Social Security Privatization

Testimony of Michael Tanner
Director of Health and Welfare Studies, Cato Institute

Senate Special Committee on Aging

September 24, 1996

Mr. Chairman, distinguished members of the committee:

Thank you for the opportunity to appear before this committee and address one of the most important questions facing this country today: whether today's young workers will have the same opportunity for a dignified retirement as do today's seniors.

I do not want to begin by attacking Social Security. For 60 years, Social Security has largely accomplished its goal. It has significantly cut poverty among the elderly and enabled them to retire with dignity. But despite all the good that Social Security has accomplished, the system now faces irresistible demographic and fiscal pressures that threaten the future retirement security of today's young workers. Only by moving to a system of privately-invested, individually-owned accounts can a system of secure retirement be preserved.

Just a couple of months ago the Social Security system's Board of Trustees reported that the retirement system will be insolvent by 2029, down from 2030 in last year's report. This represents the eighth time in the last 10 years that insolvency date has been brought forward. But focusing exclusively on that date is misleading. The implication is that Social Security's financing is fine until 2030, at which point benefits will suddenly stop. The reality is much more complex.

Currently, Social Security taxes bring in more revenue than the system pays out in benefits. The surplus theoretically accumulates in the Social Security Trust Fund. However, the situation will reverse as early as 2012. Social Security will begin paying out more in benefits than it collects in revenues. To continue meeting its obligations, it will have to begin drawing on the surplus in the Trust Fund. However, at that point, we will discover that the Social Security Trust Fund is really little more than a polite fiction. For years, the federal government has used the Trust Fund to disguise the actual size of the federal budget deficit, borrowing money from the Trust Fund to pay current operating expenses and replacing the money with government bonds.

Beginning in 2012, Social Security will have to start turning in those bonds to the federal government to obtain the cash needed to finance benefits. But the federal government has no cash or other assets with which to pay off those bonds. Of course, the Social Security insists that those bonds are safe, comparing them to the government bonds in private investment portfolios. Those bonds are backed by the full faith and credit of the U.S. government. But this is irrelevant.

Pretend for a moment that there was no trust fund and no bonds. What would happen in 2012? The government would have to raise taxes to continue paying promised benefits. Now, consider what will happen with the trust fund. The government will have to raise taxes to make good on the bonds to continue paying promised benefits. Either way, the government can only pay benefits by raising taxes--or borrowing and running bigger deficits.

Even if Congress can find a way to redeem the bonds, the Trust Fund surplus will be completely exhausted by 2029. At that point, Social Security will have to rely solely on revenue from the payroll tax. But such revenues will not be sufficient to pay all promised benefits. If the government is going to make good on all the promised benefits under both Social Security and Medicare, payroll taxes will have to be increased to between 28 and 40 percent.

Social Security's financing problems are a result of its fundamentally flawed design, which is comparable to the type of pyramid scheme that is illegal in all 50 states. Today's benefits to the old are paid by today's taxes from the young. Tomorrow's benefits to today's young are to be paid by tomorrow's taxes from tomorrow's young.

Because the average recipient takes out more from the system than he or she paid in, Social Security works as long as there is an ever larger pool of workers paying into the system compared to beneficiaries taking out of the system. However, exactly the opposite is happening.

Life expectancy is increasing, while birth rates are declining. As recently as 1950, there were 16 workers for every Social Security beneficiary. Today there are only 3.3. By 2030, there will be fewer than two. The Social Security pyramid is unsustainable.

Moreover, even if Social Security's financial difficulties can be fixed, the system remains a bad deal for most Americans, a situation that is growing worse for today's young workers. Payroll taxes are already so high that even if today's young workers receive the promised benefits, such benefits will amount to a low, below-market return on those taxes. Studies show that for most young workers such benefits would amount to a negative return on the required taxes. Those workers can now get far higher returns and benefits through private savings, investment, and insurance.

There is a better alternative. Social Security should be "privatized," allowing people the freedom to invest their Social Security taxes in financial assets such as stocks and bonds. A privatized Social Security system would essentially be a mandatory savings program. The 10.52 percent payroll tax that is the combined employer-employee contribution to OASI, the Old-Age and Survivors Insurance portion of the Social Security program, would be redirected toward a Personal Security Account (PSA) chosen by the individual employee.

PSAs would operate much like current Individual Retirement Accounts (IRAs). Individuals could not withdraw funds from their PSAs prior to retirement, determined either by age or PSA balance requirements. PSA funds would be the property of the individual, and upon death, remaining funds would become part of the individual's estate.

