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With budget surpluses over the next ten years projected to total $2.3 trillion, many in Washington are proposing to use the surplus to "save Social Security." Unfortunately, many of these proposals would do little to ensure the long-term solvency of Social Security while others are -- at best -- ill-advised public policy.

Some have suggested using the surplus to buy publicly-held U.S. debt. While using the surplus to buy publicly-held U.S. debt could indeed have a salutary effect, it does not address the fundamental problems facing Social Security.

Increasing payroll taxes would temporarily extend the life of the Trust Fund but are politically untenable and economically unwise.

However, President Clinton's idea of allowing the federal government to invest Social Security revenues in public stocks and bonds is by far the worst idea yet proposed. Permitting the government to own portions of private industry is the first step in nationalizing American industry.¹

In the final analysis, one proposed Social Security reform does warrant serious attention: individual private savings accounts.

As most Americans now realize, if Social Security is not reformed, in the year 2012 it will begin to pay out more in benefits than it will collect in revenues.² According to the General Accounting Office (GAO), Social Security's total shortfall over the next 75 years is projected to total $3 trillion.³ In the past, the government simply raised taxes in order to prevent shortfalls. In fact, the Congress has raised payroll taxes seven times since 1980 alone.⁴

Doug Bandow, a senior fellow at the Cato Institute, has noted that:

. . . Social Security will run out of money by 2012, and possibly as early as 2006, if the economy worsens (the so-called trust fund is empty, filled with government IOUs, not cash). For this reason, the president has proposed using the supposed budget surplus to "save" Social Security. But even if a surplus emerges, it won't be nearly enough. By 2015 the system will be spending $57 billion more than it is collecting; the revenue shortfall will be $232 billion by 2020. The deficits quickly escalate -- amounting to an astounding $160 trillion through the year 2075.⁵

Funding this shortfall will place an enormous burden on both taxpayers and the American economy. For example, the National Center for Policy Analysis (NCPA) estimates that "Paying all of Social Security's promised benefits on an ongoing basis appears to require an immediate and permanent 6 percentage point increase in the current 12.4 percentage point payroll tax used to finance the system. That means the system needs to take 6 cents more out of every dollar earned by the average American worker not only in this generation, but in every generation that follows."⁶ Aside from being another short-term answer, this "solution" would have adverse economic effects and is inherently unfair.

As the following chart prepared by the Retirement Policy Institute shows, other scholars have predicted a far greater burden on taxpayers in order to continue fully funding Social Security.

With the shortfall in the Trust Fund looming so prominently, it is imperative that a comprehensive reform of the system be undertaken as soon as possible. Privatizing Social Security provides a permanent solution to the long-term solvency of the Social Security Trust Fund and would provide significantly higher returns on Americans' investments than Social Security currently does.

Why Privatize?

The current Social Security system has more problems than its imminent insolvency. Most importantly to Americans, Social Security is a bad deal.

Social Security is a pay-as-you-go system. The Social Security Trust Fund does not set aside the money a worker gives it in payroll taxes and invest those funds (or merely set it aside for that matter) for his retirement. Instead, it uses the payroll taxes that workers pay to fund the retirement of those currently receiving Social Security benefits.

In fact, the Social Security Administration maintains -- and U.S. Federal Courts have upheld -- that no one has a legal right to the money they contribute to the Social Security Trust Fund. In the 1937 Supreme Court case Helvering v. Davis, the Court established that Social Security is neither a retirement nor a social insurance plan. In Helvering, the Court noted that, "The proceeds of both the employee and employer taxes are to be paid into the Treasury like any other internal revenue generally, and are not earmarked in any way."⁸

In other words, there is no "guarantee" with Social Security. The government has no legal requirement to provide for anyone's retirement, even after demanding compulsory "social insurance" taxes. Furthermore, it is free to lower -- or eliminate -- your benefits at any time.

In other words, each new generation finances the retirement of the past generation. Payroll taxes collected in any given year that exceed the Social Security obligations for that year are used to purchase non-negotiable government Treasury Bills, as prescribed by law. These Treasury Bills pay a variable interest rate that, since 1926, has averaged 3.7%.

At first glance, funding Social Security with a pay-as-you-go system that invests surpluses in government Treasury Bills may seem perfectly reasonable. Unfortunately, history is teaching us that such a system is inherently flawed.

The biggest problem with a pay-as-you-go retirement system is that it is dependent upon the number of workers being sufficient to fund the retirements of current Social Security recipients.

