The World-Wide Revolution in Social Security

A revolution in opinion and policy regarding Social Security is sweeping the world. The revolution began to flower in the South American nation of Chile, which allowed its workers the freedom to choose a private option to its traditional public system starting in 1981. In the private system, workers pay into their own individual savings, investment and insurance accounts, which are then invested by major financial institutions to finance their future benefits. Within 2 years, over 90% of workers had switched to the private system, and the revolution was under way.

Chile’s experience was recognized as such a great economic and political success that other countries around the world began adopting similar reforms. Today, seven other Latin American countries have enacted Social Security reforms similar to the system in Chile – Argentina, Mexico, Peru, Colombia, Bolivia, Uruguay, and El Salvador.

But the trend has now spread well beyond Latin America. Great Britain adopted a highly successful private option years ago. Australia replaced its public system with a private savings and investment system in 1991. Perhaps most remarkably, the trend spread to China in 1996, Russia, Hungary and Kazahkstan this year, and Poland starting next year. Around the world, other countries are studying proposals to adopt such reforms as well.

The World Bank has been promoting such reform across the globe at least since the publication of its lengthy report in 1994, Averting the Old-Age Crisis. In the United States, the National Bureau of Economic Research, under the leadership of Harvard Professor Martin Feldstein, has been advancing a private savings and investment alternative to Social Security as well. At the annual address to the American Economics Association in 1996, Feldstein estimated that the present value of the future economic benefits to the U.S. from such reform would be a truly astounding $10-$20 trillion. Such reform has also been endorsed by economic Nobel Prize winners Gary Becker, James Buchanan, and Milton Friedman, as well as American Economics Association President Arnold Harberger.

Other support for such reform in the U.S. reflects a sea change in the politics of the program in this country. The members of the 1996 Advisory Commission on Social Security, appointed by President Clinton, all agreed that some type of new, invested system was necessary, and almost half supported allowing workers a private option for almost half the system. In 1997, the liberal Oregon state legislature passed a resolution calling on Congress to grant it a waiver to adopt its own private option for the people of its state. Opinion polls are now showing broad and deep public support for such reform. And several members of Congress have already introduced legislation providing for various private savings and investment options. A private option for Social Security is now a viable political issue in the U.S.

The Basis for Reform

There are 5 fundamental reasons why a private option for Social Security should be adopted.

Insolvency of the Current System. The program is headed for insolvency. Based on projections from the program’s own Board of Trustees, the program will run short of funds to pay promised benefits by 2032. Tax rates will probably have to increase by 50%-100% to pay all promised benefits to today’s young workers. Such a tax increase is infeasible both economically and politically.

But the problem begins much sooner than that. In 2013, Social Security begins to run a deficit that just grows larger and larger until the trust funds are exhausted in 2032. Over that period, the Federal government will have to redeem about $2.3 trillion in Social Security trust fund bonds to continue to pay promised benefits. But the government has no cash or other assets to back up these bonds. So it will either have to raise taxes by $2.3 trillion over this period, or borrow it from the public through effective deficit spending, or cut other government spending by this amount.

Social Security’s Low Returns for Today’s Young Workers. Taxes are already so high that even if Social Security somehow paid its promised benefits, the program would be a bad deal for today’s workers. Even the program’s promised benefits represent a low below market return on the taxes these workers and their employers will pay into the program over their careers. These workers would get much higher returns and benefits saving and investing through the private sector.

This is shown in Chart 1, which is derived from the analysis later in this report. At conservatively assumed standard net returns for a mixed private fund of investments in stocks and bonds, workers would receive close to 3 times and more the benefits promised to them by Social Security. At returns closer to the standard long term average for the stock market, workers would receive 5 to 6 times the benefits promised by Social Security and more. This is true for all of today’s young workers, of all races and of either sex,whether high income or low income, married or single, two earner couple or one earner couple, with children or without children.

This problem arises because Social Security essentially operates on a pay-as-you-go basis. The taxes paid in today are almost all used to finance benefits to today’s retirees, with the remainder used for other government spending. The benefits for future retirees are to be financed out of taxes paid by future workers at the time.

In a private, fully funded system, by contrast, the money paid in is saved and invested in new capital investments. These capital investments increase production, and the value of this production increase is returned to investors in the form of a rate of return or interest payment on their investments.

But a pay-as-you-go system like Social Security adds nothing to capital formation or increased production. It merely transfers funds from one segment of the population to another. This means that workers under such a system lose the increased production and associated returns they would get if their money were invested in private, productive assets through a fully funded system.

Higher Savings, Investment, and Economic Growth. Privatization of Social Security would likely produce large increases in savings and investment, with hundreds of billions saved and invested though the private system each year. This means, in turn, higher productivity, higher wages, more jobs, and increased economic growth. The payroll tax for the private system can also be reduced, with most of the negative effects of the remaining mandatory payments eliminated as well, further increasing wages, jobs and economic growth. Such increased economic growth is what leads Feldstein to estimate that the present value of the net benefits from privatizing Social Security is $10 to $20 trillion.

A privatized system would also turn every worker into an owner and investor in American business and industry. This would likely improve social and political attitudes towards free market policies further enhancing economic growth.

Low Income Workers Would Benefit Greatly. Low income workers would be among the biggest winners from a private system. Even though Social Security includes special redistributive subsidies for lower income workers, these subsidies are overwhelmed by the much higher returns and benefits of the private invested system. As Chart 1 shows, even low income workers could expect about twice what Social Security promises with the conservatively assumed standard net returns of a mixed stock and bond fund, and about 5 times the benefits with a stock fund earning returns closer to the long term average in the stock market.

The higher wages, new jobs, and improved economy resulting from the private system would also be most important to low income workers, as would avoiding the higher taxes and/or reduced Social Security benefits that will be necessary on our current course.

Increased Freedom of Choice and Control. Finally, a private option for Social Security would greatly increase freedom of choice and control of workers over their own retirement finances and benefits. They could choose whether to stay in Social Security, or choose among a wide array of private alternatives. They could seek the best available market returns on their funds, and use the funds to best suit their needs and preferences in retirement, and most benefit their families..

A Reform Proposal for America

America should join the worldwide trend and adopt a private option for Social Security. This study presents a specific proposal showing how this could be done in the U.S., and how the transition could be financed. The proposal would allow workers to choose private savings, investment and insurance accounts in place of Social Security. Worker would each choose one of a number of U.S. government approved and regulated, private, investment firms, to choose and manage the investments for their accounts, and obtain needed insurance. The accounts would then provide the full range of current Social Security benefits – retirement, savings, and disability.

To provide a safety net, the government would guarantee workers a minimum benefit equal to the average benefit under Social Security, regardless of the performance of the investment account. Social Security benefits under the present system would continue to be paid in full for current retirees. There would be no change in the program at all for them. Workers would also be free to choose to stay in Social Security rather than the private option if they prefer.

Such reform should be a top priority for policymakers and opinion leaders. For perhaps no other change would do so much to increase the liberty and prosperity of the American people.