Magazine

Social Security: The Pros And Cons Of Private Accounts


Get set for the biggest political brouhaha of our time -- the battle over Social Security. Before the nation gets swept up in rhetorical excess, it might be wise to step back from Republican shouts of "crisis" and Democratic accusations of "wrecking the safety net" to take a pragmatic look at the issues at hand. Fortunately, once we get beyond the blistering heat of political discourse, the economic choices on Social Security become much clearer, and perhaps less threatening.

The Bush Administration says that there is a crisis in the Social Security system and that private accounts can help solve the problem. The first statement is false, but just because some Republicans are hyping the issue doesn't mean private accounts are a bad idea. They are, in fact, worthy of consideration.

"Crisis" implies immediacy, and there is nothing in the years or even decades ahead that suggests any crisis. Higher productivity and economic growth rates are pushing back the date when the Social Security trust fund runs dry. Federal actuaries say it will now be 2042. The Congressional Budget Office says it will be 2052. Until then, retiring baby boomers get 100% of their benefits. Worst-case scenario: If nothing at all is done to reform Social Security, payroll taxes will still cover 75% of the benefits afterwards. With net worth rising to record levels, let's be honest. Social Security is a problem, not a crisis. What are the solutions?

Private accounts are worth considering. But they are no panacea. Despite what ardent advocates say, the investment returns in private accounts cannot make up the entire $3.7 trillion shortfall in Social Security. But they can add up. And private accounts have other virtues. You own them, you have investment choices, and you can pass them on to your heirs. And a prefunded retirement system, in principle, is financially sounder than the current pay-as-you-go system.

But private accounts come with costs. The first comes in the form of risk. The experience with 401(k) retirement accounts shows that many people fail to invest enough or diversify sufficiently to maximize their returns. Low-income workers, who need safety the most, are much less likely to participate. The same is likely to happen with private Social Security accounts, hurting many, if care is not taken.

Then there is the $2 trillion it will cost the government to switch to private accounts. For a budget that is already in deep deficit, these extra trillions could send interest rates higher. The White House is trying to convince Wall Street that the new debt doesn't count because it will be offset by a reduction in the government's $3.7 trillion in Social Security liabilities. Therefore the debt won't raise rates.

Don't bet on it. The cost of long-term entitlement programs such as Social Security and Medicare is not priced into the financial markets. When the new Medicare drug benefit bill was passed in 2004, increasing government unfunded liabilities by $8 trillion, the markets didn't move. The lesson is that bond markets don't react to long-term implicit liabilities of the government, only real IOUs. Let's be honest about the cost of transition to private accounts. Rates may rise, and Federal Reserve Chairman Alan Greenspan is said to be concerned.

Let's also be honest about Social Security benefits. With or without private accounts, benefits must be trimmed for Social Security to be solvent in the long run. A plan put forth by a Bush appointed commission would switch the indexing of Social Security benefits from wages to prices. Current average Social Security checks cover 42% of the average worker's pay. The change in indexing could cut that to 20%. This is draconian. The White House is considering less drastic means of cutting benefits (except raising the payroll tax rate).

The Democrats say Social Security can be fixed without introducing the risks and costs of private accounts. They prefer a mix of raising the payroll tax rate, increasing the cap on the payroll tax above $90,000, and boosting the retirement age.

The truth is that despite their political differences, the proposed Republican and Democratic plans to reform Social Security differ little in outcomes. A plan commissioned by the White House cuts the $2,032 per month that Social Security now promises to deliver in 2075 to $1,615. One much-discussed liberal proposal cuts promised benefits by 8.6%, to $1,857. That's a difference of only $242 a month some 75 years in the future when just about anything can happen.

As negotiations over Social Security proceed in the months ahead, politicians would serve the public well by considering a practical mix of solutions to the problem. Private accounts make sense for many, but a voluntary system might fail to attract the very people who need it most.


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