• Introduction
• Reason #1: Today's insurance to protect workers and their families against death and disability would be threatened.
  
• Reason #2: Creating private accounts would make Social Security's financing problem worse, not better.
  
• Reason #3: Creating private accounts could dampen economic growth, which would further weaken Social Security's future finances.
  
• Reason #4: Privatization has been a disappointment elsewhere.
  
• Reason #5: The odds are against individuals investing successfully.
  
• Reason #6: What you get will depend on whether you retire when the market is up or down.
  
• Reason #7: Wall Street would reap windfalls from your taxes.
  
• Reason #8: Private accounts would require a new government bureaucracy.
  
• Reason #9: Young people would be worse off.
  
• Reason # 10: Women stand to lose the most.
  
• Reason #11: African Americans and Latin Americans also would become more vulnerable under privatization.
  
• Reason #12: Retirees will not be protected against inflation.
• Notes
  

REASON #1: Today's insurance to protect workers and their families against death and disability would be threatened.

"Rate of return" calculations neglect the value of Social Security's insurance protections. Of the 45 million Americans who collect payments from the Social Security program, over one-third (almost 17 million) are not retired workers. Among those currently receiving Social Security payments are 5 million spouses and children of retired and disabled workers, 7 million spouses and dependent children of deceased workers, and 5 million disabled workers. Proposals to privatize Social Security involve shifting some of the money financing the current insurance program into investment accounts assigned to each worker. But the payroll taxes carved out to pay for personal accounts are resources that are need to support today's payments to recipients of Social Security's survivors and disability insurance as well as retirement benefits. Simple arithmetic suggests that every dollar shifted from Social Security programs to personal accounts is a dollar less to provide guaranteed income to the 37 percent of beneficiaries who are not retired workers.

The three alternatives put forward by the President's Commission to Strengthen Social Security would, in the absence of individual accounts, restore long-term Social Security solvency either largely or entirely through benefit reductions that would apply to all beneficiaries-including the disabled. In the principal proposals put forward by the Commission, the reduction in disability benefits was draconian, with cuts ranging from 19 percent to 47.5 percent after the year 2030. The commission itself somewhat disavowed this aspect of its proposals, suggesting that a subsequent commission or other body that specializes in disability policy might revise how its plans apply to the disabled.

Economists Peter A. Diamond (MIT) and Peter R. Orszag (Brookings) have noted that the disabled would have limited ability to mitigate the effects of these benefit reductions by securing income from individual accounts. One reason is that their individual accounts often would be meager, since those who become disabled before retirement age may have relatively few years of work during which they could make contributions to their accounts. Second, under the commission proposals, disabled beneficiaries (like all other beneficiaries) would not be allowed access to their individual accounts until they reached retirement age.

As the Bush commission itself acknowledged, preserving existing disability and survivor's insurance greatly escalates the cost of financing private accounts. It is difficult to imagine how any Social Security privatization plan can avoid significant cuts in those essential protections.

REASON #2: Creating private accounts would make Social Security's financing problem worse, not better.

Social Security is funded by a flat tax of 12.4 percent of each worker's wage income, up to $90,000 in 2005, split evenly between employers and employees. About four out of five of those tax dollars go immediately to current beneficiaries, and the remaining dollar is used to purchase U.S. Treasury securities held in the system's trust funds. Beginning in 2018, well after the huge generation of baby boomers born between 1946 and 1964 begins to retire, a portion of general income tax revenues will be needed to pay interest and eventually principal on those bonds to fully finance benefits. A "crisis" is not forecast to arise until the program becomes entirely "pay as you go" again (as it was throughout its history before 1983) in either 2042 according to the trustees' forecast or 2052 according to the Congressional Budget Office. (By way of perspective, in 2052 the oldest surviving baby boomers will be 106 years old and the youngest will be 88.)

