Wall Street's Fondest Dream

The Insanity of Privitizing Social Security

by Christian Weller

Dollars and Sense magazine, November/December 1998


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 budget surpluses.

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 million each.


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 savings.

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.


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 anticipated.

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 individual choice.

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 coverage.

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.

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