President George W. Bush has interpreted his reelection as a mandate to restructure the troubled Social Security system. While Bush has not yet said how he'd do it, he has called for sweeping changes that would divert part of workers' payroll taxes into individual investment accounts. His goals: heading off a fiscal collapse of Social Security and promoting an "ownership society" that would give working Americans a chance to build their own retirement stake of stocks and bonds. Here's how today's system works and how Bush may change it:How does Social Security really operate?Social Security functions on a pay-as-you-go basis: Current workers' taxes pay for current retirees' benefits. The 12.4% payroll tax -- split equally between workers and employers -- raised $632 billion in 2003; $471 billion went right back into benefits. The rest was spent on programs ranging from the war in Iraq to restoring national parks.I thought it went into a trust fund.The Social Security Trust Fund is a carefully tended myth. There is no trust fund -- just a great big file drawer full of Uncle Sam's promises to pay benefits. Around the year 2018 annual payouts will start to exceed annual revenues. And by around 2042 the system as it exists will no longer be able to pay all promised benefits.How big will the shortfall be?If Washington waits until 2042 to act, revenues will cover only an average 70% of promised benefits in the decades that follow. Take a boy who was born in 2000 and makes the median income over his working life. He will be promised $290,900 in today's dollars. But the system will only have the resources to pay him $208,900.Why such a gloomy outlook?Demographics. Pay-as-you-go Social Security only functions if there are enough workers to support each retiree. Today there are 3.4 workers per pensioner. In 30 years there will be only two.Won't faster economic growth fix this problem?That's wishful thinking. Stronger growth is fueled by rising productivity, which eventually boosts wages. But each retiree's initial benefit is pegged to those wages. So while faster growth raises payroll tax revenues, it also drives up benefits. The gap never closes.Can private accounts get us out of this mess?Many conservatives think so. They argue that by diverting payroll taxes into such accounts, workers and the system could win big. Today promised benefits work out to about a 2% annual return on payroll taxes. The same funds invested in a balanced portfolio of stocks and bonds might earn 5%.Sounds good to me.It sounds good to President Bush, too. The White House has not yet endorsed a specific proposal. But outside economists who favor the concept say the accounts could range in size from 2% of wages to the full 6.2% a worker now shells out in payroll taxes. Unlike today's system, the funds in those accounts would belong to you and could be passed on to your heirs.How would the accounts work?Any worker under, say, 50 or 55 could establish an account, although they would be voluntary. Investments would most likely be limited to a handful of choices such as stock-index mutual funds, bond funds, and cash. Upon retirement, the accounts would be turned into annuities that pay out a fixed amount each month. In most plans, money would be managed by Wall Street firms. And that has critics worrying about whether fees would eat up benefits, as they have with so many 401(k) plans.Wouldn't market investments increase risk?Private accounts would generate greater potential returns by investing in stocks and bonds, but they'd also be riskier.
If the money were poorly invested or withdrawn in a bear market, some workers could end up with less retirement income than if they had stuck with the basic government benefit.Any other catches?The biggest is the cost of moving from the existing system. If workers shift, say, 2 points of payroll tax into their accounts, the government would have to find some other money to pay benefits to current retirees. The transition cost: at least $1 trillion over the next decade. If workers shift more into private accounts, costs could approach $2 trillion.
At the moment it looks as though the Administration is leaning toward having Uncle Sam borrow the money to fund the transition. Unfortunately, the feds are already borrowing $400 billion a year to finance the deficit. Shifting to private accounts would add $100 billion to $200 billion a year to that debt.Forever?No. The accounts eventually would build up enough assets so that their owners would enjoy annual income exceeding what they would get under today's system. Moreover, supporters argue, borrowing now merely prefunds future Social Security obligations that Washington must eventually finance anyway. Thus, in the long run, the accounts should cost the government less and reduce its borrowing needs. But depending on the accounts' structure, that outcome could be decades away.
It is hard to know how either the public or the bond market will respond to such a complex financing arrangement. Mark Zandi, chief economist of Economy.com, figures it would raise Treasury rates by 0.2%, but critics fear the price could be far higher.What would happen to benefits?The President has not explicitly said. But nearly all economists acknowledge that the basic government-paid benefit for those who invest in the accounts will have to be cut. That might mean reducing cost-of-living increases or raising the retirement age for workers under, say, 50. But that would be political dynamite -- Democrats are certain to attack any benefit cuts. Still, private accounts or no, benefits eventually will have to be reduced or taxes raised.What would happen to current retirees?Nothing. Despite dire predictions by Democrats, no one is proposing cutting benefits for them. No matter what happens, they are untouchable.Are private accounts the only solution to the Social Security problem?No. If all you want to do is make the system solvent so Washington will have the resources to pay future benefits, you could make far more modest changes. Some ideas: trim cost-of-living increases so they more closely track actual inflation; reduce benefits slightly for those who were high earners; boost the retirement age to better reflect life expectancy; or raise the amount of wage income subject to the payroll tax.So why create private accounts?To borrow a word being used a lot these days, think of it as a values issue. Should the government provide workers with a basic, though fairly modest, benefit in retirement? Or should workers have the opportunity to build their own nest egg -- a chance that comes with a shot at a more comfortable retirement but also the risk that their investments will come up short? With a program as important as Social Security, the issues are far bigger than just dollars and cents. By Howard Gleckman, with Mike McNamee, in Washington