For instance, in 1950 there were 16.5 workers for every 100 retirees. That number was sufficient to meet the Trust Fund's expenditures and create a surplus. However, since that time the number of workers to retirees ratio has declined. In 1965 the ratio had declined to only 4 workers for every 100 retirees. In 1995 there were only 3.3 workers per 100 beneficiaries.⁹

As this ratio has declined, and life expectancies have increased, the size of the Trust Fund's surplus has decreased. By the time the "Baby Boom" retires, there will not be enough workers to support their retirement.

Investing the Trust Fund surplus in Treasury Bills presents its own problems. For instance, when the Social Security Trust Fund holds surplus funds (as it has every year since its inception) the government does not simply place the excess money in a vault buried somewhere below Washington, DC.

Instead, it is required by law to convert surpluses into government-issued Treasury Bills that it can trade in when future payments exceed revenues.

Unfortunately, the government uses this situation to perform an accounting trick that would make even the cleverest embezzler proud. When the Trust Fund purchases the Treasury Bills, the government transfers the Trust Fund surplus to the general revenue fund used to finance on-budget spending.

In other words, the government promptly spends it. When the Trust Fund attempts to cash in its Treasury Bills, the federal government will be forced to raise taxes in order to generate the revenues to fund its debt.

Conversely, if payroll taxes were invested in private securities, the money would be invested in private capital -- a much more efficient and economically sound manner in which to invest excess payroll taxes.

The other major problem with investing the Trust Fund surplus in Treasury Bills is their historically low rates of return. A rate of return of nearly four percent appears healthy when viewed by itself. However, when compared to the rates of return on most other popular investment indexes, the return on our investment in Treasury Bills is not nearly as encouraging. Over a person's lifetime, even small differences in the rate of return on an investment can amount to tens of thousands of dollars. But since the average rates of return for private investments have been significantly higher than those on government Treasury Bills, the lost retirement income could translate to six figures or more.

The following chart shows the average rate of return on several popular private investments and the average rate of return on government Treasury Bills. It is important to note that this chart includes the stock market crash of 1929 -- which led to the Great Depression -- and the crash of 1987. This is significant for two reasons. Without either of the crashes, the rate of return would be even higher. Second, although dramatic downturns in the market are very rare, they still don't prevent private investments from being a smarter investment in the long run. In fact, Treasury Bills barely beat inflation, providing almost no real rate of return at all.

For instance, an eighteen-year-old entering the workforce today and earning an average salary can expect to have to pay approximately $700,000 in Social Security taxes while receiving just $140,000 in benefits.

In fact, almost all demographic groups born since World War II will pay more in taxes than they will receive in benefits, with the middle class faring the worst.¹¹

Clearly, this is inequitable. Private accounts would erase this inequality. The money taken out of a person's paycheck for retirement would be used to invest in his retirement. As stated earlier, these investments would be a vast improvement over the return the average American can currently expect from Social Security.

These inequities have not been lost on the American public. Numerous national polls have shown that Americans recognize the inherent opportunities of private investment and overwhelmingly support private savings accounts over government investment in the stock market.

In fact, a recent CNN/USA/Gallup survey of 1,070 adults found that only 33 percent of those surveyed "approve[d]" of the "Federal Government investing a portion" of the Social Security Trust Fund "in the stock market," while 65 percent "disapprove[d]." This proposal is a centerpiece of President Clinton's scheme that he claims will "save Social Security" from bankruptcy. Yet, by a similarly stunning margin, 64 percent "approve[d]" of "individuals investing a portion" of their savings [or taxes] "in the stock market," while 33 percent "disapprove[d]."¹²

These reputable national polls show something the media has overlooked -- the American people are indeed concerned about the future of federal retirement programs, but they trust themselves, not politicians, to reform them.

Indeed, there is significant historical evidence to suggest that the public's support of private investment is warranted. The charts below show the yearly amount several different types of workers would receive if they remained in Social Security for their entire worklife, or if they invested in various forms of private investment.¹³

It is not hard to see that Americans of all income groups would benefit immensely from private savings accounts. They would also gain the satisfaction of knowing that every penny they contributed went to their retirement and not to fund someone else's retirement. Instead of a massive cash transfer program, Social Security would be transformed into a true private social insurance system.

The preceding charts also demonstrate the long-term stability of private investment. Although the market may fluctuate from year to year, the overall soundness of the market over the duration of a person's entire career is unquestioned. In fact, market fluctuations can be taken into account and accommodated over time.

For instance, high-tech companies and smaller businesses tend to have a high rate of return but a high short-term risk factor. A younger worker may wish to invest in a diversified (meaning one's money is invested in several different -- yet related -- companies) fund that invests in high-tech and/or small businesses. Although there may be short-term fluctuations in the rate of return in this fund, the investor could be fairly certain that over the long-term, the fluctuations would balance out.

