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Privatization Only Privatizes Risk!—Some Basic Truths About Reforming Social Security

There has been a flurry of activity around Social Security reform ever since President Bush decided to make privatization of Social Security a cornerstone of his second term in office. However, in this acrimonius debate, the basic truths about Social Security and the need for reform have been clouded by the claims made by many of the parties concerned.

In his last professional work, the late Prof. Franco Modigliani, the author of the seminal papers on savings behavior (that earned him a Nobel Prize in economics) has left behind a treasure trove of basic truths about reforming Social Security that both Democrats and Republicans would benefit from. We attempt to summarize six key points here in a very simplified manner.

1. Pay-as-you-go systems are very volatile and do not foster savings: When pensions of the retired must be paid by taxes on the working population (also called a Pay-as-you-go or PAYGO scheme), the system does not foster savings as taxes are spent immediately. More importantly, the taxes levied on working populations can be subject to relatively large changes for moderately small changes in two key parameters – population growth and productivity growth (or growth in real income). Lower the future growth in these two parameters and higher Social Security taxes will be. This volatility has not been highlighted in the current debate. Any potential problems with Social Security are essentially with how benefits are financed, and PAYGO as the sole source of funding will lead to volatile Social Security taxes. In the case of the U.S. system, taxes will at some point rise from 12.4% to as high at 19% in 2070 (under the Intermediate Scenario projected by the SSA), or a 50% increase. Therefore, the need to reform Social Security systems worldwide stems from their extreme dependence on PAYGO as the sole source of financing pensions.

2. Some Funding and Investing in the Market is Good: The benefit of creating a funded system (typical in most employer sponsored pension funds) is that benefits can be paid either from contributions or usually from funds that had been collected before and invested in capital markets. The advantages of investing in the markets are two fold: (a) the potential for a diversified group of assets to earn a return greater than the sum of population and productivity growth is reasonably good; and (b) investment returns may not be highly correlated with population and productivity growth and hence a combined system is well diversified. Many argue that a funded system has lower Social Security taxes because assets earn a higher return. However, they fail to mention that this can only be the case because the assets were accumulated in the first place and we return to this point below. Transitioning from PAYGO to funding is not as simple as diverting one’s contributions into an account that is invested in the capital markets.

3. Privatization only privatizes risks: President Bush and his like-minded friends have made one too many leaps of faith to go from PAYGO to privatization. One of the attractive features of the current Social Security system is that benefits are guaranteed. Under privatization, too many problems arise; namely, (a) benefits will depend on the performance of markets, which can be volatile; (b) fees paid to investment firms will chew up a large part of the potential pension; and (c) the rich will be made richer and the poor poorer as only the rich will have access to good advice. Alternatively, the government will have to bail out retirees and these costs are very high. All the proposals about regulation of these funds etc. smack of government intervention. Minimizing this risk can be handled more effectively without leaving naive investors at the mercy of the market. For those who suggest that "choice" is the reason for privatization, then the examples of Sweden and Australia (and the World Bank’s own pension fund) are revealing. People do not exercise choice when it is in an area where they have little or no expertise. A more sensible way to earn the return of asset markets on funds is to pool these and invest them through a centralized office as is done in Canada and Ireland.

4. Defined benefit is good, but the current Social Security formula is too complex: While having pension benefits guaranteed by the government is good, very few people have any idea of what they are entitled to under the current system. Therefore, the best of all worlds would be to retain the current defined benefit structure, yet make one’s participation and entitlement more transparent. Nobody seems to realize that a defined benefit pension fund is nothing more than a guaranteed return on contributions. If the system could be reformed to have such a structure, then it is also possible to set an investment policy on pooled assets to achieve such a return. This would greatly simplify people’s understanding of what they will get from Social Security, and greatly simplify the analysis of whether the funds are available to meet this promise.

5. Social Security taxes must rise: Under all Social Security reform proposals, taxes are going to rise (or benefits will have to be cut) unless population growth, income growth or asset returns jump dramatically. The key question is how much and who bears the cost (i.e., inter-generational equity)? The most equitable solution would be to minimize this cost and to make everyone bear the pain equally.

6. Retirement age will have to increase: As people live longer and improvements in medical science increase longevity, keeping a fixed retirement age is no longer feasible if benefits are to be paid till death. Therefore, a sensible Social Security scheme should have its retirement age linked to longevity

If the current policy makers recognize these truths then the path to reform is relatively easy and is in-between privatization and "do nothing to PAYGO." Essentially, contributions must be increase (by say 1%) to partially fund a defined benefit social security, and invest the assets in a pooled manner in a diversified basket of assets. There are innovative ways in which political manipulations of these assets can be prevented. The cost of reforming social security is already high—any delay or poorly designed program will only increase the cost.

Muralidhar is co-author (with Prof. Franco Modigliani) of Rethinking Pension Reform, published by the Cambridge University Press.

Contact the author at asmuralidhar@mcubeit.com