The Benefits and Hazards of Privatizing Social Security

Patricia S. Pollard

Recently, there has been increasing talk about privatizing the U.S. retirement system—Social Security. Privatization would entail the elimination of Social Security taxes; instead, workers would be required to allocate a fraction of their wages to retirement funds-typically mutual funds. Upon retirement, workers could convert these funds into annuities.

Social Security operates essentially as a pay-as-you-go (PAYG) system. The taxes paid by each generation of workers fund the retirement benefits of the previous generation of workers. While each generation of workers has been confident that its retirement would be financed by the next, this confidence is eroding. Increases in life expectancy and declines in fertility are resulting in a rise in the number of retirees supported by each worker. At the same time, benefits have been rising faster than real wages, further increasing the cost per worker of maintaining the current system. Because of these demographic and economic trends, by 2029 Social Security tax receipts are expected to cover only 75 percent of benefits. And this shortfall will grow.

Privatization would eliminate the PAYG nature of the system. Each worker's contribution would be invested in assets to finance his or her own retirement. Thus, an individual's retirement is fully funded upon retirement rather than depending on contributions from the next generation of workers.

Such a system provides advantages for retirees and the economy. While the current Social Security system has provided a high rate of return on the contributions of previous generations of workers, this rate of return is declining precipitously because of the factors cited above. Allowing individuals to invest their contributions in financial assets raises their potential return. Secondly, Social Security contributions are not savings but simply an intergenerational transfer. A fully funded system should increase savings and thus investment in the economy, resulting in higher economic growth and, therefore, a higher standard of living for all.

If privatization can provide higher rates or return and higher standards of living, why then haven't we eliminated the old system and moved to the new one? Because privatization is not without pitfalls. The most difficult problem is how to handle the transition from a PAYG to a fully funded system. Whereas young workers and future generations should benefit from a fully funded system, many current retirees and those nearing retirement could be left destitute if the current system was abolished.

Clearly, eliminating the benefits to current retirees is not an option. However, requiring the current workers to continue financing these benefits while saving for their own retirement is also not a desirable option. One possibility is to gradually increase the portion of a worker's salary that must be invested in a retirement plan while gradually reducing the Social Security taxes workers pay. This would increase the time before a fully funded system would become operational, but would also reduce the transition costs which any one generation would bear.

Another obstacle to replacing the current system with a private system is that the investment risk individuals must bear is higher under the latter. Because of a poor investment strategy or a prolonged downturn in financial markets, an individual may approach retirement age with less savings than expected. A way to overcome this problem is to maintain a portion of Social Security taxes to provide a minimum income guarantee of some insurance against market risk in addition to providing a boost to the retirement income for low-wage workers.

Developing a retirement system that combines aspects of public (PAYG) and private (fully funded) systems should promote economic growth while maintaining a safety net for retirees.

This article is based upon the Federal Reserve Bank of St. Louis' 1996 Annual Report titled: Will Social Security Be Here for Future Generations? The report is available on the Internet at www.stlouisfed.org. You may request a hard copy by calling Debbie Dawe at (314) 444-8809.

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