Diverting 2 percent of payroll to create private accounts as proposed by the President's Commission to Strengthen Social Security doesn't sound very radical, but it would shorten significantly the time until current benefit levels could only be sustained by raising taxes. In part, this is because funds now being set aside to build up the trust funds to provide for retiring baby boomers would be used instead to pay for the privatization accounts. The government would have to start borrowing from the private sector almost immediately to be able to meet commitments to retirees and near-retirees. As the figure below shows, the trust funds would be exhausted before 2030 instead of the thirty-eight to forty-eight years projected if nothing is done. In such a short time frame, the investments in the personal accounts will not be nearly large enough to provide an adequate cushion. The upshot: a much larger share of today's workers would confront large benefit cuts, or tax increases, than if no changes were implemented.

Click to view Figure 1: Effect of a 2 Percent Carve Out on Trust Fund Assets to 2030

Source: Based on analysis in Peter A. Diamond and Peter R. Orszag, "An Assessment of the Proposals of the President's Commission to Strengthen Social Security," The Brookings Institution, Washington, D.C., June 2002.

REASON #3: Creating private accounts could dampen economic growth, which would further weaken Social Security's future finances.

Privatizing Social Security will escalate federal deficits and debt significantly while increasing the likelihood that national savings will decline-all of which could reduce long-term economic growth and the size of the economic pie available to pay for the retirement of the baby boom generation. The 2004 Economic Report of the President included an analysis of the fiscal impact over time of the most commonly discussed privatization proposal by the president's commission. It found that the federal budget deficit would be more than 1 percent of gross domestic product (GDP) higher every year for roughly two decades, with the highest increase being 1.6 percent of GDP in 2022. The national debt levels would be increased by an amount equal to 23.6 percent of GDP in 2036. That means that, thirty-two years from now, the debt burden for every man, woman, and child would be $132,000 higher because of privatization.

One impact of those seemingly abstract numbers after privatization is that interest rates are likely to be substantially higher, raising the cost to the average household of mortgages, car loans, student loans, credit cards and so on. As a result, the economy would be likely to grow more slowly than it would otherwise.

Creating private accounts with increased federal borrowing at first blush would seem unlikely to affect national savings, because additional savings in the new accounts would offset exactly any new government borrowing to pay for those accounts. Economists believe that increased national savings, especially in a country with savings levels as low as they are in the United States, can increase growth by keeping interest rates low and financing investments in productive activities.

But privatization is actually more likely to reduce than increase national savings. Diamond and Orszag point out that evaluating the overall effect on national savings requires taking into account the likely responses of government, employers, and households. Historically, neither the government nor businesses have changed their spending levels consistently in response to large changes in deficit levels. But households that consider the new accounts to constitute meaningful increases in their retirement wealth might well reduce their other saving. Diamond and Orszag argue, "If anything, our impression is that diverting a portion of the current Social Security surplus into individual accounts could reduce national saving." That, in turn, would further weaken economic growth and our capacity to pay for the retirement of the baby boomers.

REASON #4: Privatization has been a disappointment elsewhere.

Advocates of privatization often cite other countries such as Chile and the United Kingdom, where the governments pushed workers into personal investment accounts to reduce the long-term obligations of their Social Security systems, as models for the United States to emulate. But the sobering experiences in those countries actually provide strong arguments against privatization.

A report this year from the World Bank, once an enthusiastic privatization proponent, expressed disappointment that in Chile, and in most other Latin American countries that followed in its footsteps, "more than half of all workers [are excluded] from even a semblance of a safety net during their old age."

Other cautionary points made in the World Bank report and other studies about the experience in Chile:

• Investment accounts of retirees are much smaller than originally predicted-so low that 41 percent of those eligible to collect pensions continue to work.
  
• Voracious commissions and other administrative costs have swallowed up large shares of those accounts. The brokerage firm CB Capitales calculated (see english language discussion by Stephen Kay here) that when commission charges are taken into consideration in Chile, the total average return on worker contributions between 1982 and 1999 was 5.1 percent-not 11 percent as calculated by the superintendent of pension funds. That report found that the average worker would have done better simply by placing their pension fund contributions in a passbook savings account.
  
• The transition costs of shifting to a privatized system in Chile averaged 6.1 percent of GDP in the 1980s, 4.8 percent in the 1990s, and are expected to average 4.3 percent from 1999 to 2037. Those costs are far higher than originally projected, in part because the government is obligated to provide subsidies for workers failing to accumulate enough money in their accounts to earn a minimum pension.

