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Tuesday, April 19, 2005

Social Security Reform

Dwight K. Bartlett, Fellow of the Society of Actuaries, Former Chief Actuary, Social Security Administration, 1979-81

President George W. Bush has made it clear that a high priority, perhaps the highest priority, item in his economic agenda for his second term will be the “partial privatization” of Social Security. He would allow younger workers to redirect a portion of their FICA tax from the Old Age Survivors and Disability Insurance (OASDI) Trust Funds into personal accounts, with a limited variety of investment options. The argument is-;»that such accounts will, on average, earn a higher rate of return than the trust funds do, resulting in ultimately larger benefits than the present program can sustain. It would also provide lower income workers, who find it impossible to save and invest at present, a sense of ownership of a portion of our economic pie.

Some critics of partial privatization argue that it is administratively unfeasible. For many low income workers, many of whom episodically leave and reenter the workforce, the bookkeeping for their small accounts would be inordinately difficult and expensive. Others argue that the massive amounts of employee contributions entering the securities markets would make the markets subject to undesirable political influences and result in unconscionable windfall profits for the investment managers.

Another criticism of partial privatization is that, even if investments in private securities provide higher rates of return on average than the federal bonds held in trust funds, they expose the holders of the private accounts to unacceptable levels of market risk.

While I generally share the foregoing concerns, my main concerns are much more fundamental. As useful as the accounting for the OASDI trust funds is for informing the public about the costs of Social Security, it tends to obscure what really determines the long term economic supportability of the program. Benefits paid by the program are virtually entirely spent immediately by the beneficiaries to support their consumption needs. The greater the aggregate benefits to all beneficiaries at any point in time, the larger their consumption, which in macroeconomic terms is supported by our gross domestic product (GDP). Currently OASDI benefits represent about 4.3% of GDP. Current actuarial projections indicate that when the baby boom generation is fully retired in 2035, that ratio may be as much as 6.6%. Arguably that is more than is sustainable, given other federal commitments, such as Medicare. Unless benefits are reduced in the future by some means, the projected benefits under current law can be made more affordable only if our economy grows faster than it otherwise would.

The wisdom of classical economics is that the rate of growth of our economy correlates closely with our national savings rate, i.e., more savings leads to a larger economy. This forces the conclusion that the partial privatization scheme would, assuming no reduction in aggregate benefits, make Social Security more affordable only if it leads to a reduction in aggregate current consumption and an increase in aggregate current savings. It is naive in the extreme to believe that simply because younger workers will have the opportunity to divert a portion of their FlCA taxes to individual accounts, they will on average reduce their consumption and increase their savings rate. In fact, they may actually reduce their savings in other forms, such as contributions to Individual Retirement Accounts and 401 (K) plans, thereby increasing their consumption.

Another troubling aspect of the proposal is that it would tend to weaken the bias in the present benefit formulas towards lower wage workers. The present plan benefit formulas result in a higher ratio of benefits to average lifetime wages for lower earners than for higher earners. if under the proposal every worker contributed 4% of his covered wages to his individual account, than everything else being equal, low wage and high wage earners will receive benefits which have the same ratio to their contributions into their personal accounts, and thus their wage histories, i.e. there will be no bias in favor of lower wage earners. The remaining portion of the traditional Social Security program will not have sufficient resources left to compensate for the loss of this part of the bias in the present formulas.

Thus, I conclude that the proposed personal account scheme not only will not make Social Security, our most prized social welfare program, more affordable, but will damage its ability to carry out one of its underlying objectives of providing greater protection against poverty in old age for lower wage earners.

Posted on April 19, 2005  |  Write the first comment

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