Social Security.

The liberal case for partial privatization 

DEMOCRATS ARE ALREADY LINING UP in opposition to the President's plan to reform Social Security. Bush has put forth only an outline of what he proposes to do--allow workers to use part of their payroll tax to fund private investment accounts, which, upon retirement, would be used to help augment Social Security benefits. Beyond that, the President intends to leave the specifics up to a bipartisan commission. But bipartisan commission or not, it appears that the president is in for one hell of a fight.

To liberals, privatization appears, at best, a risky gamble that would leave unsophisticated investors vulnerable to the perils of the turbulent stock market. At worst, it's a plot by anti-government radicals to entirely dismantle the Social Security system. Mainstream moderates who support privatization have tried to diffuse the visceral responses to the idea by developing friendlier labels. Still, whether it's "privatizing," "personalizing" or "capitalizing," most Democrats aren't buying it.

Certainly, many of liberals' concerns are legitimate. As Vice President Gore never hesitated to point out, investing in the stock market is risky. Many workers are unfamiliar with investing. The stock market does indeed seem like a dangerous place to park retirement benefits. For the many Americans who care about preserving a strong social safety net, risking the promise of a secure retirement is precisely the wrong way to go about reforming Social Security. Bush's pronouncement that he "trusts Americans to make their own decisions and manage their own money," does little to ease their minds.

But the types of reforms many liberals favor instead, from means-testing benefits to lifting the cap on payroll taxes to increasing the retirement age, if taken alone, would not create a fully viable reform package. For one, support for the communal retirement system will erode if it is transformed into an overly redistributive welfare program. Second, when Social Security began, it was a tremendously good deal for earlier participants. People got out far more than they paid in. But the returns participants receive on what they pay into Social Security have declined precipitously and are now expected to be roughly one to two percent; for many, they will actually be negative. Increasing what is paid into the program or decreasing what is paid out, will only exacerbate the problems of the discouragingly low returns--increasing the generational inequities and tensions that already exist. Finally, even a package of benefit cuts and tax increases large enough to return the system to solvency in the short run would not do so in the long-run. It would simply postpone the problem.

Assuming certain concessions from Republicans, Democrats should embrace private investment accounts, combining the idea with traditional Democratic proposals. By recognizing the benefits private accounts have to offer, while structuring them to ensure that the risks are mitigated and the neediest retirees are protected, Democrats can, in fact, create a plan that would tackle not only the problem of the Social Security funding shortfall but that of declining returns head on. Republicans, at the same time, should be structuring their privatization plans to retain the progressivity so important to giving all the elderly security.

Searching for Compromise

The existing political standoff between the two parties does nothing to change the financial and demographic realities facing Social Security. According to our best estimates, because of the upcoming retirement of the baby boomers and growing life expectancies, the dedicated payroll tax used to fund the intergenerational transfer system will no longer provide enough money to cover promised benefits starting in 2015. By 2037, the program will be running annual deficits of $300 billion in today's dollars; it will take an infusion of $4 trillion to pay full benefits between now and when today's 30-year-olds retire. And the problems will grow rapidly thereafter.

An undertaking as financially challenging and politically explosive as reforming Social Security will demand compromise. One obvious approach would be for President Bush to back off from the contentious private investment component of his plan and to work with Democrats on developing other options. But the alternatives are, frankly, quite bleak. The only two remaining approaches to keeping the system liquid are cutting benefits or increasing revenues, either from increasing taxes, diverting money from the rest of the budget, or borrowing through deficit spending.

To keep the program solvent for 75 years, the amount of time program actuaries use to judge its financial health, Congress will in the future have to slash benefits across the board by one-third, leaving Social Security a tattered remnant of what it is today. Although such a drastic cut would not harm wealthier retirees, it would be devastating to those who depend on Social Security for a substantial part of their income.

Alternatively, we could increase the payroll tax that funds the system to cover promised benefits. That would take an unpalatable 50-percent increase over time, and that's not counting the portion of the tax used to pay for Medicare. Since financial planners estimate individuals need to save roughly seven percent of their pre-retirement income to retire comfortably, the resulting 18-percent payroll tax would be clearly excessive, even considering the additional disability and survivor benefits the program offers.

Or taxes could remain unchanged and the money to pay for Social Security, which already consumes almost a quarter of the federal budget, could be taken from other areas of the government's spending. For instance, cutting the entire federal budgets for defense, science, the environment, and education would do the trick.

