NOTHING: WHY AMERICANS SHOULD JUST SAY ‘NO’ TO PERSONAL ACCOUNTS
Missouri, Kansas City
The Center for
Full Employment and Price Stability
The issue of Social Security, long considered the
untouchable “third rail” of American politics, was avoided by both Clinton
and Dole in their bids for the presidency in 1996.
The current President, in contrast, seems to sense that, for the first time
in 60 years, the political climate is right for the restructuring of this
once-unassailable program. At least part of the credit for this ‘climate
change’ can be traced to President Reagan's successful campaign to promote
self-reliance and personal responsibility and discourage a sense of
entitlement among America's working class. But even Reagan never attempted
to dismantle the largest, most successful and most widely supported
entitlement program of our time.
And he could have made a strong case for doing so.
In the second year of Reagan’s presidency, the Trustees
of the Social Security Administration projected that the Trust Funds would
be exhausted by the end of his third year in office. Based on this forecast,
virtually everyone believed that Social Security was on the brink of
insolvency and that the system was in imminent danger of collapsing. Then,
as now, crisis rhetoric dominated the airways and filled the legislative
chambers. And yet there were no serious proposals to abandon the system or
even to overhaul it in any fundamental way. Instead, lawmakers salvaged the
system in an eleventh-hour, bipartisan deal brokered by former House members
Jake Pickle (D-TX), Claude Pepper (D-FL) and Senator Bob Dole (R-KS).
Through their collective powers of persuasion, both the Senate and the House
agreed on a series of reforms – a hike in the payroll tax, benefit cuts, and
a gradual increase in the retirement age
– that were supposed to keep the system solvent for roughly 75 years.
President Reagan signed the reform bill just two months before the Trust
Funds would have been depleted.
The 1983 compromise is often touted an example of the
kind of progress that can be made when bi-partisan leadership supplants
routine legislative partisanship. But the changes that were made in the name
of “solvency” in 1983 were no more necessary than the sweeping reforms that
are being proposed today. Then, as now, politicians, pundits and (most)
economists incorrectly linked the government’s ability to pay scheduled
benefits to the balance in the Social Security Trust Fund.
Today, the debate is not so much over whether Social
Security faces a financial crisis – both sides concede that it does – but
whether now is the time to enact sweeping reforms. Democrats emphasize that
the Trust Fund is solidly in the black and that deficits aren’t even
projected for another thirteen years.
And even then, they stress that the shortfall can be covered for another 24
to 34 years, as Social Security draws down its massive surplus – projected
to stand at $3.7 trillion by that time. Thus, with the current system
projected to honor its benefit commitments in full and on time until
somewhere between 2042 and 2052,
Democrats deny that immediate changes are needed. They believe there is
plenty of time to devise solutions to address the long range problems facing
Republicans, in contrast, insist that the long range
problems require a short range solution.
To make their case, they emphasize the $3.7 trillion shortfall
the Trustees have projected over the next 75 years, arguing that we must
change the system today, so that we do not pass the burden of tackling tough
problems on to our children and grandchildren. In their view, waiting is not
only irresponsible but, ultimately, more costly, since an additional $600
billion is added each year the problem is not addressed. In short, they
argue that the Trust Funds are becoming insolvent and that we cannot afford
to wait to react to the crisis.
It is tempting to give this paper over to a detailed
elaboration of the flaws inherent in both positions. Specifically, it would
be easy to demonstrate that payroll tax withholdings do not actually finance
retirees’ benefits and that it is meaningless to speak in terms of Trust
Fund “insolvency” or to engage in hand wringing over the balance in the
Social Security Trust Fund. The problem, of course, is that almost no one
understands or accepts these facts, making it virtually impossible to turn
their attention away from the looming financial crisis they are all
hell-bent on resolving, either now (Republicans) or at some future date
(Democrats). Thus, I shall leave this task to others
and confine my attention to an analysis of the Bush proposal. Specifically,
this paper seeks to: (1) examine the Presiden’t plan to offer private
retirement accounts; (2) consider the counterarguments that have been raised
by opponents of the president’s plan; and (3) reflect upon the British and
Chilean experiences to highlight some of the difficulties workers in those
countries have faced in retirement. The paper concludes with the argument
that Americans should reject the president’s plan and insist upon the
preservation of Social Security as we know it.
Have I Got a Deal for YOU!
In a memorandum dated January 27, 2005, House
Republican Conference Chairman, Deborah Pryce, and Senate Republican
Conference Chairman, Rick Santorum, provided Senate and House Republicans
with a ‘playbook’, outlining the GOP position on Social Security reform.
Included in the roughly 100-page document were: a set of talking points for
communicating the President’s message on Social Security; a summary of the
Trustee’s projections; two sample speeches, one tailored to younger
audiences and one designed for crowds over 50 years of age; PowerPoint
presentations to assist them in their national crusade to convince Americans
of the merits of the president’s plan; and links to dozens of
privatization-friendly websites to help embolden the party’s agenda. The
‘playbook,’ entitled A Guide to Social Security Reform, begins by
laying out the broad principles that President Bush has outlined as part of
his reform proposal:
The current system cannot afford to pay promised benefits to younger
Benefits will not change for those already retired or for those near
The President will not support any proposal that includes higher
Workers should have the option to save some payroll taxes in a
Personal accounts will give Americans the opportunity to share in the
benefits of economic growth by participating in markets through sound
Let us briefly examine each of these broad principles.
1. Why the President Says We Can’t Keep Our Promise
to Younger Workers
Anyone who has followed the debate over Social Security
reform has heard it said – It’s simply a matter of numbers. The numbers that
are of primary concern are the ‘cost rate’ and the ‘income rate’ which, on
balance, reflect the system’s ability to meet projected payment commitments.