PSAs would be managed by the private investment industry in the same way as 401k plans or IRAs. Individuals would be free to choose the fund manager that best met their individual needs and could change managers whenever they wished. The government would establish regulations on portfolio risk to prevent speculation and protect consumers. Reinsurance mechanisms would be required to guarantee full solvency.

The government would continue to guarantee a minimum pension benefit. The minimum pension could be set to a benchmark such as the minimum wage. If upon retirement the balance in an individual's PSA was insufficient to provide an actuarially determined retirement annuity equal to the minimum wage, the government would provide a supplement sufficient to bring the individual's monthly income up to the level of the minimum wage.

Given historic rates of return from the capital markets, even minimum wage earners would receive more than the minimum from the new system if they participated their entire working lives. Therefore, in the absence of a major financial collapse, the safety net would be required for few aside from the disabled and others outside the workforce.

The idea of privatizing a public pension system is neither new nor untried. Where privatization has been properly implemented it has been remarkably successful. One of the best examples is the experience of Chile.

Chile's social security system predated ours, having started in 1926. By the late 1970s its benefit payments were greater than its taxes and it had no funded reserves. On the advice of Milton Friedman and other free-market economists, Chile decided to privatize its system.

After 15 years of operation, Chile's experiment has proven itself. Pensions in the new private system already are 50 percent to 100 percent higher than they were in the state-run system. The resources administered by the private pension funds amount to $25 billion, or around 40 percent of GNP as of 1995. By improving the functioning of both the capital and the labor markets, pension privatization has been one of the key reforms that has pushed the growth rate of the economy upward from the historical 3 percent a year to 7 percent on average during the last 10 years. The Chilean savings rate has increased to 27 percent of GNP, and the unemployment rate has decreased to 5 percent since the reform was undertaken.

Under Chile's PSA system, what determines a worker's pension level is the amount of money he accumulates during his working years. Neither the worker nor the employer pays a social security tax to the state. Nor does the worker collect a government-funded pension. Instead, during his working life, he automatically has 10 percent of his wages deposited by his employer each month in his own, individual PSA.

A worker may contribute an additional 10 percent of his wages each month, which is also deductible from taxable income, as a form of voluntary savings. Generally, a worker will contribute more than 10 percent of his salary if he wants to retire early or obtain a higher pension.

A worker chooses one of about 20 private Pension Fund Administration companies to manage his PSA. Each company operates the equivalent of a mutual fund that invests in stocks and bonds. Investment decisions are made by the managing company. Government regulation sets only maximum percentage limits both for specific types of instruments and for the overall mix of the portfolio; and in the spirit of the reform, those regulations are to be reduced with the passage of time and as the companies gain experience. There is no obligation whatsoever to invest in government or any other type of bonds.

Workers are free to change from one company to another. For that reason there is competition among the companies to provide a higher return on investment, better customer service, or a lower commission. Each worker is given a PSA passbook and every three months receives a statement informing him of how much money has accumulated in his retirement account and how well his investment fund has performed. The account bears the worker's name, as his property, and will be used to pay his old age pension (with a provision for survivors' benefits).

A worker who has contributed for at least 20 years but whose pension fund, upon reaching retirement age, is below the legally defined "minimum pension" receives a pension from the state once his PSA has been depleted. What should be stressed here is that no one is defined as "poor" a priori. Only a posteriori, after his working life has ended and his PSA has been depleted, does a poor pensioner receive a government subsidy. (Those without 20 years of contributions can apply for a welfare-type pension at a much lower level.)

The PSA system also includes insurance against premature death and disability. Each company provides that service to its clients by taking out group life and disability coverage from private life insurance companies. That coverage is paid for by an additional worker contribution of around 2.9 percent of salary, which includes the commission to the managing company.

Upon retiring, a worker may choose from two general payout options. Under one option, a retiree may use the capital in his PSA to purchase an annuity from any private life insurance company. The annuity guarantees a constant monthly income for life, indexed to inflation, plus survivors' benefits for the worker's dependents. Alternatively, a retiree may leave his funds in the PSA and make programmed withdrawals, subject to limits based on the life expectancy of the retiree and his dependents. In the latter case, if he dies, the remaining funds in his account form a part of his estate. In both cases, he can withdraw as a lump sum the capital in excess of that needed to obtain an annuity or programmed withdrawal equal to 70 percent of his last wages.

In contrast to company-based private pension systems that generally impose costs on workers who leave before a given number of years and that sometimes result in bankruptcy of the workers' pension funds--thus depriving workers of both their jobs and their pension rights--the PSA system is completely independent of the company employing the worker. Since the PSA is tied to the worker, not the company where he works, the account is fully portable. The problem of "job lock" is entirely avoided.