Later, when the worker nears retirement age and short-term fluctuations could impact his retirement savings, he could transfer his investment from the high-tech/small business fund to one with a lower rate of return but with a much lower risk factor -- bonds, for instance.

Obviously, this is just one of the many different investment possibilities that would be open to all Americans. It does help to demonstrate, however, that a fairly simple investment strategy can eliminate virtually all of the risk associated with private investment and still provide vastly greater returns than Social Security currently does.

And yet there are those who continue to maintain that government must save Americans from their own ignorance. Opponents of private accounts maintain that the average American is incapable of managing his own retirement account. They have determined that Americans are fools who will soon be parted from their money if the government allows them to manage it privately.

The height of this arrogance was demonstrated by President Bill Clinton on January 20, 1999. While at a local rally in Buffalo, NY, the President removed all doubt about his assessment of Americans' capabilities to manage their money. While discussing the idea of returning surpluses to the taxpayers, he quipped "We could give it all back to you and hope you spend it right. But . . . if you don't spend it right . . ."¹⁴ The President's point was obvious: The American public is not to be trusted to manage their own money.

And yet, there are numerous examples that dispel this patronizing myth. For example, 43 percent of American workers currently manage their own retirement accounts through privately held 401(k) plans (conversely, only 25 percent of Americans are currently enrolled in defined benefit plans such as pensions). Fundamentally, private savings accounts would not be different from 401(k)s.

Both 401(k) plans and the proposed private savings accounts are defined contribution plans, whereas the current Social Security system and pensions are defined benefit plans.

Just as 401(k)s currently allow workers to invest for their retirement through privately-managed funds investing in various markets, so too would private savings accounts. Very few can question the enormous success of 401(k) plans or their popularity with the American public.

Writing in a recent issue of The Weekly Standard, Lee Harris Roberts notes that:

Employees love 401(k)s. They like having ownership and control over their money. The accounts are transparent -- employees can see how much they have, how they've invested it, and how it's doing, usually 24 hours a day via telephone or Web site. They're not penalized for changing jobs . . . And the security of their retirement doesn't depend on their company, or the Social Security system, being solvent when they retire.¹⁵

So millions of American workers are already successfully investing for their retirement through privately managed accounts, yet the government and ivory tower intellectuals claim that a similar plan to replace Social Security would fail due to the ignorance of the American worker.

401(k)s are a shining example of how workers are capable of investing in their own retirement, without the nanny-state looking over their shoulder. As Roberts notes:

As the debate over fixing Social Security -- the ultimate defined-benefit plan -- grinds on, there are lessons for policymakers in the history of the 401(k). This wonderfully successful reform was neither planned nor promoted, but has become hugely popular nonetheless. Rather than continue searching for the big legislative fix, perhaps we should build on what we already have in the 401(k). Instead of spending untold billions on the compulsory, centrally planned system that's gasping for air, why not foster the thriving alternative that allows people to make their own decisions? A highly successful and well-liked program that pays significant benefits to employees, employers, and the economy as a whole should be encouraged and expanded -- even if nobody in Washington thought it up.¹⁶

Yet, America needn't rely on hypothetical situations or comparisons to similar plans to prove the worth of privatizing Social Security. In fact, countries throughout the world are in the process of privatizing their social security plans. Those that have completed the transition are currently reaping the benefits of privatization.

Even bastions of economic socialism such as Sweden and China are moving to privatized accounts. Hong Kong, Australia, India, South Korea, Panama, Japan, Greece, Denmark and numerous other countries spanning the globe all enjoy some level of private choice in their retirement systems.¹⁷ It would seem that America is well behind the learning curve in the global move to privatize defined-contribution retirement plans.

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Alas, the era of unlimited possibilities is over
and a day of reckoning is upon us. Our national
product is no longer growing at compound rates and the
Ponzi game is running out of players. One of America's
greatest challenges is to adapt to an aging society
before the game is up.

Richard D. Lamm and Hank Brown, Co-Directors,
Center for Public Policy & Contemporary Issues

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Perhaps the best example of a country successfully moving from a defined-benefit, pay-as-you-go system, to a system of defined-contribution, private accounts is Chile.

In 1980, Chile passed a law to replace the government-run, pay-as-you-go pension system with privately-managed savings accounts called Pension Savings Accounts (PSAs). The new system went into effect May 1, 1981.