Currently, the income rate exceeds the cost rate so that the Trust Fund
continues to add to its massive surplus. But, as Figure 1 shows, the cost
rate is projected to overtake the income rate in 2018 and to fall
significantly behind from about 2010 to 2030, as the baby-boom generation
reaches retirement age. Thereafter, the cost rate is projected to rise
steadily, though more slowly, reflecting the Trustees’ assumptions that
death rates decline and birth rates remain relatively low.
Source: The 2004 Annual
Report of the Board of Trustees
Thus, the argument is that as
income from payroll taxes begins to fall short of payment commitments in
2018, the system will need to begin drawing on the Trust Fund in order to
continue to pay full benefits to retirees. Unfortunately, as Figure 2
depicts, the surplus in the Trust Fund will not last forever, making it
impossible to continue paying full benefits once it is depleted. According
to the Trustee’s “best estimate,” the Trust Fund will have depleted its
entire surplus by 2042.
Source: The 2004 Annual
Report of the Board of Trustees
If nothing is done to reform the system, the Trustees
project that it will be possible to pay post-2042 retirees only about 73
percent of the benefits they have been promised. Put simply, we have a
numbers problem – too few dollars are projected to come in and too many
dollars are projected to go out. Consequently, the President tells us, the
government cannot “afford” to honor all of its commitments to future
retirees. The numbers simply don’t allow for it.
2. The Impact on Benefits for Retirees and
The President insists that the benefits of those who
are already drawing Social Security and those who are near retirement (i.e.
those 55 and older) are fully protected under his reform plan.
The system can meet its commitments to these cohorts, but it is not in a
position to pay promised benefits to our nation’s younger generation of
3. The Case against Raising the Payroll Tax
The Social Security payroll tax rate currently stands
at 12.4 % of taxable income, a burden that is shared equally among workers
and their employers (i.e. each contributes 6.2%). According to the Trustees
of the Social Security Administration, “[f]or the trust funds to remain
solvent throughout the 75-year projection period, the combined payroll tax
rate could be increased during the period in a manner equivalent to an
immediate and permanent increase of 1.89 percentage points” (Annual
Report of the Trustees, 2004, p. 3) This means that if workers and their
employers each contributed an additional 0.945%, the system could be made
solvent until at least 2080. This “fix” involves shifting the ‘income rate’
(Figure 1) upward so that it remains above the ‘cost rate’ over the entire
But the president is adamant about holding the line on
payroll taxes. He insists that he will not sign any legislation that calls
for higher taxes, arguing that such a change would jeopardize the recovery
by hurting workers and employers.
4. The ‘Option’ to Invest in Personal Accounts
Having ruled out a hike in the payroll tax as a way of
staving off benefit reductions to future retirees, the president insists
that the best way to protect America’s younger workers is through the
(partial) privatization of Social Security. “As we fix Social Security, we
also have the responsibility to make the system a better deal for younger
workers. And the best way to reach that goal is through voluntary personal
retirement accounts” (Bush, 2/2/05).
Although the White House has not released the full
details of the plan, the president has explained that his proposal would
allow workers under the age of 55 to divert up to 4 percent of their current
payroll tax contribution into their own retirement accounts.
Workers who decided to participate would then depend upon benefits from two
sources: (1) the (now lower) guaranteed benefit they continue to receive
from Social Security and (2) the market benefit that accrues in the form of
gains in their personal account.
Those who decide not to establish a personal account are told that they
“could stay entirely in the current system” and that their “benefits are
fully protected” (A Guide to Social Security Reform, Speech 1, p. 3).
5. The ‘Opportunity’ to Come Out Ahead
Under the President’s plan, workers are told that they
will come out ahead as long as their personal account earns a rate of return
that exceeds the rate of return on the Trust Funds:
The way that the election is
put before the individual in a
account structure of this type is that in return for
opportunity to get the benefits from the personal account,
foregoes a certain amount of benefits from the
Now, the way
that election is structured, the person comes out
their personal account exceeds a 3 percent real rate
which is the rate of return that the trust fund bonds
basically, the net effect on an individual’s benefits
would be zero
if his personal account earned a 3 percent real
return. To the extent that his personal account gets a
rate of return, his net benefit would increase as a
of making that decision . . . .
. . . the
specific trade-off that you’re making in opting for a
account is based on your decision that you think you
the 3 percent real rate of return (my emphasis; White
Administration Official, 2005).
But what about the risks? Investing in a personal
account means foregoing a portion of the benefits that otherwise would have
been received under the traditional system. In addressing these concerns,
Republicans have emphasized the prospects for higher returns and downplayed
the risks associated with market investment:
Personal accounts will provide
Americans who choose to
participate with an opportunity
to share in the benefits of
economic growth by
participating in markets through sound
proposal will include limitations on the risk
of investments permitted in
personal accounts … (A Guide
to Social Security Reform,
2005, p. 2).
Despite the existence of risk, Republicans insist that
it is still easy to see the benefits of personal accounts, maintaining that
“individuals opting for a personal account can expect to receive higher
benefits than those choosing not to have an account” (A Guide to Social
Security Reform, Appendix I, A.1). To make their case, they emphasize
the stock market’s long-run performance, citing a study that shows
that rates of return on stocks – over the last 200 years – were almost 7
percent a year, after correcting for inflation. Thus, their audiences are
told that while short-run fluctuations are inevitable, “investment experts
agree that in the long-term the trend is positive” (A Guide to Social
Security Reform, Speech #1, p. 11).