In the United Kingdom, which began encouraging workers to divert payroll taxes to personal investment accounts in 1978, many citizens were victimized by poor investment choices as well as unscrupulous brokers. The national government was left with substantial new administrative expenses, lost tax revenues, and responsibilities to bail out some failed private pension plans. Indeed, the problems were so wide-ranging that even the most enthusiastic supporters of private accounts now say that the United Kingdom simply did not do it right.

A British government commission headed by Adair Turner reported in October 2004 that Britain had been living in "a fool's paradise" by thinking it had solved its pension problems. According to pension experts at the Organization for Economic Cooperation and Development (OECD), the Adair Turner report has sounded alarm bells. "What looked like a very good idea from a financial perspective in cutting costs has put pensioner poverty, which had been all but eradicated, back on the agenda."

REASON #5: The odds are against individuals investing successfully.

Privatization advocates like to stress the appeal of "individual choice" and "personal control," while assuming in their forecasts that everyone's accounts will match the overall performance of the stock market. But studies by Yale economist Robert J. Shiller and others have demonstrated that individual investors are far more likely to do worse than the market generally, even excluding the cost of commissions and administrative expenses. Indeed, research by Princeton University economist Burton Malkiel found that even professional money managers over time significantly underperformed indexes of the entire market.

Moreover, a number of surveys show that most people lack the knowledge to make even basic decisions about investing. For example, a Securities and Exchange Commission report synthesizing surveys of investors found that only 14 percent knew the difference between a growth stock and an income stock, and just 38 percent understood that when interest rates rise, bond prices go down. Almost half of all investors believed incorrectly that diversification guarantees that their portfolio won't suffer if the market drops and 40 percent thought that a mutual fund's operating costs have no impact on the returns they receive.

While predictions vary significantly about how investment markets will perform in the decades ahead, it's safe to say that any growth in individual accounts under privatization will be significantly lower than what the overall markets achieve.

REASON #6: What you get will depend on whether you retire when the market is up or down.

In the twentieth century, when stocks generally grew significantly, there were three twenty-year periods over which the market either declined or did not rise. The volatility of investment markets means that it matters a great deal whether you retire during an upswing or downturn. For example, a worker who invested his or her retirement fund in a stock portfolio that matched the Standard & Poor's 500 index and cashed out upon retirement in March 2000 would have a nest egg almost a third larger than someone who retired just a year later using exactly the same investment strategy. Of course, that is because the stock market plunged over those twelve months.

Gary Burtless of the Brookings Institution demonstrated how much timing matters under privatization by examining what would have happened to workers with forty-year careers who retired in each year from 1911 until 2002. Following Burtless's method, the figure below assumes that each worker put 7 percent of his or her earnings in the stock market every year (reinvesting dividends) and earned the actual historical return, year by year. It shows the wide variation in the retirement income workers would have received. Clearly, some workers would do much better than others based simply on when they happened to retire-that would be a major change from today's system.

Click to view Figure 2: Value of Annuity Purchased At Retirement With Individual Account Invested In Stocks

Note: Assumed contribution rate is 7 percent of wages. Author's tabulations of U.S. equity and bond return data supplied by Global Financial Data (March 2003).

Source: Gary Burtless, Personal communication.

REASON #7: Wall Street would reap windfalls from your taxes.

Brokerage houses, banks, and mutual funds have been very active in the campaign to privatize Social Security. Small wonder, since they stand to gain enormous fees if billions of dollars are shifted each year from Social Security payments into accounts under Wall Street management. Of course, those fees must come from somewhere, namely from the balances in individual accounts.

Among the one hundred best stock mutual funds, management fees range from 0.2 percent per year to 1.4 percent of the asset value of an account. The average is near the high end of that range, however, and many mutual funds charge substantially more. Smaller accounts require proportionately larger management fees because many costs such as gathering and mailing out information do not depend on account size. Indeed, most mutual funds actively discourage small accounts by setting a minimum opening deposit of $1,000 to $3,000.

Experience in the United Kingdom offers a warning about what the future could bring regarding management costs. Workers there have been allowed to open private accounts starting in 1988, since which time management fees and marketing costs among financial intermediaries have eaten up an average of 43 percent of the return on investment.

