COUNTDOWN TO REFORM: The Great Social Security Debate.

Giving Away the Farm

Why privatization won't solve Social Security's problems

SOCIAL SECURITY'S CRITICS MAKE MUCH OF the program's age. It is a relic of the New Deal, designed during a depressed era when people died younger, and trusted the market less, than they do today. And if you really want to make Social Security look dated, you point out that its basic blueprint comes from Otto yon Bismark. The implication of these historical references is perfectly clear: If we could reconstruct our retirement system from scratch, would it really be the same as the Social Security designed for dusty-faced Okies and spiked-helmeted Prussians? Brookings scholars Henry Aaron and Robert Reischauer take up this conventional question, but their unconventional answer is, Yes, pretty much.

That might not sound like such a radical notion. But step back into the debate as it existed before they produced this logical, fair, and persuasive primer, and the apostasy of the book becomes clear. Everybody knows that, when the baby boom generation retires, Social Security will begin to face large deficits unless it is reformed. And everybody also knows that Social Security is the third rail of politics--an entitlement so popular that politicians dare not propose the reforms necessary for its survival. These things have been true for so long now that they have come to define the program entirely. When you think of Social Security, you do not think of a successful system of social insurance that has kept millions of people out of poverty. You think of a budget-gobbling entitlement program propped up by greedy geezers and feckless or demagogic politicians. Social Security--due, in large part, to the excesses of its own defenders--has become a bit tacky.

This intellectual evolution has given conservatives an opportunity. They have always detested Social Security, both for its collectivist nature and the political benefits it bestows upon the Democratic Party, but never had the guts to say so in public. Now Social Security's declining prestige, and the generally agreed-upon need to reform it, have allowed conservatives to say out loud what they have always thought in the comfort of their seminars and college newspapers: Social Security should be privatized, in whole or in part. What began as the hobby-horse of a few isolated rightwing intellectuals has become a clamor for private accounts from think tanks and members of Congress. The question of reforming Social Security has become a question of privatizing Social Security.

Now, you may detect an incongruity here. Social Security's ailments derive from the fact that, without changes, it will eventually pay out more in benefits than it collects in taxes. This is not a problem of philosophy, it is a problem of application--one that can be fixed with some tweaks. Privatization, though, is not a change in application, it is a change in philosophy. It is not away to solve Social Security's fiscal shortfall; rather, it is designed to convert it from a system of social insurance into a system of atomized personal accounts much like IRAs. This distinction is the key to reforming the program. There is a consensus that Social Security needs some sort of change to stay out of the red, but only the right-wing believes it is fundamentally misguided. Privatization advocates, realizing this, carefully couch their proposals in the language of fixing Social Security rather than replacing it.

The privatizers have succeeded in this so well that they have brought their ideas to the center of the political debate with few people understanding what is at stake. Aaron and Reischauer's main contribution is to disentangle these two matters, to consider the merits of social insurance and the problem of closing Social Security's deficit as separate questions. And by doing so in a careful and systematic way, they demonstrate that social insurance--that is, a system like the one we have now--is vastly preferable to a privatized one, and they also lay out a more than adequate proposal to save it from insolvency.

Consider the various ways in which a private system differs from Social Security as it exists. Imagine that, instead of sending payroll taxes to the government, you put them into a private account that you controlled personally. Basically, you would accumulate a pile of money, and then live off of it when you retire. Of course, this would mean that people who earned more money or invested it more shrewdly would get higher benefits. But there would also be other inequalities, based on far more random factors. If you invested a large chunk of your account in stocks, then the state of the market in the year in which you retired would have an enormous impact upon your retirement income. If we were to design a retirement program from scratch, why on earth would we want to include such a seemingly random feature?

There are yet more unpleasant aspects to a private system. If you control your own account, you have one lump sum to parcel out for as long as you may live, always taking care not to run the risk of outliving your savings. (You can avoid this dilemma by annuitizing a private pension, but since annuity-purchasers tend to live longer, insurance companies charge a steep premium for this service.) Also, under a privatized system, two workers who earned the same average wages over their careers and invested the exact same way could have very different pensions. Why? Because earning money earlier in your life is much more profitable than earning it later in life, due to the power of compounding interest. There's also the hard-to-fore-see impact of inflation, which would eat away large chunks of some people's retirement income, while others would get off easy. Even if we are willing to let higher earners and smarter investors enjoy more generous public pensions than everybody else, it's hard to justify vast inequalities brought about by nothing more than pure luck.

None of these random hazards exist under the current arrangement. Social Security benefits are based on a set formula that is indexed to inflation. It pays benefits as a monthly stipend, without regard to life expectancy or the state of the market when you retired. If the goal of Social Security is to provide, well, social security, then this seems a more rational way to go about it than a system of every-man-for-himself.