Thus, in stump speeches across the nation, Republicans
are asking a simple question: Do you want “your” money in a Trust Fund that
earns a 3 percent real return, or would you prefer to invest it in a
personal account that might yield nearly 7 percent after inflation? Using
these figures, they hope to persuade Americans that the answer is fairly
obvious. Personal accounts offer better prospects for growth and,
ultimately, a more comfortable retirement. This is especially true in the
case of younger workers, explains White House spokesman Trent Duffy, because
they can get in early and experience “the magic of compound interest”
(quoted in Vandehei, 2005).
Finally, personal accounts are said to enable average
Americans to participate in an “ownership society,” creating millions of
“worker-capitalists with a direct interest in sound economic policy” (A
Guide to Social Security Reform, Case Studies, p. 21). And, since
workers “own” their private accounts, the government is prevented from
spending their contributions. Moreover, any portion of the account that
isn’t used for retirement can be passed on to one’s heirs. It is a plan that
sounds almost too good to be true: ownership, higher anticipated returns,
protection from government, and something to bequeath to one’s survivors.
It Sounds Too Good To Be True …
While the president and his allies have emphasized the
potential gains that might accrue through investment and the magic of
compound interest, they have downplayed many of the less pleasant aspects of
moving toward a partially privatized system, including: cuts for those under
55 years of age, administrative fees that cut into total returns, the costs
of financing the transition, and the windfall that might accrue to financial
middlemen at the expense of those who choose private accounts. The purpose
of this section is to ask whether, in the face of these downside aspects,
personal accounts are a good choice for Americans.
The Real Story on Benefit Cuts: Bush’s Dirty Little
Anyone who has heard the president discuss Social
Security reform knows how important the images of “choice” and “freedom”
have been in the marketing of private accounts. The president has emphasized
time and again the voluntary nature of his plan, stressing that it gives
workers the freedom but not the obligation to choose a reduction in
guaranteed benefits. But, as two Treasury officials pointed out in a
memorandum to former Treasury Secretary Paul O’Neill, workers are likely to
suffer involuntary cuts as well:
Regarding “voluntary,” it is
clear that some players in the White
House had believed (and some
still do) that “voluntary” means
that people could, if they
chose, stay in the current Social Security
with no increase in payroll
taxes and no cuts in benefits. One problem
with that approach is that it
would leave Social Security on an
unsustainable course. The other
competing understanding of “voluntary”
involves a two-step approach
originally proposed by Glenn Hubbard.
The first step would involve a
benefit cut for everyone – i.e. regard-
less of participation in
personal accounts – in order to put Social
Security on a sustainable
[path] on its own. The second step – and
where voluntary becomes
relevant – would give people the choice
to receive an additional
benefit reduction in exchange for allowing
them to divert some of their
payroll taxes to personal accounts
(Smetters and Smith, 2001).
Thus, the plan would be truly “voluntary” only if the
White House chose not to address Social Security’s long-term financing gap
by imposing an across-the-board reduction in benefits. But this is not what
the president’s team is calling for.
The president’s Commission to Strengthen Social
Security has sketched out the most up-to-date and comprehensive description
of the (still nebulous) White House reforms. The framework, known as “Plan
2”, proposes two key changes to the current system: 1.) the introduction of
personal accounts and 2.) a change in the formula used to calculate
retirees’ benefits. While the merits (and demerits) of the former are
routinely examined, the implications of the latter are frequently
overlooked. Let us consider these implications.
Currently, Social Security benefits are calculated in
- The Social Security Administration (SSA) keeps
track of wage history and converts your past earnings into a single
number – your Average Indexed Monthly Earnings (AIME).
- A formula is used to convert your AIME into a
- If you decide to retire early, the monthly benefit
- Upon retirement, benefits are adjusted annually by
a Cost of Living Allowance (COLA)
The second step requires closer examination.
The formula used to convert AIME into a monthly benefit
90% of your first $629 of AIME, plus
32% of your next $3152 of AIME, plus
15% of AIME over $3,779.
The “bend points” – the $627, $3,152 and $3,779 – are
indexed each year to reflect growth in nominal wages so that when the
economy does well, retirees are permitted to share in the benefits economic
growth. And, since nominal wages tend to grow over time, the system promises
higher benefits to future generations of retirees than it pays to current
retirees. But the President and the members of his Commission contend that
Social Security cannot afford to pay these higher promised benefits, due to
the forecasted shortfall in payroll tax revenue. Figure 3 shows what current
retirees receive, what future retirees are promised and what the system can
afford to pay retirees, based on projected payroll tax receipts.
Source: A Guide to Social Security Reform
Benefits promised to an average wage earner who retires
in 2050 are a full 69% higher than the benefits that were paid to the
average retiree in 2004. Republicans argue that these increases are too
substantial and that the system promises a full $5,600 more than it can
afford to pay to retirees in 2050. To deal with this problem, “Plan 2”
calls a change in the way future benefits are calculated.
If the President succeeds in redefining the formula,
the “bend points” will be calculated using an inflation index instead of the
current wage index. At first glance, this might seem like a relatively
innocuous adjustment. After all, the historical trajectory for prices is
also upward, so benefits will still tend to increase over time. But prices
tend to rise more slowly than nominal wages – over the long run – so
benefits would increase less rapidly under inflation-indexing.
To see the full impact of switching to inflation
indexing, consider the benefits that would be due to a hypothetical 20
year-old worker who enters the labor force in 2005, earns the average wage
throughout her working life (roughly $36,500) and retires at age 65 in 2050.
Using Congressional Budget Office (CBO) projections, she would be scheduled
to receive benefits of roughly $22,000 (in today’s dollars). Thus, under
the current system, she would receive $459,800 in guaranteed benefits
over the course of her retired life (estimated at 20.9 years).
