We have developed a permanent solution to Social Security's problem of maintaining current benefits levels and stable contribution rates.
Our approach, which we label "risk diversification through a common portfolio," achieves lasting reform by gradually shifting Social Security from pay-as-you-go to a more traditionally funded pension system typical of those in the corporate world. The pensions would be funded by the capital accumulated through contributions made during the working career, while maintaining the attractive defined benefit structure.
To cover the growing funding gap in Social Security, its resources must be gradually increased above the level projected with the current system. We agree with President Bush's Social Security commission that one way of securing these additional resources is to invest reserves in the securities market, rather than in low-yielding loans to the government.
But we hold that the cost- and risk-effective way to do so is not through individual accounts managed by some manager from a government approved list, but by continuing to direct all contributions to the existing trust funds, which will invest all reserves in a common portfolio. We require that portfolio to be highly diversified, under the supervision of a blue-ribbon board. Ireland and Canada have successfully created such boards.
The basic reason so many national retirement plans worldwide are affected by aging populations, slowing productivity growth and increases in longevity is that they are not funded. They are financed instead on a pay-as-you-go basis, by the current contributions of the younger working generations. These unfavorable trends would tend not to affect a funded system because the pensions of the retired would be paid by their own accumulation and not by the contributions of the young.
Faced with the problem of insolvency, many well-meaning reformers have come out in favor of moving toward a type of radical restructuring of the current pay-as-you-go system, centered on shifting contributions to individual accounts, which goes under the name of "privatization of Social Security." There are a number of reasons why this approach is finding support.
In the first place, the word privatization and the notion of eliminating a public pension agency (such as the Social Security Administration) appeal to the many (especially the fans of the market) who were easily persuaded that the malady affecting all pay-as-you-go systems was due to the usual presumed shortcomings of publicly managed agencies (stupidity, wastefulness, dishonesty, personal interests, etc.). Hence, returning to private investors the right to decide how to invest their retirement reserves was bound to look like a great improvement.
But this view of the cause of Social Security's problems is largely fallacious. The current difficulties arise from the structure of pay-as-you-go system and the trends discussed earlier. The troubles are not due to public mismanagement, but to poor design, which can be eliminated without resorting to individual accounts. At the same time, those who have pushed for privatization have failed to recognize some very fundamental flaws. The crucial one is that privatization eliminates the "progressive" pensions guaranteed by the government under the current defined benefit structure. It replaces them with a defined contribution structure under which the contributions remain government mandated, but benefits become highly erratic, depending on luck in choosing one's portfolio (and date of retirement, if not date of conception).
Indeed, privatization leaves all major decisions to the government. The only thing that is truly "privatized" is risk. This results in an arbitrary and capricious redistribution of pension income. To be sure, some will end up above average, as is often emphasized by the supporters, but supporters conveniently forget about the rest who will do worse. The inequalities generated by privatization are especially repellent because they are artificial and serve no useful (e.g., incentive) functions. In addition, the management costs, combined with additional costs of administration and regulation, would be prohibitive, often causing a reduction in pensions of as much as 15% to 20%. And these costs are a total social waste, for the competition between portfolio managers is a zero-sum game. It cannot increase the overall return earned on reserves. When all these flaws are taken into account, one must reject privatization, or individual accounts, unconditionally in favor of defined benefits.
With our reform, we continue to direct all contributions to the existing trust funds, which will invest all reserves in a common portfolio to ensure all participants enjoy the same, safe return, thereby providing the foundation for the continuation of defined benefits. We ensure that the same safe return is guaranteed to all (fundamental to Social Security is a guarantee of benefits or, equivalently, a guarantee of returns). Pooling reserves also dramatically lowers management and administrative costs.
But to carry out the reform of the system that we are advocating — from the present pay-as-you-go to (partially) funded — requires some accumulation of capital through extra levies during the "transition" period. It is often claimed that, during the transition, current participants would have to pay double contributions: one to finance the old pensions and one to fund the new system. This claim is a gross exaggeration. In fact, we calculate that, provided our reform is executed promptly, the required increase in contribution could be a bit more than one percentage point, raising contributions from approximately 12.4% to 13.5%, assuming a trust fund long-run real return of approximately 5.25%. That increase could be reduced, or even eliminated, with a higher return and/or by introducing some reasonable modifications, such as indexing the standard retirement age to life expectancy. The reason for this low cost is that the United States can count on some special favorable circumstances, including the accumulation of reserves from past surpluses now held by the trust funds, and the gain from investing these reserves and future surpluses in the securities markets.
But if we procrastinate until the trust funds are exhausted, individual contributions needed to maintain benefits would have to rise by approximately 50% to a tax of 20% of wages. If we act now, Social Security can be saved for the indefinite future, in substantially its present form with a few simple, affordable reforms.