The final option, borrowing, would make the deficits of the past look microscopic compared to those we would run in the future, and it would drain the economy of savings, thus dragging down economic growth and incomes.

The difficulty of creating comprehensive reform plans that exclude private accounts is the reason there are no realistic alternatives floating around. A few years back, the Clinton administration, pledging to put Social Security first, proposed channeling new money out of general revenues into Social Security to be invested by the government in the stock market. Acknowledging the need to increase the program's returns, few Democrats voiced fears about the stock market then. In fact, at a 1999 White House conference on Social Security, Vice President Gore pointed out that "over any 10-year period in American history, returns on equities are just significantly higher than these other returns."

But while the stock market itself was not seen as a threat, the notion that the government would oversee the investment decisions was received about as warmly as the Presidential pardon of Marc Rich. Most politicians who initially flirted with the plan later recoiled from it in light of the inherent risks in intertwining financial markets and politics, not to mention the difficulties of the government investing a multi-trillion dollar fund without adversely affecting Wall Street.

Clinton quickly dropped the idea and, as The New York Times reported, Gore determined that "The magnitude of the government's stock ownership would be such that it would at least raise the question of whether or not we had begun to change the fundamental nature of our economy."

Generational Risk

While critics regularly refer to the market risks that would exist in an investment program, they ignore the risks in the current system, those spread between generations rather than portfolios.

Members of smaller generations have to pay far more in taxes to support larger, older generations, greatly reducing the returns they get from Social Security. Because these generational risks are less transparent, they tend to be overlooked in discussions about fairness and risk. But ignoring these risks promises to unravel support for the program from young workers on the wrong end of what has become simply a bad deal.

By allowing workers to invest a portion of their payroll taxes, they would, for the first time through Social Security, be able to save and invest and benefit from compounding returns. Assuming average returns of only five percent, lifetime workers could expect accounts with assets of anywhere from $100,000 to $600,000. Once the accounts had time to grow, they would be able to more than offset the benefit reductions needed to keep the program solvent.

Addressing the Risks

There are legitimate concerns about the risks of pursuing higher returns, and a new system needs to be structured accordingly. For instance, partial privatization could present an opportunity for unscrupulous money managers to take advantage of unsophisticated investors, churning their accounts or robbing them of their assets the way many subprime mortgage companies fleece elderly homeowners.

Clearly, Social Security must not be turned into a freewheeling laissez-faire system with workers trusting their friend's second cousin to invest in commodity futures or currency swaps. Instead, the privatized part of the system should be structured like an employer-sponsored pension system, with workers choosing from a variety of government-regulated, well-diversified, professionally managed stock and bond funds. Few decry these types of savings opportunities as too risky; in fact, Democrats and Republicans alike encourage their expansion as a way to increase personal savings and wealth.

Government regulations can protect workers against charlatan money managers, but what about the roller-coaster stock market? Annual returns have ranged from negative 12 percent to positive 32 percent over the past twenty years. But while markets are rocky, diversified investments--as the Social Security investment options would be--have always been the best method to combat risk.

Furthermore, the perpetual year-to-year fluctuations are irrelevant. Market returns over one's working lifetime really count. The U.S. stock market has never failed to provide positive returns for any 20-year period going back to and including the Great Depression; the average return on the S&P 500 over that period was 12 percent.

The pronounced risk of recent years to workers who couldn't afford to save, (due in no small part to the payroll tax) has been far greater than anything the stock market has dished out. They missed the opportunity to build wealth while a booming economy doled out profits to those on the upper half of the income spectrum. Declaring the stock market too risky for the least well-off mainly ossifies existing wealth inequities.

While regulations will be instrumental in mitigating risk, no one should insist on regulating out all selection in investment choices. Workers will have a long time horizon over which to save, with different investments appropriate at different stages of life. Young workers would be more likely to choose higher-yielding equity-fund options, while those approaching retirement would be more likely to switch into safer bond funds. People shouldn't be forced to shoulder more risk than they choose. By making government bond and money market funds available, they wouldn't have to.

Investment vehicles structured particularly for retirement, such as funds that guarantee minimum returns, allowing participants to lock in their gains and guard against unwanted risk, like today's system, should also be included as investment options.

Additionally, Social Security's fundamental purpose --to ensure a decent retirement--should not only be preserved, it should be strengthened. A base benefit should be set to guarantee that the lowest-level benefits would still be higher than what today's system offers.