Now consider the impact of indexing to inflation rather
than nominal wage growth over this same period. During the relevant period,
the CBO projects that nominal wage growth will outpace inflation by 1.2
percent (i.e. real wages will grow at 1.2 percent). With the “bend points”
indexed to inflation beginning in 2009, this worker will lose 1.2 percent of
her scheduled benefit in each of the 39 years (2009 to 2047) included in her
benefit calculation, leaving her with only 62.8 percent of her scheduled
This amounts to a reduction of $8,184 in her scheduled benefit (0.628
× $22,000), which translates into a
$170,000 reduction over the course of her lifetime!
Baker and Rosnick (2005) estimate the impact of
inflation-indexing on other generations of workers. Figure 4 shows their
Baker and Rosnick (2005)
As Figure 4 reveals, inflation-indexing would sharply
reduce the level of defined benefits for all future retirees. Indexing to
inflation of, say, 2% instead of nominal wage growth of, say, 3.2%, means
that workers must forego the 1.2% real wage growth that previously increased
the “bend points” and raised their defined benefits. The longer a worker
must endure increases at the (lower) inflation rate, the more severe the
cuts will ultimately be. Thus, America’s youngest cohort of workers would be
most adversely affected by the President’s plan to introduce
If the President succeeds in changing the way defined
benefits are calculated, all workers will suffer a cut in future
benefits. On top of these cuts, “Plan 2” gives workers the option
to further reduce their defined benefit by diverting a
portion of their payroll taxes into a personal account – a choice that
seems to make sense for those who expect their personal account to earn
a rate of return that exceeds the rate of return earned on Treasury bonds
(held in the Trust Fund). But does it? Let us look more closely at the
implications of diverting withholdings into personal accounts. Chart 1 shows
the role of personal accounts in offsetting guaranteed benefit reductions.
When a worker agrees to establish a personal account he
is effectively asking the government to lend him part of his Social Security
tax so that he can invest it in the stock market.
The government would monitor these loans and investments by establishing
parallel accounts, a ‘notional account’ to keep track of the loan and a
‘personal account’ to keep track of the investment. Thus, diverted payroll
contributions would be double-counted, and each account would be credited,
over time, with interest – the notional account would accumulate interest at
the rate of return on Treasury bonds, and the personal account would
accumulate interest at the nominal portfolio rate of return, less annual
To make the argument concrete,
consider a highly simplified example. Suppose an individual’s notional account
would equal $100,000 at retirement. If this person’s life expectancy at
retirement is 20 years and the annuity draws zero interest and comes at zero
administrative costs (simplifying assumptions), the annuity on this account
would be $5,000. This sum – the “clawback” – would be deducted from the
defined benefit amount, to arrive at the “benefit after clawback”. If the
defined benefit (calculated using an inflation-index) would have otherwise been
$12,000 per year, it will now be $7,000. Now, if the poverty-level of income is
$16,000, this individual’s personal account will need to be sufficiently large
(well above $100,000) to allow an additional (lifetime) benefit of $9,000 per
year through annuitization.
As time goes on, the size of the clawback would grow,
relative to the benefit, because the clawback would be proportional to wages,
whereas the defined benefit would be fixed in real terms (i.e. indexed to
prices). This would make workers increasingly dependent on the annuitized value
of their personal accounts. Moreover, workers will have to pay a fee – to
financial firms – to annuitize their individual accounts, a cost that could
absorb as much as 10 to 20 percent of their savings (Baker and Rosnick, 2005).
With the size of the after-clawback benefit projected to
decrease over time, it is likely that the whole private account will
need to be annuitized. And, unless the stock market performs incredibly well,
there is a good chance that the annuitized value of the private account will be
insufficient to sustain many Americans in retirement.
The groups who are most vulnerable to this kind of
shortfall are women and minorities, who make up a disproportionate share of
America’s low-wage workers. This has been emphasized by Diana Zuckerman,
president of the National Research Center for Women and Families, who argues
that “[w]omen depend more on Social Security than men do, because women are less
likely to have their own private pensions when they retire” (2004). And, even
when they do have pensions, “their pension checks are, on average, half as large
as men’s are” (ibid.). Thus, our nation’s low-wage workers are particularly
vulnerable because they are less likely to have other forms of saving, pensions,
etc., to supplement Social Security in retirement.
Democrats are particularly worried about the impact of
privatization on low-income workers.
In their view, the president’s plan would shift a disproportionate share of risk
onto low-income workers, who may not survive through retirement if their
personal accounts lose money. Indeed, some Democrats have argued that these
groups would be better off under the current system, which can only pay 73% of
promised benefits, than they would be under a partially privatized system that
might result in much larger cuts.
In response, supporters of the Bush plan like to argue that
even pre-2042 benefits cannot be guaranteed since the government replaced
Social Security surpluses with government IOUs that are “all trust and no fund”
(Rich Tucker, Heritage Foundation).
Such assertions are designed to scare workers into believing that the government
has spent its hard-earned retirement money and replaced it with pieces of paper
that the government may not be able to redeem when the time comes:
The idea that the problem does not
start until 2042 depends on
sleight of hand. For several
decades, the program, in anticipation
of the retirement of Baby Boomers,
has collected more revenues
than it pays out. The surplus has
been banked in a Social Security
trust fund. The liberal argument is
that when payouts start to
outstrip revenues, in 2018, the
program can just draw on the trust
fund – and it can keep drawing on
it until 2042, when it is
scheduled to run
out. . . [But these folks] know perfectly well that
the trust fund is
a ledger-book entry, and will do nothing to save
having to raise taxes or cut benefits to meet the
promise of the
old-age retirement program (A Guide to Social
Reform, Articles, pp. 9 and 24).