After that day, all new employees entering the work force were required to participate in the new PSA system. Those who were currently participating in the old, government-run system when the law went into effect were given the choice of remaining in the old system until retirement and receiving a pension, or transferring to the new PSA system. Those who left the old system were given credits for the contributions they had made to the old system called "recognition bonds." Finally, current retirees receiving a pension were guaranteed their pensions.

Those who entered the new PSA system found it to be both simple and far more financially rewarding than the old system. Under the new system, payroll taxes on both the individual and the business were eliminated. Instead, throughout their working lives, employees have 10 percent of their salary deposited in their own, individual PSA. Furthermore, the individual may contribute an additional 10 percent of his salary (deductible from taxable income) to his PSA in the form of a voluntary contribution.

The system's creator, Chile's then-Minister of Labor and Social Security, Dr. Jose Pinera, was also careful to create a system that would mute critics' charges that the PSAs would be too complicated for average workers to manage. Under the system, a worker chooses from several private Pension Fund Administration companies (Administradoras de Fondos de Pensiones, or AFPs) to manage his PSA.

Pinera recently described how these AFPs operate while testifying before the Senate Committee on Banking, Housing and Urban Affairs' Subcommittee on Securities:

These companies can engage in no other activities and are subject to government regulation intended to guarantee a diversified and low-risk portfolio and to prevent theft or fraud.

Each AFP operates the equivalent of a mutual fund that invests in stocks and bonds. Investment decisions are made by the AFP. Government regulation sets only maximum percentage limits both for specific types of instruments and for the overall mix of the portfolio; and the spirit of the reform is that those regulations should be reduced constantly with the passage of time and as the AFP companies gain experience. There is no obligation whatsoever to invest in government or any other type of bonds. Legally, the AFP company and the mutual fund that it administers are two separate entities. Thus, should an AFP go under, the assets of the mutual fund -- that is, the workers' investments -- are not affected.¹⁸

Additionally, workers are permitted to move from one AFP to another, thus ensuring competition to provide higher returns, keep commission costs down, and provide superior customer service.

Pinera further testified to the ingenuity displayed by the AFPs to ensure their clients' PSAs are easily accessible and as simple to manage as possible. Additionally, significant effort is expended to ensure investment flexibility while allowing for oversight:

In the branch offices of many AFPs there are user-friendly computer terminals that permit the worker to calculate the expected value of his future pension, based on the money in his account, and the year in which he wishes to retire. Alternatively, the worker can specify the pension amount he hopes to receive and ask the computer how much he must deposit each month if he wants to retire at a given age. Once he gets the answer, he simply asks his employer to withdraw that new percentage from his salary. Of course, he can adjust that figure as time goes on, depending on the actual yield of his pension fund or the changes in the life expectancy of his age group. The bottom line is that a worker can determine his desired pension and retirement age in the same way one can order a tailor-made suit.¹⁹

Upon retiring, workers can choose from two different payout options. First, they may take their accumulated savings and purchase an annuity from any private life insurance company. This annuity would guarantee a monthly annuity payment -- indexed for inflation -- based upon the amount of their accumulated savings. Additionally, they provide survivor's benefits for the workers' dependents.

Alternatively, a worker could choose to leave his savings in the PSA and make programmed withdrawals that would be subject to limits based on the life expectancy of the retiree and his dependents. Upon his death, the remaining savings are considered a part of his estate.

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Privatization of Social Security in Chile led
to an increase in national saving from 10 percent in
1986 to nearly 29 percent in 1996. The higher growth
resulting from the higher saving and investment
increased government revenues, helping to finance the
transition from the old system to the new.

National Center for Policy Analysis

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According to Pinera, in both cases a worker is permitted to withdraw " . . . as a lump sum the capital in excess of that needed to obtain an annuity or programmed withdrawal equal to 70 percent of his last wages."²⁰ This excess could be used to buy a new house, pay for a grandchild's college, fund a fantasy vacation -- whatever the person wished.

Those who were unable to earn enough to ensure a retirement above the poverty level receive a subsidized pension from the Chilean government once their PSA has been depleted. In this way, a "social safety net" is maintained.

The benefit to the Chilean worker has been nearly immediate and far greater than anyone predicted. Since the system's inception in 1981, the average real return on investment has been 12 percent a year. This is three times higher than the previously anticipated yield of 4 percent a year.

In fact, Pinera points out that "Pensions in the new private system already are 50 to 100 percent higher -- depending on whether they are old-age, disability, or survivor pensions -- than they were in the pay-as-you-go system."²¹

Clearly, the success of Chile's system cannot be ignored or explained away. And yet, Americans are repeatedly told by politicians such as Bill Clinton that private savings accounts won't work in America. Americans, they are told, are not capable of managing their own retirement accounts.

