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Social Security Reform and Privatization

Updated on May 12, 2013

Social Security is the single largest expenditure of the federal budget, which makes it the number one priority for federal budget reform.  At over $708 billion per year, Social Security payments account for over 20 percent of the federal budget.  Before discussing reform, I think it is important to understand the current system and why it is insolvent.

Background

Social Security was initially signed into law in 1935 by Franklin D. Roosevelt as part of his New Deal plan.  This was seen as a way to combat poverty, as over 50% of the retired population lived in poverty.  The program initially withheld 1% of wages, and paid out retirement income beginning at age 65.  As time has passed, more provisions have been added to the bill which increased contributions, but at the same time increased benefits to a greater degree.

The expansion of benefits has been a great contributor to social security insolvency.  During the 1950’s and 60’s, social security ran huge surpluses, so it was popular to expand benefits.  Not surprisingly, most benefit expansions took place in election years. 

Another great contributor to social security insolvency has been the increase in life expectancy.  In 1935, when social security retirement age was 65, the average life expectancy was 63….meaning that the average person would not live long enough to collect.  Today, with social security retirement at age 67, average life expectancy is 78 years old.  Had the surpluses of the 1950’s and 60’s been invested, we may have been able to “weather the storm” of the increase life expectancy; however that did not happen.

One of the greatest problems of surplus social security funds is that politicians can’t seem to keep their hands off of the money.  Every administration since (and possibly before) Carter has done it, with the exception of President Obama (but let’s be honest, since social security is no longer running a surplus, he can’t raid the trust fund).  During the Clinton administration, it was claimed that there was a budget surplus….but we still increased the federal deficit.  Where do you think the budget surplus came from?  If you guessed social security trust fund, you guessed right.

 Now, some may argue that the trust fund is filled with treasury bonds and has plenty of money left.  Let me make this clear: A treasury bond is an IOU issued by the US government.  Claiming that there is money in the social security trust fund is like trying to claim your car payment as income. 

Reform

For long term solvency, the only option is to privatize the system, essentially creating a 401k-type private retirement account for every working American.  This has been done with great success in other countries, most notably Chile.  Unlike true 401k’s, this system would need to be highly regulated.  While I am normally not in favor of government regulation, this is one place I make an exception.  As sorry as I am to say it, most Americans are financially illiterate, and would not make good investment choices.  So, this is one place where I think government regulation is a necessary evil for the good of the American people.

Before I go any further, let me make one thing perfectly clear:  this new system would not have any effect on those who are already retired, or who are about to retire, as they are too advanced in years to adapt to the new system.  So, I would suggest that those who are 50 and above will remain in the current system.  Those who are 35-49 would be in a “hybrid class”, where they receive a reduced social security benefit, as well as draw from a private retirement account.  Those who are 34 and under will only be in the new system.  As time goes on, there will be fewer and fewer people in the old social security system, until it essentially ceases to exist.

Some people may be unwilling to put their social security funds into a 401k type plan, as they believe it is risky.  Look at the employees of Enron, or what happened to many people when the stock market crashed.  However, this is why these individual retirement accounts will need to be regulated.  In the case of Enron employees, the 401ks were invested in Enron stock; as a result, when the company went belly up, so did the 401ks.  And in the case of people who lost huge sums of retirement money in the stock market crash, you will find that these people were heavily invest in stocks (or stock-heavy mutual funds), which increased risk.  Properly managed, risk can be minimized in the individual retirement accounts.

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Individuals would be free to choose what investment company to have their accounts with, and could switch companies as they wished. The investment company would be required to invest a diversified portfolio to reduce risk. In addition, the investment company would be required to provide a minimum return on investment of 5%; any less, and the company must make up the difference. 

Upon reaching retirement, the individual would have 2 options.  The first would be to use all or part of the retirement account to purchase an annuity that would provide a reasonable standard of living throughout retirement years.  The remaining value of the account could be withdrawn as the individual sees fit.  The second option would be a no-annuity option.  However, in this case, the individual would have a maximum amount that could be withdrawn each year, thus providing for income throughout the retirement years.

As far as contributions go, individuals would be required to contribute a minimum of 5% of their salary, with the option of contributing more.  Employer contribution (currently 6.2%) would be split in half; one half going toward the employee account and half going into the current system to continue to fund it as it is phased out.  Eventually, the employer contribution to social security could be used to create a disability fund, which I will discuss next.

Disability

Detractors to a privatized system may point to disability payments as a disadvantage to the private system, as a person who becomes disabled may not have been in the workforce long enough to build up a substantial sum to retire.  First of all, I would suggest a program to assist in the retraining of someone who has become disabled.  In a majority of the disability cases that I have seen, it would not be difficult to retrain an individual for a job where the disability is not an issue.  If retraining is not possible, then the individual’s account could be supplemented by additional government subsidies, funded by the employer contribution to social security.

Inheritance Benefit

One of the greatest benefits to families would be inheritance.  Upon the death of the retirement account owner, the remaining balance would be inherited by the individual’s beneficiary.  This would be a huge benefit to low and middle income families, where the inheritance rate is less than 10%.  This might also function as a motivation to save more….knowing that one’s children will inherit whatever you have left.

Conclusion

To me, it is clear that privatization is the only way to save social security.  Individual retirement accounts would free retirees from dependence on the federal government, as well as give them the opportunity to pass something on to their children.  We need to make this change now, as the longer we wait, the harder it will be to adapt to the changes. 

Social Security Privatization, Part 1

Social Security Privatization, Part 2

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