Privatizing Social Security: Who Wins?

— Nomi Prins

OVER THE YEARS, there have been numerous attempts and proposals to privatize the social security system.  It was a key Republican platform item in the 2000 election.  The idea was subsequently thwarted by the small matter of the stock market bust that wiped out $8 trillion of market value, and caused a 60% drop in the NASDAQ over the first two years of Bush's first term.

Once the market appeared healthier and Bush had another election under his belt, however, privatization got put back on the table.  The main underlying argument posed by the administration is that individual retirement money would be better off invested outside the system.

This reasoning is meant to appeal not to the future economic well-being of retirees, but to the new sense of "individualism" or the "ownership society" as promulgated by Bush.  As he gushed so eloquently at the Republican National Convention, "In all these proposals, we seek to provide not just a government program, but a path, a path to greater opportunity, more freedom and more control over your own life."  Gee, thanks George.

This is doubly ironic coming from an administration that has consistently increased the number of governmental agencies and indiscriminately paid for its favorite policies by borrowing from the future in deficit and debt terms.

The debt cap that stood at $2.4 trillion when Bush took office has been raised repeatedly, culminating in the most recent increase on November 18th, which took it to $8.2 trillion.  The annual budget zoomed from a $127 billion surplus when Bush took office, to the current $413 billion deficit.

It's not just individuals who would suffer economic uncertainty if social security were partially privatized—it's the entire U.S. budget.  The transition cost alone has been estimated between $1-$2 trillion.  Yet the administration is spinning the idea that any American individual with an Internet connection and an eager (and supposedly objective) financial advisor could do better on his or her own then either the social security system or the government.

But not even the agencies already designed to handle pension funds, like the Pension Benefit Guaranty Corporation (PBGC), are managing to stay firmly afloat.  The PBGC, created in 1974 to insure employee pensions and funded by corporate premiums, posted a $23.3 billion deficit for 2004.  Although PBGC still has cash reserves of $39 billion, it owes its current retirees $62.3 billion for the life of their plans—that's if no other firms go under.

Unfortunately, the PBGC doesn't have the legal means to protect itself from growing pay-outs resulting from mounting corporate frauds and bankruptcies.  Only Congress has that ability and Congress isn't budging.  This doesn't bode well for how it would act to secure individual retirement funds in the future.

Aside from individualism, there are well-placed, constantly churned fears about future depletion of the system.  Fear, of course, is something this administration is so adept at evoking.

Currently, the social security tax per each employee is 6.2% (up to $87,900).  In addition, another 6.2% is paid into the system by all employers, thus every dollar in earnings up to $87,900 is taxed 12.4% (half paid by employer, half taken out of the employee's paycheck).(See note 1)

Under Plan I of the Commission to Strengthen Social Security (CSSS), 2% of employee's taxable wages, or one-sixth of the current incoming amount, could be privatized.  Plan II allows 4% of employee wages up to $1,000 to go into a private account.  Plan III states 2.5% would be eligible, up to $1,000, if they contribute an additional 1% of taxable earnings.(See note 2)

Financing the Deficit

Lost in the debate is the fact that the system is actually operating at a surplus.  Thus we aren't in quite the crisis that the administration would have us believe.  In fact, Bush is so unbothered by the current state of social security affairs that on December 10 he unequivocally denounced the idea of raising payroll taxes to save money for any future problems.

According to the 2004 OASDI Trustee Report, the total amount coming in is $632 billion and being paid out is $479 billion, representing a surplus of $153 billion.(See note 3)  A little over half of that surplus represents interest payments the system is supposed to receive from social security bonds. 

But that interest is not being paid back into the system.  According to Ellen Frank, author of The Raw Deal, "The problem is that if you took away a significant portion of what's going into the system right now by pushing it into private (accounts), there wouldn't be any remaining surplus or cushion."

When President Franklin Delano Roosevelt originally signed the Social Security Act of 1935, as part of the New Deal, the tax rate was 2%.  The Mission Statement of Act said its purpose was "to promote the economic security of the nation's people through compassionate and vigilant leadership in shaping and managing America's social security programs."(See note 4)

Over the next 65 years it was increased a total of 10.4% to help keep that socially responsible promise.(See note 5)  That included a chunky hike in 1983.  At the time, the Greenspan Commission, under Reagan, raised the social security tax from 8.05% to 12.4% to ostensibly save for baby boom retirement.  However, the related savings was overshadowed by government spending and a growing deficit.

The form in which social security saved this money was through the issuance of bonds which represented the magnitude of the government's debt to the social security trust fund.  Like any other collected tax money, these flowed into the general accounts of the U.S. Treasury Department, which in turn credited the social security trst fund by the additional amount.  This left them free to use the actual cash elsewhere.

The same Alan Greenspan is leading the warning chatter about the social security system running too much debt, which is really an outcome of his 1980s proposed savings.  In other words, the surplus of the social security trust fund was converted, by virtue of being accounted for in the same place, into a debt to the U.S. Treasury.  Now he's pointing fingers to the more convenient debt that supports his cut-the-social-security-program policies.