REASON #8: Private accounts would require a new government bureaucracy.

From the standpoint of the system as a whole, privatization would add enormous administrative burdens. Instead of the current trust fund accounts, the government would need to establish and track many small accounts, perhaps as many accounts as there are taxpaying workers-147 million in 1997.

Many workers' accounts would be so small that they would be of no interest to profit-making firms. The average taxable earnings of a worker are roughly $25,000 (in 1997, the last year with complete data, the average taxable earnings of the workers who paid into the system were $22,400). Two percent of $25,000 comes to $500 per year. Francis X. Cavanaugh, who has supervised the thrift savings program for federal employees, a program that privatization advocates often point to as a model, has argued that the costs of administering so many small accounts would overwhelm any benefits to be gained from the stock market. For example, he estimates that the government would need to hire 10,000 highly trained workers just to oversee the accounts and answer questions from workers. In contrast, today's Social Security has minimal administrative costs amounting to less than 1 percent of annual revenues.

REASON #9: Young people would be worse off.

Social Security privatization is often sold to young adults as a much better deal for them than the current system. But two recent studies show that if Social Security is converted to a system of private accounts, younger generations will be the ones who bear the costs of transforming the program. The added costs arise from the huge increases in federal borrowing needed to finance the new accounts while continuing to direct payroll taxes toward existing benefits for current retirees. According to the Congressional Budget Office, "to raise the rate of return for future generations by moving to a funded system, some generations must receive rates of return even lower than they would have gotten under the pay-as-you-go system."

A July 2004 Congressional Budget Office analysis of a private account proposal by the President's Commission to Strengthen Social Security compares it with the existing system. It looked at two scenarios for the traditional Social Security system, one with payments continuing in full indefinitely and the other with the trust funds becoming depleted in a few decades and payments shrinking to three-fourths their current level. In both scenarios, nearly all birth cohorts at all income levels born from the 1940s through the first decade of the 21st century on average do worse under the proposed system of private accounts. Only individuals in the lowest earning quintiles from the 1950s and the 1990s do slightly better, on average. Even assuming a worst case scenario where the trust funds evaporate and benefits are cut substantially, cohorts from the 1960s to 2000s would see reductions with private accounts between 1 percent and 17.5 percent on average, depending on their income and birth year.

An earlier analysis by economists Henry Aaron, Alan Blinder, Alicia Munnell, and Peter Orszag used the broad outlines of then-Governor Bush's Social Security privatization proposals to compare retirement benefits under current law to those if private accounts were introduced. They found that benefits for an average earning worker who retired in 2037 at age 67 (someone aged 34 today) would be 20 percent lower than they are now given historical rates of return over a fifty-year period.

REASON # 10: Women stand to lose the most.

The Social Security system is gender-blind. None of its provisions treat women differently from men. But that does not mean that the results are gender-neutral. Various cultural and biological differences add up to the fact that Social Security is much more essential, and a much better deal, for women than for men. Of all groups, none has more to lose from the privatization of Social Security than women. Compared to the average man, the average woman

• works fewer years outside the home,
  
• earns less per year, and
  
• lives longer after retiring.

Together, these differences mean that women depend more than men do on spousal and survivors' benefits, they collect benefits for more years than men do, and a greater proportion of their total retirement income comes from Social Security.

Since women on average work fewer years at lower pay, they contribute less in payroll taxes over their lifetimes than do men. But in their various roles as retirees, spouses, and widows, women collect Social Security benefits for more years than men. The result is that women get more net benefits over their lifetimes than do men.

There are fourteen women for every ten men aged 62 or older. Above age 85, this ratio reaches twenty-four women per ten men. Consequently, 60 percent of all Social Security beneficiaries are women. Among those receiving survivor and disability benefits, women and children constitute 85 percent. Women also depend more on Social Security. Older women who are not part of a couple (either widows, divorcees, separated, or never married) get 51 percent of their income from Social Security, and 25 percent of them have no income but Social Security. For men in the same situation (a far smaller proportion of the total), the figures are 39 and 20 percent, respectively.

