Wall Street's Fondest Dream
The Insanity of Privitizing Social Security
by Christian Weller
Dollars and Sense magazine, November/December
In past years Alan Greenspan looked out for his friends on
Wall Street by hiking interest rates, even when doing so cost
workers their jobs. Now he backs privatization of Social Security,
an equally bad deal for working families -especially low income
workers, most women, disabled workers, and survivors of deceased
workers. Meanwhile, Greenspan's colleagues would profit quite
nicely. Financial firms, who often bankroll the pro-privatization
projects of conservative think tanks, would gain huge fees from
administering the privatized individual accounts.
Real life experiences with privatization in Chile and in Galveston
County, Texas show that its claimed benefits for workers do not
hold up. Employees in Galveston and Chile have been part of privatized
systems since 1981, and both experiments have been hyped by pro-market
pundits, such as the former governor of Delaware, Pete DuPont.
But due to high administrative costs and measures to lessen the
risks of stock market losses, neither experiment has lived up
to its promises.
For 63 years, workers and their families have relied on Social
Security as their major source of retirement income, survivorship,
and disability insurance. In 1997, 44 million workers and their
families received benefits from Social Security in one form or
another. It provides the majority of retirement income for two
thirds of retirees. It replaces two thirds of the income of a
25-year old worker with a young child who becomes disabled and
up to 81% of the average earnings of a worker who dies leaving
two young children and a spouse.
Although projecting demographic and economic trends so far
into the future involves great uncertainty, current estimates
say that Social Security faces a long-term shortage of funds.
Its Trustees say that revenues will cover only 75% of benefits
after 2032 if the system remains unchanged. Longer lifetimes,
along with declining birth and immigration rates, mean that retirees
are growing faster than the working population. Hence, the number
of current workers who pay for one Social Security recipient has
fallen sharply, from 5.1 workers in 1960 to 3.4 in 1997, and it
is expected to decline to 2.0 by 2030. In addition, slow wage
growth and rising inequality reduce Social Security tax revenues.
The money needed to cover the financing shortfall is potentially
large-an extra 0.8% of GDP each year for the next 75 years. Today
Social Security tax revenues are about 4.4% of GDP, so the percentage
would rise to 5.2%. In other words, to continue seeing the basic
retirement needs of our senior citizens through a publicly-run,
equitable program we will need to devote about one-twentieth of
total economic output to that purpose.
Such a shift in government spending priorities has been accomplished
in the past, and can be done again. For example, twice as great
a shift took place when defense spending rose by 1.6% of GDP between
1978 and 1986, notes Dean Baker of the Economic Policy Institute.
So while the needed changes are serious (assuming that demographic
and economic factors don't change in future years), they can be
managed without privatization.
Several policies have been proposed that would preserve the
main features of Social Security, particularly its emphasis on
giving more back to those with relatively low incomes, while bringing
in the necessary revenue. Among them are eliminating the cap on
taxable earnings, extending coverage to newly hired state and
local employees, putting some of the Social Security Trust Fund
into stock market investments, and making use of projected federal
Privatization, on the other hand, would do away with exactly
those aspects of Social Security which make it "an example
of successful-and popular-government, and [why] conservatives
are determined to demolish it," says Frances Fox Piven of
the City University of New York.
Ideological opposition to "big government" and redistributive
policies is one reason why right-wingers are pushing privatization.
But its backers are mainly large Wall Street companies. They stand
to gain $240 billion in fees within the first 12 years of a privatized
system-enough for 20,000 managers to make annual salaries of $1
BIG RISKS, BUREAUCRATIC WASTE
Currently, Social Security guarantees the same "defined
benefits" to all workers with the same work and earnings
history when they retire. Privatization would mean that each worker
has to fend for herself by investing her "defined contributions"
in individual accounts. By doing so, the worker bears all costs
and risks involved in investing her retirement income, with no
insurance if her investment goes sour.
The risk of losing hefty chunks of one's retirement savings
may be acceptable - to some, particularly high earnings workers
who have other sources of income, but it would mean severe burdens
for others. While Social Security benefits constitute only 29%
of the retirement income of those in the top fifth of the income
distribution, they amount to 89% of the retirement income of those
in the bottom fifth. In fact, Social Security is the most important
anti-poverty program for the aged, keeping 42% of all recipients
out of poverty in 1994. And people who rely on Social Security
to escape poverty usually have little if any extra income to make
up for losses in the stock market.
Most privatization proposals are based on the assertion that
returns on stocks have historically been greater than those on
Social Security's investment in government bonds. Due to these
greater returns, privatizers contend, retirement income security
would improve if individuals were free to invest their own savings.