A second way a private system would differ from Social Security is that it would not allow for redistribution. Social Security provides higher returns for lower earners. For instance, $30,000 earners pay half the payroll taxes of $60,000 earners, but receive benefits only 29 percent smaller. Social Security also diverts some of its benefits to survivors, spouses, and disabled workers. These kinds of transfers, from rich to poor and from lucky to unlucky, can only happen because all Social Security taxes go into one big pot. If everybody controls their own account, then you can't redistribute the money. And if you partially privatize the system--by diverting some of the payroll tax from public to private accounts--then you reduce the amount of funding available for the social assistance component.

What, then, is the appeal of a private system? The one incontrovertible advantage is individual control. If you are offended at the notion of a government-guaranteed retirement income and believe that individuals should take responsibility for their own welfare, then privatizing Social Security is a way of enhancing personal freedom. This is the honest argument for privatization, adhered to by hard-core libertarians. But of course most people don't consider Social Security to be inherently immoral, and so the privatizers have devised a more popular, but less cogent, rationale: A private system will save Social Security from its looming deficits and give workers a higher return on their taxes. But look more closely, and the claims don't hold up.

There are several ways to partially or completely privatize Social Security, but none of them does anything to stave off its budgetary ills. Most plans to phase in a private system would allow current workers to keep their payroll taxes in personal accounts, instead of supporting current beneficiaries. How do we get the money to pay current beneficiaries? Well, you have to raise taxes. But if you can raise all that new tax money, then Social Security doesn't face a deficit anymore. The only way privatization saves Social Security is by doing something--raising taxes--that could be done without privatization.

The most popular partial privatization idea--such as the one put forth by Senators Phil Gramm and Pete Domenici--would use the budget surplus to fund new individual accounts. For every dollar individuals earned in their private accounts, their Social Security benefits would be reduced by 75 or 80 cents, which would save the government money. The trouble is, the funding source for those accounts--the budget surplus--is temporary. When it dries up in a decade or so, the budget would have a massive shortfall to make up, which it could only do by raising taxes, cutting benefits, or going very deeply into debt.

This plan, then, would just create a new predicament that's identical to the one we already have.

So privatization, whatever its strengths and weaknesses, is not a way to save Social Security. But what about the higher yields? Right now, our Social Security taxes earn a puny rate of return. Imagine--the privatizers ask--if we could keep that money and invest it in the stock market instead!

It is true that your payroll taxes earn a low rate of return. In part, though, this is due to circumstances we can't, or shouldn't, avoid. A portion of our payroll taxes goes to pay off current beneficiaries, who receive more generous benefits than future retirees will. That may be wrong, but not even the most radical privatizers propose to change that. And another portion is siphoned off to subsidize people who paid little or nothing into the system. We could take back that money, too, but that would mean cutting off crippled steelworkers and widowed housewives.

The biggest reason for Social Security's low rate of return, though, is that the trust fund is invested only in low-yielding Treasury bills, whereas individual accounts could select more lucrative investments, like stocks. And so, if the Social Security Trust Fund must confine its reserves to low-yield federal bonds, then a private system can indeed offer higher returns, at least in the aggregate.

But Aaron and Reischauer suggest this needn't be the case. They lay out a plan by which the Trust Fund could invest a portion of its reserves in private equities. By offering high returns to Social Security, of course, this would rob advocates of individual accounts of their strongest argument.

Naturally, this plan--since adopted by President Clinton--has drawn fierce opposition from privatizaters, who argue that it would lead to state control of private industry. Anticipating this objection, Aaron and Reischauer propose multiple safeguards against political interference: the establishment of an independent, Federal Reserve-like body to handle the investing. Its governors would serve long, staggered terms to assure their independence, would be selffunding, and hire private managers on a competitive basis to invest only in passive index funds, on which the Trust Fund would forfeit all voting rights. I count seven firewalls against political interference, which would make the new board more independent than the Federal Reserve (which is a far more tempting target for political interference). Conservatives thus far have refused even to consider the plan, hysterically dismissing it as socialism. No doubt they are also aware that any plan that would allow for higher rates of return without creating individual accounts would undercut the strongest argument for privatization.

Aaron and Reischauer have taken some criticism for the last section of the book, which compares various reform plans. (Their own gets the highest mark; hence the sneering). But the truth is, if you judge by criteria such as equitable benefits and sharing of risk--the basic notions of social insurance--then keeping the essential structure of Social Security makes far more sense than privatizing it. If critics place less of a value on social insurance than on the possibility of greater wealth for certain individuals, as seems to be the case, then that is the argument they ought to make.

JONATHAN CHAIT is a fellow at the New America Foundation.