The poverty rate for older women is almost twice that of older men (in 1997, 13.1 percent versus 7.0 percent). For older women who are not in a couple, the rate gets much higher: more than one in four lives below the poverty line. Fewer than half of them had incomes in 1997 above $1,000 per month. Without Social Security's guaranteed benefits, the already marginal income security for older women would be much worse.

In spite of the improvement in employment opportunities for women, the role of homemaker and primary parent still falls unequally on wives and mothers. Private accounts would jeopardize income that wives, widows, and divorcees now receive under Social Security. The more individual control that passes to workers, the fewer rights their dependents will retain to secure retirement income. If the guarantees and redistributive features of Social Security are replaced with a system that provides benefits according only to how much a worker earns over that worker's lifetime and how fortunate that worker is in financial markets, the average woman, especially the average widow, will lose security and income from already low levels.

REASON #11: African Americans and Latin Americans also would become more vulnerable under privatization.

Privatization advocates often claim that converting Social Security to a system of private accounts would disproportionately help African Americans and Latin Americans because those groups are purportedly shortchanged by the current system. But in fact there is almost no difference in Social Security's payback by race. And because both of those groups on average earn lower lifetime earnings than whites, those minorities would be at greater risk of facing poverty in their retirement under privatization.

African Americans on average have two characteristics that are disadvantageous under Social Security: shorter life expectancy and a lower marriage rate. But they also have traits that lead to greater benefits under Social Security: a higher disability rate, more survivors receiving benefits, and lower average wages. Latinos also have relatively low incomes on average, but a longer life expectancy and fewer average years in the workforce. As the figure below shows, the bottom line is that there is almost no difference by race in the benefits per dollar of Social Security taxes paid.

Source: Lee Cohen, C. Eugene Steuerle, and Adam Carasso, "Social Security Redistribution by Education, Race, and Income: How Much and Why," paper presented at the Third Annual Conference of the Retirement Research Consortium, "Making Hard Choices about Retirement," Washington, D.C., May 17-18, 2001. A 2 percent discount rate is used, which tends to reduce the benefits per dollar of taxes. The numbers are for those born between 1956 and 1964.

But because African-Americans and Latinos on average have substantially less wealth upon retirement than whites, they are far more dependent on Social Security. Converting the program into a system where their retirement income would be more dependent on investment markets would make those groups even more vulnerable to poverty.

Source: Marjorie Honig, "Minorities Face Retirement: Worklife Disparities Repeated?" in Forecasting Retirement Needs and Retirement Wealth, B. Hammond, O. Mitchell, and A. Rappaport, eds. (Philadelphia: University of Pennsylvania Press, 1999), Table 4. The data are for 1992 adjusted to 2001 prices.

REASON #12: Retirees will not be protected against inflation.

Social Security privatization plans, including all three recommended by the President's Commission to Strengthen Social Security, require retirees to convert the lump sums in their personal accounts into annuities that provide them with monthly payments until their death. The reason for that is that otherwise retirees could outlive their nest eggs, or even squander them, requiring taxpayers to bail them out.

The market for annuities, which are financial contracts sold by insurance companies, is very thin now, with relatively few bought and sold. Such a market would probably develop under privatization, but it is unlikely that those annuity payments would increase in line with inflation, as today's Social Security benefits do. Without inflation protection, the purchasing power of retirees' pensions would fall precipitously during times when prices are rising rapidly. Because insurance companies would bear significant new risks for offering inflation protection, they would be likely to charge very substantial fees over and above the already steep 10 percent that they now charge.

Conclusion

Current Social Security insurance protections have served the country well for decades. Diluting those protections in exchange for new accounts poses all kinds of new risks while making the relatively manageable long-term challenges confronting Social Security far more immediate and severe.

Notes

Introduction

". . . amounting to be between $2 trillion and $3 trillion . . ." Peter A. Diamond and Peter R. Orszag, "Reducing Benefits and Subsidizing Individual Accounts: An Analysis of the Plans Proposed by the President's Commission to Strengthen Social Security," Center on Budget and Policy Priorities and The Century Foundation, June 2002, p. 7.

REASON #1

Diamond and Orszag, pp. 10-11.

See also Greg Anrig and Bernard Wasow, "What Would Really Happen under Social Security Privatization? Part IV: Insecurity for the Disabled and Dependents of Workers and Retirees who Die," The Century Foundation, New York City, December 10, 2001.