Privatizers promise high rates of return for individual accounts
if workers are allowed to invest in the stock market. Although
stock market gains have fluctuated wildly over time, on average
the market has produced higher real rates of return (adjusted
for inflation), about 7%, than the 2.3% return from U.S. Treasury
debt-which is where the Social Security Trust Fund is invested.
Thus, individual stock market investment should produce higher
retirement incomes than Social Security-if we ignore costs that
make the comparison null and void.
Social Security has far lower operating costs than do private
financial firms. These costs are of two types, collection of taxes
and disbursement of benefits. In a privatized system, there would
be three main options for disbursing a worker's accumulated savings.
One for employers to simply hand all savings over to the worker
without any attached requirements. This is done in Galveston County,
where workers get a check for their total savings. Since there
is no requirement to invest the money in order to cover years
of retirement, some people use the extra cash to buy a house or
a boat, or to go on a vacation-thus defeating the purpose of retirement
Most privatizers, though, have come to understand that this
is too risky an option. A second possibility is that workers would
withdraw funds from their savings at a schedule pre-determined
by the government. But, depending on their lifetime, this leaves
the risk that a retiree runs out of money while still alive.
The third option is for workers to buy "annuities,"
which would guarantee them fixed annual payments for as long as
they live. If such annuities rose with inflation, they would function
just like SociaI Security does today. But annuities are essentially
forms of insurance, and insurance companies charge large fees
for providing them. For example, in Chile, a typical insurance
company charges a worker 4% of her accumulated savings for providing
this service, while a U.S. insurer charges 4% to 6%.
The annuity fees would come on top of administrative fees
that workers would have been paying all along for the management
of their investments. Combined, these two types of costs amount
to 20% of a worker's contributions in Chile and to 40% of life
insurance premiums in the United States. Social Security is a
far better deal-its administrative costs are a mere 0.8% of contributions,
while it also provides disability and survivorship insurance benefits.
Why is Social Security so much more cost effective than private
firms? The answer lies in the simplicity of its financing. By
investing entirely in one asset (U.S. Treasury debt), no money
is spent on managing the overall portfolio or individual accounts.
On the benefits side, current contributions pay for current benefits.
Since wages and hence taxes generally increase with inflation,
Social Security need not worry about benefits outrunning incoming
revenues due to inflation. Private insurers, though, must promise
retirees that their benefits will keep up with inflation, even
though the insurer's income may not grow at the same rate- and
insurers charge more for taking this risk.
Privatization would be particularly costly for low income
workers, since investment companies and insurers charge higher
percentage fees on small accounts than large ones. Costs would
further increase because, while investment options might be restricted,
workers would still have several choices. Thus, besides 4% to
6% in insurance fees, workers would also pay around 1% of their
savings to investment managers.
BUT WON'T STOCK MARKET GAINS OUTWEIGH THE COSTS?
The greater costs of individual accounts could be out weighed
by even bigger benefits-a prospect the sounded more likely before
the stock market's recent slump. But as Dean Baker of the Economic
Policy Institute has pointed out, backers of privatization make
contradictory assumptions to justify their claims. First they
accept the Social Security Trustees' projection that economic
growth during the next 75 years will average 1.4 % a year-less
than half what it was during the last 75- resulting in lower tax
revenues. But then they project high stock market returns, which
can only take place if economic growth is rapid (except for short-term
speculative "bubbles" such as we experienced the last
few years). If stock prices do not soar, and yield returns closer
to 4% than the 7% which they have averaged in the past, then the
benefits from privatization shrink dramatically. On the other
hand, if the economy does grow quickly, then Social Security's
revenue problem will disappear because real wage growth will be
higher than expected.
In addition, future workers would face large costs due to
the necessary transition from our current "pay as you go"
system to one based on individual retirement accounts (see box).
Columbia University professor Stephen Zeldes, for instance, has
argued that transition costs would wipe out any difference between
Social Security returns and stock market returns. Even the Heritage
Foundation's Daniel Mitchell admits that the transition costs
are "sizable," and likely to eliminate much of the potential
benefits from privatized accounts.
So, on average workers would be no better off, if the costs
of privatization are taken into account. Some workers would gain,
while others would lose, since hardly any individual would receive
the average stock market return. How much worse off could an investor
potentially be? As it turns out, there is a high risk of doing
quite poorly, based on one's skill or luck in choosing investments,
and on the overall state of the market. For instance, suppose
a worker invests all her contributions in stocks, hoping that
after 35 years of work she will obtain the average returns that
the market has yielded in the past. But, because market returns
have varied greatly depending on the time period, she would face
a 1-in-4 chance of having only 25% as much savings as she had
If, for whatever reason, an individual account does not provide
enough retirement income, the government may have to provide extra
help. To lower the risk of such assistance, though, governments
have limited the investment options of individual accounts, so
that high-risk investments are not permitted.