It is true that the Trust Fund is a ledger-book entry but
it is inaccurate to suggest that the Trust Fund can play no role in funding
post-2018 benefits because it is full of empty promises. Against the asset known
as the Social Security Trust Fund sits a liability of the U.S. government – a
stockpile of non-marketable, interest-bearing government securities. The notion
that the government might have trouble redeeming these securities in 2018 – when
the revenue shortfall begins – is utter nonsense. The system endured cash
deficits when payroll taxes were insufficient to cover benefit payments in the
past, including the period from 1957 to 1964 and again from 1971 to 1983, and it
can do so again simply by retiring some of the Trust Fund bonds (Sawicky, 2005,
The government does not need outside buyers for these
bonds. Indeed the bonds are non-marketable, which means that the government
cannot look to private citizens, institutions or foreigners to purchase them.
Only the U.S. government can buy them back, and it will do so simply by reducing
both its liability – the non-marketable bond – and the balance in the Trust
It would, quite literally, take an act of Congress to prevent this from
And, as David Kaiser, Professor of Strategy and Policy at
the Naval War College, has emphasized, such an act would probably be
unconstitutional. As he points out, Section 4 of the 14th Amendment
to the US Constitution reads:
The validity of the public debt of the United
States, authorized by
law, including debts incurred for
payment of pensions and bounties
for services in suppressing
insurrection or rebellion, shall not be
questioned (2005, p. 1).
Thus, Kaiser suggests that “[i]f the Trust Fund should ever
have trouble collecting on its assets, the AARP, or some other citizens’
organization, should file suit under this provision to force the Supreme Court
to reaffirm the validity of the Federal Government’s obligation to the Trust
In sum, the president’s plan calls for both voluntary and
involuntary reductions in benefits. The former are incurred only by those who
choose personal accounts, but the latter are envisioned for all as
inflation-indexing replaces wage indexing in the calculation of defined
benefits. Americans must understand that if “Plan 2” succeeds, they will
suffer benefit cuts. Indeed, if the president’s plan succeeds, the guaranteed
benefits of every worker under age 55 will be lower in the future – and this is
true whether they opt for a personal account or not.
Transition Costs and the Explosion of Debt
The portion of current payroll taxes that gets diverted to
personal accounts won’t be available to pay current retirees. As a consequence,
the government recently announced that it would borrow huge sums in order to
help pay for adding personal accounts to Social Security.
These costs – estimates range between $1 and $2 trillion dollars – are
considered “transitional” because, as current retirees begin to die, costs
decline, disappearing altogether (along with beneficiaries) over the longer
Both those critical of and those supportive of the
president’s plan have raised concerns about the costs associated with
transforming the system to include personal accounts. Critics (mainly Democrats)
argue that the president's privatization scheme is fiscally irresponsible
because it adds hundreds of billions to the federal deficit and, ultimately,
trillions to the national debt.
Tom Davis R-VA offered a less hostile critique, suggesting that “[f]loating a
bond issue of a trillion dollars is not the message you want to send to the
markets right now” (Froomkin, 2004).
Finally, Alan Greenspan, who has been generally supportive of the president’s
plan to introduce private accounts, has admonished the White House, arguing that
increased spending to finance the transition to personal accounts may put the
federal budget “on an unsustainable path, in which large deficits result in
rising interest rates and ever-growing interest payments that augment deficits
in future years” (quoted in Hays, 2005).
Others have simply questioned the logic of selling bonds to
help facilitate the purchase of stocks, noting that when the government floats
bonds in order to finance the transition to a partially-privatized system, it
means that investors are exchanging stocks – those being sold to individuals who
will hold them as assets in their personal accounts – for newly-issued Treasury
debt. This begs the question: why would investors agree to add over $1 trillion
in long-term government debt to their portfolios if the stock market is expected
to outperform government bonds over the long haul? The implication, as Krugman
points out, is that “politicians are smart – they know that stocks are a much
better investment than bonds – while private investors are stupid, and will swap
their valuable stocks for much less valuable government bonds” (Krugman, NYT,
The Short-Run Bubble Effect and Longer-Term Prospects
for Stock Market Growth
While it is not difficult to envision stocks outperforming
bonds over the long-haul, it is quite conceivable that stocks will generate even
larger short-term gains, as tens of millions of Americans begin buying shares
for their personal accounts. The prospect of a sudden surge in the demand for
shares has raised concerns about the possibility of a short-term bubble in
stocks prices – a consequence of too many dollars chasing too few shares.
If privatization puts upward pressure on stock prices, those who already own
shares of large cap stocks and those who manage the transactions would reap
significant gains, while today’s youth would suffer lower rates of return, as
they buy into the market in the midst of a stock-price inflation. Thus, as
Kenneth Apfel, Social Security commissioner from 1997-2001 suggests, Bush’s
proposal calls for “a radical restructuring that’s not in the interests of the
young and old alike” (Apfel, 2005).
But the young need relatively high rates of return in order
to compensate for the cuts they would suffer under the president’s plan. And the
president insists that the stock market can deliver these rates, telling
Americans that “[p]ersonal accounts are a better deal,” because “your money will
grow, over time, at a greater rate than anything the current system can deliver”
(State of the Union Address, 2005). Specifically, the White House has projected
a 6.5 percent real return on private accounts. At this rate, private accounts
are projected to yield returns high enough to cover projected fees plus
inflation, thereby raising the income and consumption of future retirees.
