SSP No. 1

August 14, 1995

Dismantling the Pyramid: The Why and How of Privatizing Social Security

by Karl Borden

Karl Borden is a professor of financial economics at the University of Nebraska.

Executive Summary

Social Security is an unfunded pay-as-you-go system, fundamentally flawed and analogous in design to illegal pyramid schemes. Government accounting creates the illusion of a trust fund, but, in fact, excess receipts are spent immediately. The government's own actuaries predict the system will be bankrupt by 2030, but Social Security could face financial crisis as early as 2014. Moreover, Social Security's relatively poor rate of return makes the program an increasingly worse investment for today's young worker.

The liabilities already created, which are unrecognized by the government accounting system, represent sunk costs that cannot be recovered. Only adjustments in spending patterns can pay for those commitments. Short-term fixes to increase revenue or reduce benefits will be unsuccessful in the long run. The system design itself is fatally flawed and cannot be repaired. It must instead be replaced by one derived from free markets and operated by a free citizenry making individual economic decisions in their own self-interest. The choice remaining is between continuing to support a bankrupt system and building a financially sound structure for the future.

Reform is long overdue. If we fail to act soon, our children will either inherit a bankrupt system or be forced to pay an impossibly high level of taxes. Only private pensions with individual property rights to accumulated fund balances can create a secure pension system. Chile, which privatized its system in 1981, provides evidence of such a system's effectiveness. Chile's new system has been both successful and popular, but it stops short of full privatization. Various plans have been proposed for the United States, including recent legislation by Sens. Alan Simpson (R-Wyo.) and Bob Kerrey (D-Neb.), but each suffers the effects of compromise with central-planning approaches.

A much bolder approach is called for. A plan that achieves the dual objectives of security and personal liberty would divert current Old-Age and Survivors and Disability Insurance payments to private personal retirement accounts, similar to individual retirement accounts, managed by the financial securities industry. Modern risk-management methods should be used for the portion of the account necessary to finance minimum retirement needs. Personal risk preferences should be allowed to guide the investment of fund balances in excess of the minimum. Individuals should be free to choose their own retirement age. Government intervention and regulation should be minimized.

Transition to a new system requires the recognition of current intergenerational commitments and the making of choices that minimize transaction costs as we liquidate obligations to ourselves and integrate system liabilities into a privatized financial structure.

Index of Social Security Choice Papers