By addressing the risks of privatization, privatizers suddenly
find themselves between a rock and a hard place. Once they admit
that investment options should be restricted, they eliminate much
of what makes privatization so attractive for conservatives, namely
In both the existing privatization experiments, governments
chose to direct where workers can invest their savings. Galveston
County picks one insurance product in which its employees have
to invest their contributions. Similarly, in Chile investment
options are limited to a few assets, with the largest share going
to government bonds.
Not only do these restrictions signal that governments consider
the risks of unregulated accounts too high, but they also fail
to protect workers from doing poorly. For instance, despite government
regulations, the number of Chileans receiving welfare pensions
has quadrupled since the 1970's.
To be an investor who is either not savvy or simply unlucky
is one thing, but it is more serious when even the savviest investors
struggle because the market is stagnant. Michael Tanner from the
conservative Cato Institute claims that "the worst 20-year
period of stock market returns (1928-1948) ... shows a positive
real return of more than 3%." But history proves Tanner wrong.
For three 20 year periods in this century, the average real return
has been zero instead of 7%-from 1901 to 1921, from 1928 to 1948,
and from 1962 to 1982.
Social Security's future is too important to be left to the
special interests of investment-management companies. Instead,
we should focus on reforms to maintain its redistributive character
and hence its insurance aspects. To that end, several proposals
are available, including using future federal budget surpluses,
investing part of the trust fund in stocks, extending coverage
to newly hired state and local employees, and lifting the cap
on taxable earnings.
Using future federal budget surpluses sounds attractive, but
it may be unrealistic. For the first time in almost 30 years,
the U. S. government is looking at a surplus, and President Clinton
has asked Congress to consider saving Social Security before cutting
taxes or raising government spending. But the current surplus
is really due to the current excess of Social Security revenues
over spending. A true surplus will probably not appear for another
two years. In addition, Social Security and workers might be better
off if the money were publicly invested, helping to raise the
economy's growth rate.
Part of the trust fund assets, currently standing at $655
billion, could be invested in stocks. Robert Ball, a member of
the 1994-96 Advisory Council on Social Security, proposed that
we begin doing so in the year 2000, and build stock holdings up
until they are 40% of all assets, with the remainder of the trust
fund still in government bonds.
But having the government invest broadly in the stock market
has a downside. While it would eliminate the risk of adverse investment
outcomes for individual workers, it would shift the risk of a
weak stock market to the Social Security system as a whole. If
stocks performed badly over a long time period, the trust fund
could be depleted earlier than expected, and the government could
face an unexpected financial crisis.
There is a third possible solution that would not raise taxes
or cut benefits-extending coverage to newly hired state and local
employees, most of whom are not currently in the Social Security
system. Since these employees are moderate to high income earners
and since Social Security's structure is redistributive, new income
for low income earners already in Social Security would become
available. While this proposal would not only improve the long-term
financing situation of Social Security, but also bring it closer
to a universal system, it faces opposition from public sector
unions whose members are afraid of losing their often better pension
Last but not least, Congress could enact a progressive tax
hike that would counter the effects of stagnant real wages and
increasing inequality in recent decades. It could eliminate the
cap on earnings which are subject to Social Security taxes, which
is currently set at $68,400, covering 87% of wages and salaries.
Raising or eliminating the cap could provide substantial additional
income. The Advisory Council estimated that raising it slightly,
so that 90% of wages are taxed after the year 2000, would cover
22% of the financing shortfall.
Several policy options involving the income cap are currently
being discussed in Washington, all of which would provide much
additional income and would keep the progressive structure intact.
For instance, it is possible to eliminate the cap only on the
employers half of Social Security payments, so individuals would
not feel a tax increase. This should help to maintain the popular
support for Social Security across all income groups. Alternatively,
the cap could be lifted on employers and employees, but the tax
rate lowered for everyone to, for instance, 10.4% versus 12.4%.
Thus, only the richest income earners would see their taxes increase
while everyone below the current cap would receive a tax cut.
A combination of several reform policies will be necessary
to address Social Security's long-term financial soundness, and
the time to discuss such reforms is now. Ensuring the program's
long-term viability may require some uncomfortable choices for
progressives, but if the system is to continue its success story
for another 60 years, these choices need to be made.
So far, conservatives have gained ground with their insupportable
privatization idea. But progressives cannot leave the future of
the nation's leading income security program to the special interests
of Wall Street and their conservative think tank cronies.
Christian Weller is an economist, currently at the Center
for European Integration of the University of Bonn in Germany.
He formerly worked in the Public Policy Department of the AFL-CIO.