Question

What are the reasons why social security should be privatized? In essay form.

Answer 1

olicymakers and the public show growing interest in the idea of replacing Social Security with a private system of individual retirement accounts. It is too soon to tell whether curiosity will lead to popular acceptance, but it is already plain that many Americans are thinking about private alternatives to Social Security for the first time.

Proponents of privatization see three main arguments, in addition to ideological advantages, for moving toward a private retirement system:

• it can lift the rate of return workers obtain on their retirement contributions;
• it can boost national saving and future economic growth;
• it has practical political advantages in comparison with a Social Security rescue plan based on higher payroll taxes and a bigger accumulation of Social Security reserves.

Any transition to a private system must overcome a major financial hurdle, however. Social Security has accumulated trillions of dollars in liabilities to workers who are already retired or who will retire soon. To make room for a new private system, policymakers must find funds to pay for these liabilities while still leaving young workers enough money to deposit in new private accounts. This requires scaling back past liabilities – by cutting benefits – or increasing contributions from current workers. Most large-scale privatization plans also involve major new federal borrowing. Consequently, if a balanced budget amendment becomes part of the constitution, it would torpedo any attempt to replace most of Social Security with a private retirement system.

Privatizing Social Security can boost workers’ rate of return by allowing retirement contributions to be invested in private assets, such as stocks, which yield a better return than the present pay-as-you-go retirement system. Returns can be boosted still further if the government borrows on a massive scale to pay for past Social Security liabilities, allowing workers to invest a larger percentage of their pay in high-yielding assets. Exactly the same rate of return can be obtained, however, if the current public system is changed to allow Social Security reserves to be invested in private assets.

By shifting the retirement system away from pay-as-you-go financing and toward advance funding, privatization can boost national saving. Such a move will require a consumption sacrifice, through either a cut in benefits or a hike in combined contributions to Social Security and the new retirement plan. Privatization plans that do not impose a consumption sacrifice will not achieve a higher saving rate. Higher national saving can also be achieved by reforming the present public retirement system. The crucial change in policy is the move to advance funding, not the move to a private system.

The claimed economic advantages of privatization can be obtained in either a public or a private retirement system. In either case, a short-term consumption sacrifice is needed. The best political argument for privatization is that the consumption sacrifice will be more palatable if workers are given ownership rights over the extra contributions they will be forced to make.

Privatization plans are based on a simple idea. Instead of contributing to a collective, pay-as-you-go retirement program, workers would be required to build up retirement savings in individually owned and directed private accounts. Workers could withdraw their funds from the accounts when they became disabled or reached the retirement age, and their heirs could inherit any funds accumulated in the account if the worker died before becoming disabled or reaching the retirement age. At the time a worker chose to start receiving a pension, some or all of the funds in the worker’s account would be converted into an annuity that would last until the worker died. If the worker is married, both worker and spouse might be required to accept a joint survivors’ annuity, that is, an annuity that would last until both the worker and spouse have died. Under some proposals, workers could choose to withdraw some of the funds as a lump-sum distribution when they become disabled or retire.

Workers would be free to decide how their contributions were invested, at least within broad limits. In some privatization plans, contributions would be collected by a single public or semi-public agency and then invested in one or more of a limited number of investment funds. A worker might be given the option of investing in, say, five different funds – a money market fund, a stock market index fund, a real estate investment trust, a corporate bond fund, and a U.S. Treasury bond fund. By pooling the investments of all covered workers in a small number of funds and centralizing the collection of contributions and funds management, this approach would minimize administrative costs, but it would limit workers’ investment choices. Another strategy is to allow mutual fund companies, private banks, insurance companies, and other investment companies to compete with one another to attract workers’ contributions in hundreds or even thousands of qualified investment funds. This strategy would permit workers unparalleled freedom to invest as they chose, but administrative costs might be high.

Privatization has attracted growing interest because many public retirement systems around the world have encountered serious financial difficulties. In Chile, a costly and failing public system was replaced by a less costly private system that has so far been quite successful. The United Kingdom has also shifted toward much greater reliance on private pensions. Advocates of privatization in the United States have proposed several plans for moving to a partially or fully private retirement system. Two plans were outlined in the just-published report of the 1994-1996 Advisory Council on Social Security. A majority of Advisory Council members voted to scale back defined-benefit Social Security pensions and require workers to contribute a percentage of their pay to private defined-contribution retirement accounts. Under one plan, workers would be required to contribute 1.6 percent of their covered wages to publicly managed but individually selected retirement accounts. The 1.6 percent contribution would be on top of the 12.4 percent combined tax that workers and employers already pay into Social Security. Under the more ambitious privatization plan, the overall contribution would rise by 1.5 percent of covered wages, but 5 percentage points of the higher tax would be redirected into individually selected and privately managed personal security accounts.

Privatization plans differ from Social Security in two important ways. First, the worker’s ultimate retirement benefit would depend solely on the size of the worker’s contributions and the success of the worker’s investment plan. Workers who made larger contributions would receive bigger pensions, other things equal. Workers whose investments earned high returns would enjoy more comfortable retirements than workers who invest poorly. Second, in a private system workers’ pensions are paid out of accumulations of their own previous savings. In contrast, Social Security pensions are financed mainly by the payroll taxes of active workers (see box 1). This difference between the two kinds of system implies that the savings accumulation in a private plan would be many times larger than the reserves needed in pay-as-you-go Social Security.

Advocates of privatization see a number of advantages in increasing the size of the private system and shrinking the size of the public one. For some proponents of privatization, ideological concerns are paramount. They are fundamentally opposed to public provision of retirement benefits. More common are people who see important economic advantages in privatizing Social Security. They believe workers will receive larger pensions and the economy will grow faster under a private rather than a public retirement system. Finally, some advocates of privatization believe the United States is more likely to take needed steps to prepare for a rising aged population if the retirement system is reformed to include a bigger private role.