But, as his critics point out, retirees may actually end up
with less if the stock market fails to perform the way the Administration
implies that it will. For example, Paul Krugman, a vocal opponent of Bush’s
plan, points out that equity serves only as a potential source of future
revenue. Equity is a claim on corporate income that provides gains when: (1) the
corporation pays cash dividends or initiates stock buybacks, or (2) rising stock
prices yield capital gains. Thus, Krugman notes that the Administration’s
projected 6.5 percent return is possible only if, in addition to the 3 percent
currently coming from dividends and buybacks, inflation-adjusted stock prices
increase by 3.5 percent. In the short run, Krugman admits that this is clearly
possible. But the Bush plan requires these high rates of return “for at least
the next 75 years” (Krugman, 2005, NYT). The problem, he points out, is that the
Trustees’ own assumptions about growth, inflation, etc. make this a highly
If, as the Trustees project, the economy slows from its
historic 75-year average growth rate of 3.4 percent to a rate of only 1.9
percent over the coming 75-year period, it will be virtually impossible for
shareholders to earn an inflation-adjusted 6.5 percent rate of return in the
stock market. With such low growth rates – and hence low profit growth
– cash dividends and stock buybacks will account for an increasingly small
portion of the total yield on stocks. This, of course, places an ever increasing
burden on the portion derived from capital gains. But this would require an
increase in stock prices that outstrips profits for the next several decades,
something that would push the average price-earnings (P/E) ratio to five times
its current level.
Thus, based on the Trustees’ predictions about the future course of U.S. growth,
Krugman argues that an after-tax annual rate of return on the order of 6.5 to 7
percent “is mathematically impossible” (ibid.). He is also quick to point out
the irony in this conclusion: “if the economy grows fast enough to generate a
rate of return that makes privatization work, it will also yield a bonanza of
payroll tax revenue that will keep the current system sound for generations to
Administrative Costs and the Windfall for Wall Street
Under the current system, less than one cent out of every
dollar paid into Social Security benefits goes to pay administrative costs. In
contrast, privately managed retirement accounts, like those in Chile and
England, “waste 15 cents of every dollar paid out in benefits on administrative
fees” (ibid.). Thus, critics maintain that the costs of administering more than
100 million small, private accounts “could dwarf Social Security’s
administrative overhead, which currently amounts to less than 1 percent” (Dreyfuss,
1996, p. 3).
The president insists that his plan would contain these
costs, estimating that only about 5 cents of every dollar paid out in benefits
would go to money managers. But even if the president succeeds in limiting the
fees that financial intermediaries can charge to administer personal accounts,
Wall Street stands to gain $940 billion or more (in present value terms),
according to University of Chicago business school professor Austan Goolsbee.
Goolsbee’s findings fueled criticism from Democratic Presidential Candidate John
F. Kerry, who claimed that the president was pushing privatization in a
quid-pro-quo move designed to benefit Wall Street donors who contributed
generously to his campaign – a claim that does not appear to be farfetched.
The serious push for privatization began over a decade ago,
with a coalition of conservative ideologues (neo-cons) and Wall Street money
managers, determined to dismantle Social Security and replace it with a system
of individual retirement accounts. Around this time, the Washington Post
predicted that “[b]y 2010, more than $4 trillion a year could be pumped into the
stock market from Social Security account plans, generating as much as $44
billion in annual fees for Wall Street under the personal security account
plans” (Fromson, 1997). State Street Bank & Trust, a little-known Boston firm,
which specializes in the management of smaller accounts, was one of the many
firms that wanted a piece of the action. It had its own privatization agenda,
but it also began to seed “other research groups with about $100,000 in grants –
including about $20,000 to the libertarian CATO Institute’s privatization
project” (IAF, 2001).
The mutual-fund industry, which was also poised to
capitalize on this opportunity, began “funneling millions of dollars in seed
money to think tanks, ‘grassroots’ organizations, and politicians friendly to
the ideas of privatization” (Dreyfuss, 1996).
To realize their goal of privatization, these investment
companies needed two things – politicians willing to promote their cause and the
capitulation of the American public. In the run-up to the 1996 Presidential
election, fund managers and heads of major investment banks began greasing the
palms of the Democratic and Republican nominees.
And, while neither candidate adopted privatization as part of his political
agenda in the mid-nineties, Wall Street brokers were not dissuaded.
In the run-up to the 2000 election, Charles Schwab, Dan
(Goldman Sachs) and Richard Gilder (a stockbroker) were busy “pouring money into
the presidential campaign of George W. Bush” (Silverstein, 2001, p. 1). And so
were scores of other brokers and money managers. In total, Wall Street shelled
out $10 million in campaign cash to the GOP (ibid.). By June 18, 2001, Treasury
Secretary Paul O’Neil was on board, throwing his shoulder into Wall Street’s
push for private accounts. At a luncheon high atop the World Trade Center, he
served as keynote speaker, helping participants such as Citigroup Inc., Deutsche
Bank AG and Morgan Stanley raise money for a $20 million campaign to support the
privatization of Social Security (IFA, 2001).
While Republicans insist that Wall Street does not stand to
reap extraordinary benefits from privatization, security brokers and investment
managers clearly see things differently, doling out staggering sums to
politicians, conservative think-tanks and grassroots privatization campaigns, in
the hopes that their dream of charging fees and commissions on nearly 100
million new accounts might one day be realized. And when the conservative
Wall Street Journal characterizes the privatization of Social Security as
potentially, “the biggest bonanza in the history of the mutual fund industry,”
you can be sure there is something to the claim (Dreyfuss, 1996a).
from Chile and the UK: (Big) Brother Can You Spare a Dime?