Obviously, this is far from the case. Countries such as Chile have proven that private accounts do work.

Conclusion

America's current, pay-as-you-go retirement system cannot be maintained in its present form for much longer. It is on the verge of insolvency and was designed for an economy and set of demographics that no longer exist.

In short, Social Security's time has come and gone. It is now time to replace it with a system that answers the problems caused by the demographic changes in the past 60 years. A system that allows Americans to save and invest in their own retirement. A system that takes advantage of the opportunities that exist in the free market.

A historical examination of private investments has shown the vast economic benefit of investing in stocks and bonds instead of Treasury Bills. This examination has also dispelled the myth that private investments are too risky.

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To ensure that today's debt and spending commitments
do not unfairly burden America's children, the government
must act now. A bipartisan coalition of Congress, led by
the President, must resolve the long-term imbalance
between the government's entitlement promises and
the funds it will have available to pay for them.

Bipartisan Commission on Entitlement and Tax
Tax Reform Interim Report, August 1994

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The great number of Americans currently benefiting from a 401(k) plan proves wrong those who think the American public too ignorant to invest their own money. And the shining success of Chile's PSAs demonstrates that it can be done on a large scale.

All that is left is for our leaders in Washington to remove their blinders and have the political courage to determine what is truly best for tomorrow's retirees. The limited thinking that has led to years of status quo and minor adjustments must be abandoned in favor of the creative thinking that has saved other social security systems around the world.

The special interests who reject change solely for their own selfish interests and the elitists who doubt the abilities of hard-working Americans should be ignored; instead Washington should listen to the millions of taxpayers who want to be able to save for their retirement.

About the Author

Eric V. Schlecht is a Senior Legislative Analyst for National Taxpayers Union Foundation.

Endnotes

1 See Marc L. Kaplan and Salo L. Zelermyer, "Conflict and Interest: An Analysis of the President's Social Security Proposal," National Taxpayers Union Foundation, Policy Paper No. 109, March 26, 1999.

2 "Testimony of Jose Pinera, President of the International Center for Pension Reform, Co-Chairman of the Cato Project on Social Security Privatization, before the Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities," June 26, 1997. p.1.

3 U.S. General Accounting Office, "Social Security: Different Approaches for Addressing Program Solvency," Report HEHS-98-33, July 22, 1998.

4 Advisory Commission on Intergovernmental Relations, Significant Features of Fiscal Federalism (Volume 1) Budget Processes and Tax Systems, (September 1995).

5 Doug Bandow, "Want To Save Social Security? Privatize It." http://www.teleport.com/%7Eprf/ss/feb98/wt2-6.html.

6 NCPA Policy Report No. 217, July 1998. http://www.ncpa.org/~ncpa/studies/s217.html.

7 A. Haeworth, Robertson, Social Security: What Every Taxpayer Should Know (Washington: Retirement Policy Institute, 1992), p.72.

8 "Do I have a right to Social Security?" The Cato Project on Social Security Privatization, http://www.socialsecurity.org.

9 Neil Howe and Richard Jackson, Entitlements and the Aging of America, chart 5-5 (Alexandria, VA: National Taxpayers Union Foundation, 1998).

10 "Historical Data" Investor Home, http://www.investorhome.com/history.html.

11 NCPA Policy Report No. 217.

12 National Taxpayers Union Foundation, "Polls Point to Tax Cuts, Not Trust Fund Gimmicks," Capital Ideas, March/April 1999.

13 Peter J. Ferrara and Michael D. Tanner, Common Cents Common Dreams (Washington, D.C.: Cato Institute, 1998), pp.7-11.

14Washington Times, January 21, 1999, p.1.

15 Lee Harriss Roberts, "The 401(k) Boom," The Weekly Standard, March 1, 1999, pp. 14-15.

16 Ibid. Roberts notes that the formation of 401(k) plans was almost inadvertent. No government bureaucrats, Congressional staffers, or think tank came up with the idea and began promoting it. Instead, they arose from a obscure 1978 provision in the Internal Revenue Service Code that allowed workers to contribute bonuses and other awards on a pre-tax basis to retirement accounts. When, in 1981, the IRS ruled that pre-tax regular wages could also be contributed, the 401(k) took off. In fact, one could argue that the government stumbled into one of the most successful policy initiatives of the last 25 years.

17 Peter J. Ferrara and Merrill Matthews Jr., Private Alternatives To Social Security in Other Countries, National Center for Policy Analysis Policy Report No. 200, October 1995.

18 Testimony of Jose Pinera, before the Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities, June 26, 1997.

19 Ibid.

20 Ibid.

21 Ibid.