In order to come up with the money borrowed at the time, it would have to be extracted from general revenues, in other words from taxes, more borrowing, raising the retirement age or cutting future benefits and cost-of-living increases.

The cost of restructuring the program reflects the losses that would be incurred by deflecting payroll taxes outside the system.  The result would be an immediate rather than a future claim on the social security fund, which would grow rapidly as more people will be retiring.

According to Troy Daum, investment planner at Wealth Analytics, a wealth management and retirement planning firm, "Borrowing money is the simple solution for the government, but it mortgages our kids' future.  The only other option would be to raise taxes."

Who Takes the Hit?

The impact of changing the system would vary according to age group.  The first group is people already retired.  Despite assurances to the contrary, they would likely see some benefits cut because the system would face an immediate shortfall as fresh money diverted to external accounts.  Even if the cuts were in the form of smaller cost-of-living increases, they'd be felt.

The second group is comprised of those nearing retirement, between the ages 50 and 65.  These pre-retirees would suffer the most.  Many have already been hit with huge 401K losses and diminished health benefits.  They simply don't have enough time to save for a major drop in future expected payments.

The third group, people in their 20s and 30s, are being heavily targeted by the administration and the business media with the heady concept of "financial individualism."  The argument is that private account money could be managed in a way that exceeds the value expected to be received from social security.  As Bush said, "We must strengthen Social Security by allowing younger workers to save some of their taxes in a personal account, a nest egg you can call your own and government can never take away."

And therein lies on of the biggest falsehoods in the debate over privatizing social security; the idea that somehow an individual will be able to get a greater return than the government could provide.  The reality is that the fees alone involved in churning millions of tiny accounts would be individually higher than anything the government could capture more efficiently in bulk.  Nor do either the stock or bond markets offer any downside guarantees.  And we've certainly witnessed from Enron, WorldCom and other major debacles that brokers employed by large banks that fund those same corporations, have no problem giving out bad advice.  Not only are average historical stock returns very volatile, but none of the current proposals insures individuals when things go south.  There would be no contingency system if retirement money ran out due to fraud, no recourse for those who received misleading financial advice that destroys their nest eggs.

The Winners!

Additionally, none of the proposals include maintaining the disability and survivor benefits that the current social security system offers.  Under a privatized system, this insurance would need to be obtained separately, likely at a greater cost, translated to profit for eager insurance companies.

Meanwhile, other financial service companies remain on stand-by to benefit from both the management and the administrative set-up cost of new retirement funds.  So, the real winners are firms in the financial services industry that have short term profit, not long term retiree well-being at heart.

"Wall Street is banking on future dollars to invest," says Daum.  "But you need to take Wall Street out of the equation."

Yet it's rather unlikely that super-banks and mutual fund companies will back off from this golden opportunity.  This is particularly true since commercial bank conglomerates like Citigroup and JPM Chase-Bank One, which house individual checking and savings accounts, will probably find ways to link them to new private retirement accounts.

All of this will be made to sound like a good deal for customers.  According to Austan Goolsbee, Professor at The University of Chicago Business School, the banking community would reap a $940 billion windfall in fees and other administrative charges for managing private accounts.(See note 6)

Just the costs of setting up the accounts would be equivalent to six months of increasing the retirement age. For the average worker, these fees would equate to wiping out 20 percent of their retirement value—and that's at fairly conservative estimates.

Warns Goolsbee, "In order to lower these expenses, you'd have to severely limit the scope of investment choices."  Unfortunately, this kind of limitation flies directly opposite the administration's pitch about individual freedoms.  "Still," says Goolsbee, "any privatized system should include appropriate cost controls."  That would also not be a likely scenario given our bank-friendly Capitol Hill.

Other countries, like the United Kingdom, discovered egregious fees being levied on individual retirement accounts after implementing privatized systems without controls.  Costs shot so high that caps to fees had to be implemented.  This however, would also not jive with the modus operandi of today's Congress and regulatory bodies.  In the end, privatizing the system, partially or otherwise, is hazardous for individuals and likely to increase debt for the government.  Thus, it's really not a financially sound idea for either.  The fact that it would offer a new pot of money to Wall Street, which could be invested in riskier assets at more lucrative fees, is not a reason to make the switch.  But it's a very good reason to keep fighting it.

NOTES

  1. Social Security Online, Trust Fund Data: Social Security & Medicare Tax Rates.
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  2. "The Final Report of the President's Commission to Strengthen Social Security", Report of the President's Commission, December 2001.  Available at http://www.csss.gov/reports/Final_report.pdf
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  3. 2004 OASDI Trustee Report.  Available at http://www.ssa.gov/OACT/TR/TR04/index.html
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  4. Social Security Mission Statement, Social Security Online.
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  5. Social Security Online, Trust Fund Data: Social Security & Medicare Tax Rates.
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  6. Austan Goolsbee, "The Fees of Private Accounts and the Impact of Social Security Privatization on Financial Managers", University of Chicago Business School Study, September 2004.
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ATC 114, January-February 2005