It is sometimes said that a fool learns from his mistakes,
while a wise man learns from the mistakes of others. In recent years, a number
of countries around the world have converted their government-sponsored
retirement programs into systems that rely, in whole or in part, on private
accounts. The purpose of this section is to examine some of the problems that
have emerged as a consequence of privatization. Because Chile and the United
Kingdom have had the most experience with privatization – each has had private
accounts in place for over a decade – they will be our focus.
The Chilean Experience
Bush’s proposal is modeled on a Chilean reform program put
in place almost 25 years ago under the authoritarian government of General
Augusto Pinochet. The Chilean experiment ended the multi-contributor insurance
program in which individuals, their employers and the government each made
financial contributions toward an employee pension. In its place, stands an
private system that requires
workers to devote 10 percent of their salaries to private investment accounts
which they control.
Twenty five years after its introduction, the first
generation of Chileans to depend on the new system is beginning to retire, and,
despite the relatively strong returns workers have earned on their investments,
many of them are finding it impossible to survive on the money accumulated in
their private accounts. The clear winners are the Chilean money managers, who
charge large commissions and hidden fees for their services. Many middle-class
workers, on the other hand, have found that these fees have eaten into as much
as a third of their original investment (Rohter, NYT). For example, Dagoberto
Saez, a 66-year old laboratory technician, who could have remained in the old
system, opted to participate in Columbia’s privatization scheme:
Colleagues and friends with the same pay grade
who stayed in the old
system, people who work right
alongside me are retiring with pensions
of almost $700 a month – good
until they die. I have a salary that allows
me to live with dignity, and all
of a sudden I am going to be plunged into
poverty, all because I made the
mistake of believing the promises they
made to us back in 1981 (Rohter,
His experience is not unique. Inelia Pardo Acevedo, a
64-year-old retired nurse is looking for a part-time job to supplement the $225
a month she draws under Chile’s privatized system. “They fooled me,” she said,
angered by the fact that her colleagues who stayed in the old system get “three
times as much, guaranteed for the rest of their lives” (Dickerson, 2005). Like
Acevedo, hundreds of thousands of Chile’s retirees and near-retirees are
discovering that they would have been better off under the old system.
Even Chile’s government officials have conceded that there
are serious problems with the new system. For example, Ricardo Scolari, the
Minister of Labor and Social Security, admits that “it is absolutely impossible
to think that a system of this nature is going to resolve the income needs of
Chileans when they reach old age” (quoted in Rohter, 2005). As a result, the
government routinely spends billions of dollars in supplemental aid, assisting
those whose incomes were not large enough to ensure some minimum security in
The British Experience
While Americans can learn from the problems that have
arisen in a developing country such as Chile, it may be more instructive for
them to draw lessons from a large developed country such as the United Kingdom.
It is also easier to draw comparisons with the British experience because the
U.K. introduced voluntary “personal pensions” as part of a partial
privatization scheme. Additionally, the British government switched benefit
indexing from the higher of inflation or wage growth to inflation only.
Thus, the British framework more closely resembles the model the U.S. government
is trying to put in place at home.
The British retirement system has two tiers: a first tier
and a second tier. Under both tiers, benefits go to men at age 65 and to women
at age 60. The first tier provides mandatory flat-rate weekly benefits (paid by
the government) which are independent of earnings. This level of benefits
was put in place in 1908 to ensure minimum (i.e. poverty level) benefits to
retirees. The second tier, introduced in 1961, provides earnings-related
benefits from either public or private pensions.
The introduction of this second tier marked the first phase
of privatization, because it gave employers the option not to participate in the
public portion of the second tier and, instead, establish a private
second tier known as an “occupational pension”.
In 1978, the British government introduced the State Earnings-Related Pension
Scheme (SERPS), which improved the second-tier public pension by
replacing a higher percentage of contributed earnings. Thus, upon retirement,
British workers would either receive (1) a small, first tier pension plus a
second-tier pension through SERPS or (2) a small, first-tier pension plus an
employer-sponsored occupational pension. Under either scenario, workers were
protected under a defined benefit plan.
The second phase of privatization came in 1988, when the
government allowed workers to voluntarily opt out of either the public SERPS or
the employer-sponsored occupational pension and set up tax-deferred, individual
Those who chose to opt out of the second-tier coverage would draw only their
small, first-tier pension plus whatever their personal accounts could provide
Thus, the U.K. system currently resembles the model envisioned by President
Bush, where workers would continue to draw a portion of their benefits from
Social Security but would rely more heavily on the annuitized value of their
If we were to measure the success of the British reform
simply in terms of worker participation, we would have to conclude that the
second phase of privatization was a great success.
Roughly 3.1 million people opted out of the SERPS during the first year. And, by
the end of the fifth year, another 2.3 million people had joined them in
establishing “personal pensions” (Department of Social Security, 1998, Table
26.0). But, of course, success is not so easily judged.
With the passage of time, workers have discovered many of
the system’s flaws. First of all, they have come to realize the detrimental
effects of inflation-indexing.
Since inflation typically increases about one-and-one-half to two percent
more slowly than wages, workers who remain in the second tier can
expect benefits that are forty to fifty percent lower than they otherwise
would have been. Worse, opting out of the second tier hasn’t proven to be much
of a safeguard.
Scandals and fraud have plagued Britain’s money managers,
delivering a black eye to the very idea of privatized public pensions. In
exchange for their services, financial middlemen often gouged workers, charging
“not only an initial fee (including a percentage commission and a lump sum), but
also an annual fee on invested funds and a monthly flat fee that is generally
indexed according to price or wage increases” (Liu, 1999, p. 36). In some cases,
these charges were more than 20 percent of contributions. For an estimated 30 to
40 percent of account holders, fees and commissions are so high that workers
never earn enough to recover their principal (ibid.).
