* The Commission to Strengthen Social Security will almost certainly endorse the partial privatization of the system. If privatization were to occur, it would be an important development because it would lead to significantly more issuance of Treasury debt and greater private sector demand for corporate equities.
* However, the prospect for such a proposal being enacted is virtually nil. Passage by the 60-vote supermajority needed to cut off filibuster in the Senate is virtually impossible. Most Democrats will be strongly resistant to partial privatization as they view it as the first step to the abolishment of the Social Security system.
* As this debate unfolds, there will presumably be considerable spinning of the facts by both sides. To set things straight, privatization could reasonably be expected to reduce the financial burden associated with funding retirement somewhat. However, it is no panacea because to earn higher returns, you have to take on more risk. Also, the ability of the economy to support its seniors' retirement is determined by national saving and investment. If privatization does not change this, then it has not truly increased the economy's capacity to support the increasing number of retirees relative to the workers. Privatization should be judged on this basis.
Privatizing Social Security: Don't Hold Your Breath
President Bush appointed a Commission to Strengthen Social Security this spring. The commission's mandate is to produce recommendations that would reform and revitalize Social Security. Because the commission members were carefully selected on the basis of their support of privatization, it is a foregone conclusion that partial privatization will be a key feature of the Commission's recommendations.
If enacted, privatization would be important for the relative prices of Treasuries and corporate equities because the monies diverted into privatized accounts would, dollar for dollar, have to be replaced by increased issuance of marketable Treasury debt. Also, because a high proportion of the privatized funds would presumably be invested in equities, the demand for equities would increase as well. So, at the end of the day, Treasury bond yields and equity prices could be expected to be slightly higher and the spreads between Treasuries and corporate bonds somewhat narrower.
But this is all theoretical. It is very unlikely that the Commission's finding will lead to legislative reform for four reasons:
1. Democrats will resist fiercely as they view partial privatization as the first step in the elimination of Social Security. There is something to this worry. High-income households would generally do considerably better under a partially privatized system and this would probably erode the support for Social Security over time.
2. Passage in the Senate would be particularly difficult given Democratic control and the need for a 60-vote supermajority to cut off the debate.
3. The equity market's poor recent performance underscores the risk of privatization. To get higher returns you have to take more risk. The attractiveness of diverting funds into the equity market is less compelling now that it is clear that the stock market just does not just go straight up.
4. Privatization would probably worsen the Social Security trust fund finances, pulling forward the insolvency date. That is because the diversion of payroll taxes will lead to a smaller social security trust fund surplus, which would then be more quickly exhausted by the still-high benefit payments to current and prospective beneficiaries.
In the discussion of Social Security reform, both sides of debate have often been less than even-handed in their analysis of the key issues. What follows is a brief question and answer session to clarify the key issues that are often distorted in this ideological debate.
Q. Why would privatization shore up the finances of Social Security?
A. The idea is that privatization would lead to higher rates of return as some of the funds now invested in government securities were instead invested in higher-yielding corporate bonds and equities. The problem with this argument is that the higher returns require taking greater risk. Also, if reform does not lead to greater saving and investment, then the ability of the country to afford a given level of benefits will not have changed (this has been a point stressed by Chairman Greenspan).
Q. Isn't the expected return on Social Security contributions virtually negligible at this point?
A. Yes, but less of this has to do with the lower returns of government bonds versus equities than the fact that current contributions have to cover the disparity between past contributions and promised benefits. Retirees in the 20th century reaped a windfall in that their benefits were large relative to their contributions. This had to stop if the system was going to be viable and shifted from a fully pay-as-go system to a partially pre-funded system. In comparing returns between the current system to a privatized system it is important that you compare apples-to-apples by including the cost of these past liabilities.
Q. Haven't the Social Security trust fund balances already been spent?
A. Yes, in the sense that the excess revenue of Social Security has been used to fund the rest of the government. The trust fund balances are just IOUs from the Treasury to the Social Security administration. No, in the sense that these surpluses have been used to retire outstanding marketable debt. The net indebtedness of the US is lower because the Social Security surpluses have been used to pay off debt. By improving the government's current financial situation, this allows greater capacity to borrow in the future when Social Security moves from surplus to deficit.
Q. How close it the Social Security system to insolvency?
A. The insolvency date under the trustees' intermediate assumptions is now 2038, back from 2030 about four years ago. But Social Security outlays begin to exceed payroll tax receipts on these projections in 2016. So the pressure on government finances begins much earlier.
Q. What is the problem? Just the retirement of the baby boom generation?
A. The problem is not just the bulge in retirees from the baby boom generation. It is also the rise in life expectancy, which is raising the ratio of beneficiaries to workers. So even after the boomers are long and gone, you still would have a problem.
Q. If the economy grew faster, wouldn't that help a lot?
A. It would only help a little because the initial level of the retirement benefit is tied to real wage growth. Only after retirement do benefits become indexed to the CPI. Of course, there is no reason why the linkage between benefits and real wage growth couldn't be loosened. If real benefits were frozen, for example, and real wages per capita were to grow at about a 1% annual rate, that probably would be sufficient to restore solvency to the system. The problem is that freezing the real benefit would be characterized as a benefit cut relative to the current system.
Q. Can the problem be solved?
A. Absolutely. Reduce the growth of benefits relative to wages, increase payroll taxes, extend the retirement age. The key point to recognize is that if the US economy is growing over time, that will generate the resources we can use, if we choose, to fund Social Security. The Social Security problem is much easier to address than Medicare. For Medicare, the solution is not as straightforward as everyone wants high-quality health care. Moreover, the financing problems are more immediate and worsen much faster.
Bill Dudley