Privatizing Social Security

Policy Reports | Social Security

No. 217
Wednesday, July 01, 1998
by Laurence J. Kotlikoff

Privatizing Social Security

To recapitulate, the U.S. Social Security system is broke and is treating the vast majority of current contributors very badly. Privatization is far from a painless panacea, but it does represent an opportunity to resolve most of the system's financial woes and to rationalize a program that is highly inequitable, replete with inefficiencies and economic distortions and extraordinarily uninformative about the benefits it provides in exchange for the contributions it demands.

Full vs. partial privatization. Once we decide that privatizating is worth doing, we must decide whether to fully or partially privatize the system. As noted above, partial privatization will leave the nonprivatized portion vulnerable to periodic financial half-measures which condemn the system to ongoing financial difficulties. Equally important, partial privatization will leave us with two basic retirement systems with all the extra administrative costs that entails. Finally, partial privatization will lead to a large number of extremely small retirement accounts - those of society's lowest earners. The fixed transaction costs of transmitting and recording contributions to these accounts, sending annual reports to the accounts' owners and disbursing payments could wipe out much of the returns. For these reasons, if privatizing a dollar of the retirement portion of Social Security makes sense, privatizing all of it makes more sense.

"The Personal Security System fully privatizes the retirement portion of Social Security, leaving unchanged the disability and survivor portions."

A proposal.12 The Personal Social Security (PSS) plan fully privatizes the retirement portion of Social Security. [See the sidebar.] The PSS plan leaves unchanged the contributions and benefits under the disability and survivor insurance portions of Social Security.13 Only those contributions currently being made to the retirement portion of Social Security (about 70 percent of the total) are eliminated and replaced with mandatory contributions of equal size to private PSS accounts. What follows is a summary of the plan's seven provisions.

Protecting spouses. To protect nonworking spouses as well as spouses who are secondary earners, total PSS contributions made by married couples are split 50-50 between the husband and wife before being deposited in individual PSS accounts. Although this provision is gender neutral, it is much more important for women than for men since women remain the major caregivers for young children and spend less time in the labor market.

Protecting low-income earners. The federal government would match PSS contributions of low-income contributors on a progressive basis, allowing them to accumulate proportionately more savings than they otherwise would. It would also make PSS contributions through age 65 on behalf of disabled workers.

Tax treatment of PSS accounts. PSS contributions would be subject to the same tax treatment as current 401(k) accounts. Contributions would be deductible and withdrawals would be taxable.

Investment of PSS account balances. All PSS balances would be invested in a single, market-weighted global index fund of stocks, bonds and real estate. Participants would purchase this security from (set up their accounts with) their preferred financial institution. Although participants could choose their financial institution, they could not sell their global index securities and purchase others. Forcing everyone to hold this and only this asset would ensure maximum portfolio diversification and guarantee all participants the same rate of return on their PSS contributions. It would also force people to invest for the long term and prevent them from playing the market.

"All PSS balances would be invested in a single, marketweighted global index fund."

It is useful to contrast this approach to the one Chile adopted in privatizing its social security system. Chile requires participants to invest their mandatory savings with pension companies. The pension companies charge very high fees for "managing" contributors' money.14 But the system is so highly regulated that all of the pension companies choose identical portfolios. Hence, as in the PSS proposal, the Chilean system is delivering a single portfolio, but at very high transaction cost and with a huge regulatory bureaucracy. The Chilean pension companies also invest almost solely in Chile, depriving Chilean workers of the opportunity to invest in stocks and bonds of major and minor companies around the world as well as U.S. Treasuries and other bonds issued by national governments. If the Chilean economy suffers a major downturn, the value of its assets and the retirement incomes of its elderly will decline precipitously. Putting all your eggs in one basket (in this case, your own country) makes no sense for Americans or for Chileans.

Annuitization of PSS account balances. Between ages 60 and 70, participants in each birth cohort would have their PSS balances converted into inflation-protected pensions that continued until they died. This conversion would take place under government-established rules. After a competitive bidding process the insurance company winning the bid for a cohort would provide each PSS participant an inflation-protected pension based on his or her account balance. All participants would be annuitized on identical terms, regardless of their health status (life expectancy). The insurance company winning the bid for a particular birth cohort would sell off a portion of the cohort's PSS global index fund holdings each day as the cohort aged between 60 and 70. This would average out the risk of annuitizing PSS account balances when financial markets are temporarily depressed.

In being forced to bid for the right to annuitize a cohort's PSS account balances, the insurance industry would end up providing this service at the lowest possible price. The annuities would be paid out from the date of conversion so people would start receiving pension income even as they continued to work. The choice of a retirement date would be completely up to the individual - his or her pension income would be unaffected. Insurance companies could easily hedge the risk of protecting the annuities against inflation by investing the annuity premiums in inflation-indexed U.S. Treasury bonds.

Survivor provisions of PSS accounts. If contributors died prior to age 70, any nonannuitized portion of their PSS account balances would go to their heirs. Survivors would also receive precisely the same Social Security survivor benefits they receive under the current system. Hence, the proposal increases survivor protection.

"Benefits of current Social Security recipients and past contributions of current workers would be protected."

Protecting current retirees and the past contributions of current workers. Current recipients of Social Security retirement benefits would continue to receive their full inflation-indexed benefits. When they reached retirement, future retirees would receive the full amount of Social Security retirement benefits they had accrued as of the time of reform. These benefits are calculated by filling in zeros in the earnings records of all Social Security participants for years after the transition begins. Since new entrants to the workforce would have only zeros entered in their earnings histories, they would receive no Social Security benefits in retirement. This ensures that after a transition period aggregate Social Security retirement benefits would be completely phased out.

Financing the transition. During the transition, Social Security retirement benefits would be financed by a federal business cash-flow tax that would operate like a value-added tax. The business cash-flow tax would also finance the government's ongoing PSS contribution match. Over time, the PSS business cash-flow tax rate would decline as the amount of Social Security retirement benefits declined. Provisional calculations suggest that the tax would begin around 8 percent and would decline to a permanent level of roughly 2 percent within 40 years.

No one likes paying taxes, so it's important to note that financing the transition in this manner is revenue neutral - it does not represent an overall tax increase. Recall that the payroll tax being used to pay for Social Security retirement benefits is, under the PSS plan, being eliminated. It's true that workers are compelled to contribute these amounts to the PSS accounts, but this represents private saving. Workers who are already saving at more than adequate levels would be free to cut back on their non-PSS saving. Workers who are saving less than the compulsory PSS contribution likely are saving too little and would benefit the most from being forced to save.

Other proposals being debated call for letting workers contribute their Social Security taxes to private accounts and finance the transition with modest increases in other taxes. These proposals tend to a) recognize only a third of the long-run fiscal problem, b) be highly complicated, c) invoke heroic assumptions and d) finance the transition in large part by wiping out workers' claims to the future Social Security benefits they already have accrued. Such proposals sound too good to be true - because they are.

Read Article as PDF