One challenge is to define the permanent PSA system. Another is to manage the transition to a PSA system. In Chile there were three basic rules for the transition:

1. The government guaranteed those already receiving a pension that their pensions would be unaffected by the reform. That was important because it would be unfair to the elderly to change their benefits or expectations at this point in their lives.



2. Every worker already contributing to the pay-as-you-go system was given the choice of staying in that system or moving to the new PSA system. Those who left the old system were given a "recognition bond" that was deposited in their new PSAs. That bond reflected the rights the worker had already acquired in the pay-as-you-go system.



3. All new entrants to the labor force were required to enter the PSA system. The door was closed to the pay-as-you-go system because it was unsustainable. This requirement assures the complete end of the old system once the last worker who remains in it reaches retirement age (from then on, and during a limited period of time, the government has only to pay pensions to retirees of the old system). That is important because the most effective way to reduce the size of government is to end programs completely, not simply scale them back so that a new government may revive them at a later date.

The financing of the transition is a complex technical issue, which each country must address according to its own circumstances. Chile used five methods to finance the short-run fiscal costs of changing to a PSA system:

1. On the state's balance sheet (which showed the government's assets and liabilities), state pension obligations were offset to some extent by the value of state-owned enterprises and other types of assets. Therefore, privatization was not only one way to finance the transition but had several additional benefits such as increasing efficiency, spreading ownership, and depoliticizing the economy.



2. Since the contribution needed in a capitalization system to finance adequate pension levels is generally lower than current payroll taxes, a fraction of the difference between them can be used as a temporary transition tax without reducing net wages or increasing the cost of labor to the employer.



3. Using debt, the transition cost can be shared by future generations. In Chile roughly 40 percent of the cost has been financed by issuing government bonds at market rates of interest.



4. The need to finance the transition was a powerful incentive to reduce wasteful government spending. For years the budget director had been able to use this argument to kill unjustified new spending or to reduce wasteful government programs.



5. The increased economic growth that the PSA system promoted substantially increased tax revenues, especially those from the value-added tax. Only 15 years after the pension reform, Chile is running fiscal budget surpluses.

Since the system began to operate on May 1, 1981, the average real return on investment has been 12.8 percent per year (more than three times higher than the anticipated yield of 4 percent). Of course, the annual yield has shown the oscillations that are intrinsic to the free market--ranging from minus 3 percent to plus 30 percent in real terms--but the important yield is the average one over the long term.

Pensions under the new system have been significantly higher than under the old, state-administered system, which required a total payroll tax of around 25 percent. The typical retiree is receiving a benefit equal to nearly 80 percent of his average annual income over the last 10 years of his working life, almost double the U.S. replacement value.

The new pension system, therefore, has made a significant contribution to the reduction of poverty by increasing the size and certainty of old-age, survivors, and disability pensions and by the indirect, but very powerful, effect of promoting economic growth and employment.

What would happen if the United States followed Chile's example? The benefits to the U.S. economy would be substantial. The U.S. savings rate, the lowest in the industrialized world, would increase dramatically. In addition, the movement of so much capital into private markets would have a significant impact on economic growth. Harvard professor Martin Feldstein, for example, estimates that "the combination of the improved labor market incentives and the higher real return on savings (of moving to a fully funded Social Security system) has a net present value gain of more than $15 trillion, an amount equivalent to 3 percent of each future year's GDP forever."

Chile's reforms are seen as such a huge economic and political success that countries throughout Latin America, including Argentina, Peru, and Colombia, are beginning to implement similar changes. In Europe, Britain has allowed some people to opt out of its upper tier of benefits and Italy has begun to privatize some aspects of its social security system.

Obviously, privatization of Social Security in the United States would not come without questions and problems.

First, the current Social Security system involves several elements of social insurance that make it much more than a simple retirement system. For example, portions of the payroll tax support the Disability Insurance and Medicare programs. Transferring those programs to the private sector is both possible and desirable, but entails considerably more difficulty than privatizing the retirement portion of Social Security. Their fate should be decided separately.

Social Security also currently provides survivors' benefits that would disappear under a privatized system. But that would be largely offset because privatization would make benefits part of an individual's estate. In addition, it would be relatively easy to use a portion of PRA funds to purchase life insurance.

Finally, it's important to recognize the redistributional aspect of Social Security. Benefit formulas are calculated on a progressive basis that provides a relatively higher return to low-income workers than to higher. A privatized system would generally reverse that. High-wage individuals would receive a higher return on their investment, leading to greater income inequality.