REASON #3

Economic Report of the President (Washington, D.C.: Government Printing Office, February 2004), p. 144.

"If anything, our impression . . ." Peter A. Diamond and Peter R. Orszag, Saving Social Security: A Balanced Approach (Washington, D.C.: Brookings Institution Press, 2004), p. 161.

REASON #4

"more than half of all workers . . ." Indermit S. Gil, Truman Packard, and Juan Yermo, Keeping the Promise of Old Age Income Security in Latin America (Washington, D.C.: The World Bank, 2004), p. 10.

"Investment accounts of retirees are much smaller . . ." Stephen J. Kay and Milko Matijascic, Social Security at the Crossroads: Toward Effective Pension Reform in Latin America, Unpublished paper prepared for the XXVI Conference of the Latin America Studies Association-LASA, Las Vegas, Oct. 6-8, 2004, p. 6.

"The World Bank found that . . ." Gil et al, p. 8.

"The brokerage firm CB Capitales . . ." Tema Especial: ¿Cuál ha sido la verdadera Rentabilidad del Sistema de AFP? CB Capitales, Departamento de Estudios, April 8, 1999; also see Stephen J. Kay, State Capacities and Pensions, Unpublished paper prepared for the Latin American Studies Association XXIV International Conference in Dallas, March 27-29, 2003, p.12.

"The transition costs of shifting . . ." Jos�EE. Devesa-Carpio and Carlos Vidal-Meli�E The Reformed Pension Systems in Latin America, Social Protection Discussion Paper Series, No. 0209.

"A British government commission . . ." Andrew Balls and Chris Giles, "Dubious Special Relationship Links Two Pension Reform Schemes," Financial Times, November 18, 2004, p. 2.

REASON #5

"Indeed, research by Princeton economist Burton G. Malkiel . . ." Burton G. Malkiel, "Returns from Investing in Equity Mutual Funds 1971 to 1991," The Journal of Finance 50, no. 2 (June 1995): 572.

"For example, a Securities and Exchange Commission report . . ." "The Facts on Saving and Investing: Excerpts from Recent Polls and Studies Highlighting the Need for Financial Education," The Securities and Exchange Commission, Washington, D.C., April, 1999.

REASON #6

"Gary Burtless of the Brookings Institution demonstrated . . ." Gary Burtless, personal communication, see also "Risk and Returns of Stock Market Investments Held in Individual Retirement Accounts," Testimony before Task Force on Social Security Reform, House Budget Committee, May 11, 1999.

REASON #7

"Among the one hundred best mutual funds . . ." Consumer Reports, March 2001.

REASON #8

"Francis X. Cavanaugh . . . has argued . . ." Statement of Francis X. Cavanaugh before the Senate Budget Committee, July 21, 1998.

REASON #9

"According to the Congressional Budget Office . . ." "How Pension Financing Affects Returns to Different Generations," Congressional Budget Office, Washington, D.C., September 22, 2004.

"A June 2004 Congressional Budget Office analysis . . ." "Long-Term Analysis of Plan 2 of the President's Commission to Strengthen Social Security," Congressional Budget Office, Letter to Senatior Larry E. Craig, July 21, 2004 (updated September 30, 2004).

"An earlier analysis . . ." Henry J. Aaron, Alan S. Blinder, Alicia H. Munnell, and Peter R. Orszag, "Governor Bush's Individual Account Proposal: Implications for Retirement Benefits," Issue Brief 11, The Century Foundation, New York, 2000.

REASON #10

Bernard Wasow, "Setting the Record Straight: Women and Social Security," The Century Foundation, New York City, April 1, 2002.

REASON # 11

Bernard Wasow, "Setting the Record Straight: Two False Claims about African Americans and Social Security," The Century Foundation, New York City, March 1, 2002.

Bernard Wasow, "Social Security Works for Latinos," The Century Foundation, New York City, May 1, 2002.

REASON #12

Greg Anrig and Bernard Wasow, "What Would Really Happen Under Social Security Privatization? Part III: Millionaires One and All?" The Century Foundation, New York City, December 10, 2001.