To reap these fees and commissions, money managers
aggressively marketed their services, indiscriminately recommending personal
pensions to every generation of workers. In 1992 a random sample of accounts was
audited by the Securities and Investment Board. The audit, which was performed
against the objections of the insurance industry, revealed that “a staggering
percentage of pensions had been sold to those who would be worse off in
retirement as a result” (Cohen, 2005, 3).
The findings resulted in a scandal that generated enough of a public outcry that
the government was forced to act. In the end, some 1.7 million people “sought
and received compensation that ultimately cost the insurance industry £12
billion. In addition, hundreds of millions were paid out in fines and penalties.
It was the biggest financial scandal in the United Kingdom to date” (ibid.).
Nearly half of British retirees now qualify for additional
benefits under a separate welfare program for the elderly. To avoid this fate,
more than 500,000 people decided to opt back into the state plan
in 2002-03, and another 500,000 joined them in 2004.
Another 250,000 are expected to opt back in this year, a trend that is expected
to continue into the future. There is a lesson here for Americans. As Robin
Ellison, Chairman-elect of the National Association of Pension Funds in the U.K.
recently noted, “[i]t is curious that as we’re moving towards one system, the
United States appears to be thinking and moving to the system we’re moving away
from” (National Public Radio, Record Number: 200502171004). Perhaps failing to
learn from the mistakes of others will make us the greatest fool of all.
As Americans, we used to be entitled to certain things –
government-sponsored health insurance, education, and various forms of welfare
protection. Increasingly, the government is telling us that we are entitled to
nothing. Current and previous Administrations have weakened welfare,
unemployment and after-school programs and pushed school vouchers, medical
savings plans and private Social Security accounts. And, so far, there has been
little resistance to many of these reforms. In particular, younger Americans
seem unafraid to “go it alone,” perhaps reflecting a shift in their attitudes
toward dependency, work and worthiness.
But before America’s youth throw their support behind the
president’s plan, convinced of their ability to provide for themselves in their
retirement, they should remind themselves that, they, like their forefathers
have done the work, paid into the system and earned the right to receive the
benefits they have been promised. And they should recognize that some of their
security has already been sacrificed, as scores of our nation’s employers
continue to replace guaranteed pensions with 401(k) plans. Acquiescing to the
president’s plan would simply remove another leg of the stool, reducing their
guaranteed benefits and placing their future security in the hands of
indifferent market forces.
Social security is a social insurance system, designed to
guarantee a minimum income to our nation’s elderly in retirement. It was never
intended to help Americans build financial wealth or create “worker
capitalists.” Before they allow the prospects of large financial returns to
persuade them to support a plan that may significantly undermine their future
well-being, America’s youth should remember that “more than half of seniors
receive a majority of their retirement income from Social Security” (Tanner,
2004, 1). If this trend persists, odds are, today’s worker will eventually
depend heavily on the benefits paid by Social Security. And, if the British
experience has taught us anything, it is that the costs and risks associated
with private accounts far outweigh the value of the returns they are likely to
But the current debate should be about more than narrow
self-interest. It should about the kind of society we want to have. Are we
willing to ensure the security of America’s elderly and disabled or are we
content to place their fate in the hands of capricious markets? Will we sit idly
by as more and more Americans slide into poverty or will we be forced to act
when future retirees find it impossible to survive on the annuitized value of
their personal accounts plus their reduced benefit payments? In an ideal world
the answers would be obvious – Americans would reassert their commitment to our
nation’s largest and most successful entitlement program and just say ‘no’ to
the president’s plan.
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Obviously, not every member of the Republican Party supports the
president’s agenda to act swiftly to privatize part of Social Security,
just as Democrats are not entirely united in their opposition. On the
Republican side, Bill Thomas, Chairman of the House Ways and Means
Committee, described the president’s proposal to reform Social Security
as a “dead horse”, implying that it would never survive a Congressional
President Bush likes to call it an $11 trillion shortfall, which he
arrives at by rounding (up) the $10.4 trillion shortfall the Trustees
project over an infinite time horizon.
How, exactly, we ought to go about preserving the system is the subject
of a forthcoming paper.
In 2002, more than 60 million Americans between the ages of 25 and 64
reported incomes of less than $25,000. And, according to government
statistics and polling results, many of them are already worried about
how they will survive their retired years. This is not surprising, since
many low income workers are unable to build up sufficient savings during
their working years and tend to have small or no pensions when they
The president has made the same kind of argument, arguing that moving
toward private accounts has the added benefit of “replacing the empty
promises of government with the real assets of ownership” (Bush,
And the administrative costs don’t end at retirement. Workers who live
long enough to reach retirement will be required to purchase an annuity
– monthly payment that ceases only upon death. But financial firms
typically take another substantial bite out of workers, charging
anywhere from 10 to 20 percent of accrued savings to set up the annuity
(Baker and Rosnick, 2004).
Merrill Lynch gave a reported $472,930 in political donations in 1996,
including $27,150 to Bill Clinton and $36,300 to Bob Dole, while
Fidelity Investments and T. Rowe Price began to openly call for Social
Security reform (Dreyfuss, 1996).
Unlike the large brokerage houses that manage their accounts, workers
can lose big when the market swings against them; the profits of the
financial middlemen tend to be more buoyant, rising even when the market
turns bearish. This happened in Chile in 1995, when a lull in the stock
market caused workers to lose 4 percent of their investments. At the
same time, the firms that managed their accounts earned profits of more
than 20 percent (Dreyfuss, 1996).