Still, and far more important, low-wage workers would likely receive far more in benefits than they do under the current system. Because low-income workers are far more likely than the wealthy to rely on Social Security for all or most of their retirement income, the current system's low rate of return actually hurts them the most. Indeed, some studies show that because of the regressive nature of the payroll tax and the shorter life expectancy of the poor, they are the major victims of today's system.

The most difficult issue associated with any proposed privatization of Social Security is the transition. Put quite simply, regardless of what system we choose for the future, we have a moral obligation to continue benefits to today's recipients. But if current workers divert their payroll taxes to a private system, those taxes will no longer be available to pay benefits. The government will have to find a new source of funds. The Congressional Research Service estimates that cost at nearly $7 trillion over the next 35 years.

While that sounds like an intimidating figure, much of it is really just making explicit an already existing unfunded obligation. As noted above, the federal government already cannot fund as much as $4.9 trillion of Social Security's promised benefits. Those who claim we cannot afford to finance the transition have yet to explain how they will continue to fund benefits for our children.

Even so, proponents of privatization have an obligation to explain how they would fund the transition. The reality will probably involve some combination of four approaches.

The first of those is a partial default. Any change in future benefits amounts to a default. That could range from such mild options as raising the retirement age, reducing COLAs, or means testing benefits to "writing off" obligations to individuals under a certain age who opt into the private system. For example, any individual under the age of thirty who chooses the private system may receive no credit for past contributions to Social Security.

The second method of financing the transition is to continue a small portion of the current payroll tax. For example, rather than privatize the entire OASI portion of the payroll tax, workers would be allowed to invest 6 or 8 percentage points, with the remainder temporarily continuing to fund a portion of current benefits.

Third, Congress can identify additional spending cuts and use the funds to pay for the transition cost. Steve Entin, an economist with the Institute for Research on the Economics of Taxation (IRET), estimates that fully funding the transition would require slowing the rate of growth in federal spending by an additional one half percent beyond currently envisioned cuts, eventually reaching a reduction of $60-70 billion per year.

The final proposal often suggested for funding the transition is for the government to issue bonds to current system participants and taxpayers. The present value of the actuarially determined annuity due each system participant may be easily calculated and each system participant may be issued zero-coupon T-Bonds maturing at the participant's projected retirement date. The bonds would be placed in each individual's PSA. However, while that has the virtue of making explicit the government's long-term obligations, it is really simply and accounting gimmick. Ultimately, the government will still have to find the funds to make good on the bonds.

Let me conclude by saying something about the politics of Social Security privatization. Social Security has long been, in former House Speaker Tip O'Neill's words, the "third rail" of American politics--touch it and your political career dies. This was because of a perception that American voters would not tolerate any major change to the program.

However, according to a poll of registered voters conducted by Public Opinion Strategies on behalf of the Cato Project on Social Security Privatization, the public understands Social Security's problems and strongly supports efforts to privatize the system.

No one should doubt the continued popularity of Social Security. Our poll results clearly showed that Social Security remains one of the most popular of all government programs, with two-thirds of those polled holding a favorable view of the program. This popularity cuts across all age groups. Even among so-called baby-boomers and Generation X, groups that have expressed skepticism about the program's future, Social Security is viewed as a program that has succeeded for 60 years in ensuring a dignified retirement for America's elderly.

Beneath the surface, though, there is growing awareness that Social Security is faces significant problems and needs reform. Only 37 percent of Americans believe that the current Social Security system is fair. In addition, far more Americans describe the current system as risky than describe it as safe or secure. A majority of Americans, 56 percent, believe the system either is already in trouble or will be in trouble in the next five to 10 years.

That is why young people do not believe that Social Security will be there for them. Fully 60 percent of all individuals under the age of 65 express this belief, with larger majorities among younger voters. As a result, more than two-thirds believe that Social Security will require "major" or "radical" change within the next 20 years. Among younger voters, approximately half believe that major or radical change is needed today. The support for change cuts across ideological and party lines.

What about solutions to the Social Security crisis? Our poll showed that a majority of voters reject most traditional Social Security reforms such as raising the retirement age, raising payroll taxes, or reducing benefits. They correctly perceive that such tinkering with the system will simply make the system a worse deal for young workers, who will have to pay higher taxes for fewer benefits.

However, privatization does have strong popular support among voters. More than two-thirds of all voters, 69 percent, would support transforming the program into a privatized mandatory savings program. More than three-quarters of younger voters support privatization. Support for privatization, particularly among young voters, cut across party and ideological lines.

As this public support emerges into the political process, Social Security will no longer be the third rail of American politics. Indeed, if politicians refuse to deal with Social Security's problems, they may soon face a new third rail in their search for support among younger voters.