Under the plans being considered to partially privatize Social Security, the bulk of funding would continue to finance traditional benefits, not private accounts. Gradually folding in an investment component, initially using, for instance, only four percent of the payroll tax, would leave the other 8.4 percent of the tax to finance additional benefits for retirees, as well as disability and survivors' benefits. The traditional retirement benefit could be structured to provide a base-level benefit for all retirees or, better yet, a more generous one for those who needed them most.

Making Privatization Progressive

Liberals should insist that any privatization system remain progressive. Because private accounts would partly offset the current Social Security benefit, some of the progressivity built into the current benefit structure--where lower-earning workers receive larger benefits relative to their earnings--would be lost. The purpose of privatization reform plans should be to increase the efficiency of the system, not to lessen the progressivity.

Under a simple privatization plan saving four percent of earnings, workers earning $20,000 could expect to accumulate roughly $150,000 by the time they were 67, but someone earning $65,000 might have $500,000. The low-income workers' savings would certainly be higher than what they would be without the program, but they would still be far more dependent on the rest of their Social Security benefit to supplement their personal savings.

A better option would be a progressive privatization plan, with low-income workers' savings matched by the government. The savings of low-income workers could be matched by say 2-to-1, scaling down as income increased. Under this scenario, a $20,000 earner would retire with closer to $300,000. While government matches would cost more initially, decreasing poorer workers' reliance on the government-guaranteed portion of the system would more than make up for the cost over time. Some Republicans, notably Congressman Kolbe of Arizona, have developed bipartisan plans structured to help low-income workers that could serve as blueprints for compromise.

To be fair, partial privatization is not the panacea some claim. Mending a system running out of money is never easy. Even with the prospect of private accounts providing new funds and higher returns over time, additional measures will be necessary to keep the program solvent. It will take time to build up private accounts, and in the meantime, part of the payroll tax used to fund the current system will be diverted into investment accounts. Social Security surpluses can provide some of the money to fund both the current system and private accounts, but once the surpluses have abated, the system will need either benefit cuts or new revenues sources.

The Road Less Traveled

Though politicians on both sides of the aisle have promised to protect current Social Security benefits at all costs, it makes no sense to take changing the benefit structure off the table. If current beneficiaries are exempt from any adjustments needed to keep Social Security liquid, the entire responsibility will be shifted onto younger workers and future generations -- regardless of their economic situation--who already face a far worse deal in Social Security than do current beneficiaries.

Of course, scaling back benefits should not be done through an across-the-board benefit cut, which would rip away benefits from the 60 percent of retirees who depend on the program for at least half their income. But means-testing benefits, or lowering payments for the wealthiest seniors, can easily be structured to protect the less affluent. This would spread the costs of reform among those who can afford them regardless of age.

Secondly, what every politician knows but few are willing to acknowledge is that we need to increase the retirement age. When Social Security began, life expectancies for 65-year-olds were for another 12 years; today they live for another 18. It is absurd for people to be living longer but still retiring at the same age as their grandparents. While the retirement age is gradually increasing to 67, it needs to be increased faster and then indexed to life expectancies. Disability benefits would still be available to anyone forced to stop working before the retirement age.

Critics will no doubt decry these changes as draconian and unfair. But without private investment accounts to fill in much of the funding gap over time, the changes will in fact, have to be much larger. Plans that don't include an investment component inevitably fall out of balance and run huge deficits in the long run.

Finally, the budget surpluses present a unique opportunity to ease the pain of keeping Social Security in the black. If the surpluses materialize as projected, the government will run out of publicly held debt to repurchase and have to pursue the discredited idea of becoming a massive owner of stocks and bonds. Avoiding this quagmire has become one of the newest justifications for large tax cuts. But using the surpluses for tax cuts, stimulating consumption, ignores the reason for reducing the debt in the first place: to increase national savings.

By using the surpluses instead to jump-start private investment accounts and to fund the progressive matches for low-income workers, we would have enough money to cover benefits and build new investment accounts. Moreover, we would ensure that the surplus dollars would still be saved, adhering to the successful fiscal discipline of the past decade.

To give this story a happy ending, Republicans and Democrats will have to cast aside their suspicions and recognize that neither side's concerns are misplaced. Partial privatization--if done right--can achieve liberal goals of equity and conservative goals of efficiency alike. There's plenty of room for compromise. Politicians will look for excuses to delay because there will always be hard choices involved, but the choices will only get harder with time.

MAYA MACGUINEAS is a Fellow at the non-partisan New America Foundation in Washington, D.C.