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A Modest Proposal for Privatizing Social Security

The people who want to privatize Social Security say that it's a unsustainable Ponzi scheme, using payments from current workers to pay current retirees, and paying future retirees using contributions from future workers. They say that by allowing workers to invest part of their payroll contributions, President Bush's plan will aid Social Security by increasing the returns on that portion of contributions, enabling benefits to be lowered without any net loss to retirees. They say that raising taxes to fund future Social Security shortfalls is unacceptable. And they say that assuming a trillion dollars or more in debt to fund this partial transition wouldn't harm the economy, since the markets already assume that the government has obligated itself to pay out that money.

The people who are against privatizing Social Security say that it shouldn't be thought of as an investment vehicle, but rather as an expression of society's desire that no one be consigned to retire in poverty. They say that President Bush's plan does nothing to strengthen Social Security, since it reduces contributions into the system along with reducing payouts. They say that Social Security's future shortfall could be closed by raising taxes only the wealthiest few. And they say that borrowing money in the financial markets will have a radically different effect on the economy than simply promising to pay future retirees a certain amount.

The problem as I see it is that both sides are mostly right. Social Security is a Ponzi scheme. We're paying the price for past generations' desire to begin paying retirees immediately, instead of paying retirees only in step with their contributions. But at the same time, we don't want to see anyone live our their retirement in abject poverty. The President's plan could help by increasing returns, but there are no guarantees that it will do so, and no way of accurately projecting by how much, if at all. Social Security taxes are high already, and it seems fundamentally unfair to point to a single segment of society to pay more in order to benefit everyone else. And yes, we do owe the money to future retirees one way or another, but it would be a huge economic risk to actually go out and borrow that money in the markets.

Social Security is a defined-benefit plan, like private pensions: you pay in a certain amount of money, and you're guaranteed to receive a specified benefit upon retirement. It's useful to note that defined-benefit plans are going the way of the dodo because of the risks they pose to the companies who operate them (who may find themselves with staggering bills down the road) and to their would-be recipients (who could find themselves retired but with no benefit if their plan collapses).

American firms have been replacing defined-benefit plans with defined-contribution plans: you contribute to your own retirement account (usually with assistance from your employer), but how you manage that account and the resulting returns are solely up to you. Defined-contribution plans lower risk dramatically for everyone. The firms operating them have no long-term risk, because they're not responsible for the accounts (and in fact can't touch them at all), and their workers have no risk that their employers' future problems will affect their retirement.

It would be great if we could wave a magic wand and simply transform Social Security from a defined-benefit to a defined-contribution plan. The problem is that if we switched over all in one stroke -- in other words, if workers began to invest all their payroll taxes in private accounts beginning tomorrow -- then we would have no incoming revenue to pay our obligations to current and future retirees who have paid into the system for decades expecting a retirement benefit. My guess is that those obligations would run into the tens of trillions of dollars.

President Bush's plan essentially says, "Whoa, that's a lot of money. We can't do that. Let's just do a little of it and see how that goes." But that begs the question. Whether you allow current workers to invest a fraction of their payroll taxes or the full amount, you still have to pay the costs of transitioning the system -- it's just a matter of scale.

I seem to remember (I'm being link-lazy this morning) opinion polls showing that more young workers believe in the existence of UFOs than believe they'll receive a Social Security benefit. I don't blame them. They sense that it's a fundamentally unsound system and they want out. And therein lies a potential solution to this problem -- one distinct from raising taxes (as per the Democrats) or borrowing money to fund private accounts (as per the Republicans).

Step 1: We mandate that all future workers enter into a defined-contribution system. All their payroll taxes would go into their own private accounts (with the appropriate checks and balances to prevent outlandish investments).

Step 2: We offer any current worker the choice to opt out of Social Security. They would continue to pay payroll taxes, but all such taxes would go into a private account, with a broad choice of low-risk investments. Beginning immediately, every penny they put away would begin building interest for their own retirement. But in doing so, they would relinquish any claim to future benefits based on their past contributions. In other words, for the privilege of opting out of Social Security, workers would give up the privilege of receiving retirement benefits from it.

What would be the result of this? Countless organizations -- from news outlets to advocacy groups -- would provide analyses showing workers whether it would make financial sense for them to convert. Despite this, some people wouldn't switch no matter what, even if they were very young and had built up only a trivial retirement benefit. That's fine. But many young people would wisely choose to give up their Social Security benefits knowing that they would easily make up the shortfall with their private accounts. And probably more than a few middle-aged people would opt out as well, especially if they had otherwise provided for their retirement.

I don't have access to the data to be able to run the numbers on this, but my hunch is that enough people would give up their retirement benefits to pay most of the unfunded mandate cost. And they would have chosen to do so. No one would be forced to do anything -- no current worker would be forced out of Social Security or have his or her taxes raised, and no current or future retiree would have his or her benefits cut.

As for the remainder of the unfunded mandate cost, we face a shortfall no matter what, and that will need to be dealt with at some point. But this plan could reduce that shortfall, and it solves the problem that no existing plan addresses: how to completely transition Social Security to a defined-contribution system so that future generations don't have to deal with the problems we're facing now.

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