes or contributions, provided that reserves are invested in the same sorts of assets. That conclusion follows from the laws of arithmetic. Some advocates of privatization have claimed that returns to workers under a system of privatized accounts would exceed those under a reformed Social Security system (or, equivalently, that lower taxes could support given benefits). They point to the average historical return on mixed stock and bond funds of about 5 percent above the rate of inflation which is higher than the projected return on Social Security of about 1 percent above the rate of inflation. Conservative and liberal economists alike agree that this claim is false for two reasons.
The first reason is that whether we continue Social Security or privatize, today's workers will still have to pay the costs of retirement benefits for current retirees and those soon to retire. Reserves were never accumulated to meet these costs because successive Congresses and presidents decided to pay more generous benefits to workers who retired early in the life of the Social Security system than their payroll taxes warranted (see my answer to question 5). Today's workers must cover this "unfunded liability." Unless privatizers proposed to cut current retirees off without a penny—and none does—these costs are inescapable. We handle those costs now through Social Security and, even if we privatized, we would have to cover those costs somehow. Since the personal return to today's workers for taxes they pay to support someone else's retirement benefits is -100 percent, that cost has to be built into the calculation of returns to individual accounts.
The second reason for low returns under Social Security is that Congress restricts investment of reserves to relatively low-yielding government securities. If these reserves were invested in a prudently diversified portfolio, Social Security would earn about the same return before administrative expenses as would any system of individual accounts. The reason is that when one is dealing with large pools of investment, the average return is about the market average. Some individuals might do better, but some would do worse. But Social Security would have lower administrative costs for funds management and benefit payment than would any privatized system, as I explain in my answer to question 3.