Making Transition to Privatized Social Security

By Mike Tanner

Social security is in serious financial trouble. Only by privatizing the system can we avoid the huge tax hikes and benefit cuts required to keep the system solvent — tax hikes and benefit cuts that will worsen an already bad deal for today’s young workers.

However, any proposal for privatizing Social Security must deal with the difficult question of financing the transition to a new privatized system.

Put quite simply, regardless of what system we choose for the future, we have a moral obligation to continue benefits to today’s recipients. But if current workers divert their payroll taxes to a private system, those monies will no longer be available to pay current benefits; the government will have to find a new source of funds. The Congressional Research Service estimates that cost at nearly $7 trillion over the next 75 years.

While this may be an intimidating figure, much of it reflects an already existing unfunded obligation.

As we discussed in earlier commentaries, the federal government already cannot fund as much as $4.9 trillion of Social Security’s promised benefits. Those who claim we cannot afford to finance the transition to a private system have yet to explain how they will fund benefits for our children.

Even so, proponents of privatization have an obligation to explain how they would fund the transition.

The reality will probably involve some combination of four approaches.

The first is a partial default.

Any change in future benefits amounts to a default. That could range from such mild options as raising the retirement age, reducing COLAs, or means testing benefits to “writing off” obligations to individuals under a certain age who opt into the private system.

For example, any individual under the age of 30 who chooses the private system might receive no credit for past contributions to Social Security.

Because the investment returns from a privatized system will be so much greater, these young people will still receive higher retirement benefits, even if they receive nothing from Social Security.

The second method of financing the transition is to continue a small portion of the current payroll tax. For example, rather than privatize the entire OASI portion of the payroll tax, workers would be allowed to personally invest 6 or 8 percentage points, with the remainder temporarily continuing to fund a portion of current benefits.

David Altig, chief economist with the Federal Reserve Bank of Cleveland, estimates that if individuals under the age of 45 were allowed to privately invest just 6 percentage points of their Social Security tax, everyone would receive retirement benefits as high or higher than those currently promised under Social Security. That would leave the other 6.4 percentage points to finance the transition, with that tax being phased out over 30 years. Once current beneficiaries are paid off, the payroll tax (transformed into a mandatory savings requirement) would be reduced to 6 percent.

Third, Congress can identify additional spending cuts and use the savings to pay for the transition cost.

Steve Entin, an economist with the Institute for Research on the Economics of Taxation (IRET), estimates that fully funding the transition would require slowing the rate of growth in federal spending by an additional one half percent beyond currently envisioned cuts, eventually reaching a reduction of $60 billion-$70 billion per year.

The final proposal often suggested for funding the transition is for the government to issue bonds to current system participants and taxpayers.

The present value of the actuarially determined annuity due each system participant may be easily calculated and each system participant may be issued zero-coupon T-Bonds maturing at the participant’s projected retirement date.

The bonds would be placed in each individual’s Personal Security Account. However, while this approach has the virtue of making explicit the government’s long-term obligations, it is really just an accounting gimmick. Ultimately, the government will still have to find the funds to make good on the bonds.

The important thing to recognize is that, while not painless, the transition to a privatized Social Security system can be managed.

The transition challenges should not be allowed to stand in the way of a secure retirement for today’s young workers.

In conclusion, Social Security is in trouble. By 2012, the system will be running a deficit and by 2029 it will be completely insolvent. At the same time, payroll taxes are already so high that today’s young workers will receive back less money than they pay into the system.

There is, however, no reason to panic. There is time to make the reforms necessary to ensure that both today’s and tomorrow’s elderly will be able to retire with dignity.

We can follow the successful example of Chile and privatize our Social Security system.

The crisis is coming. The question is: do our political leaders have the courage to ensure that tomorrow’s retirees have a secure retirement.

Mike Tanner is director of health and welfare studies with the Cato Institute in Washington, D.C. 

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