Thursday, December 23, 2004

Dealing Dirt to Retirees....

December 23, 2004
The Bottom Line on Overhauling Social Security

HOW can Americans be anything but confused by the complex debate over the privatization of Social Security? Investing part of the payroll taxes we pay in stocks and bonds to produce a personal nest egg is alluring. But until there is a detailed plan to analyze, we cannot know the true consequences.

At last week's economic summit meeting, the Bush administration began to give clues as to its plan. The administration appears to be leaning toward the Reform Model 2 proposed in December 2001 by its Commission to Strengthen Social Security, which was under the direction of former Senator Daniel Patrick Moynihan and Richard D. Parsons, the chief executive of Time Warner.

The plan is disheartening. Based on an analysis done by the Social Security Administration and the Congressional Budget Office, it will result in significant benefit reductions from the levels promised under the present system.

But is this still better than the present system, which as baby boomers retire may not be able to meet all its future promises? Here is the heart of the matter. Even if benefits must be reduced under the current system, many retirees will still do better than they would in a privatized system. Or so an analysis of Reform Model 2 suggests.

The Bush privatization plan coming into view would work as follows. Workers now pay to Social Security 6.25 percent of their wages up to $87,900, matched equally by their employer. Workers would be allowed to divert four percentage points, up to a maximum of $1,000 a year, to private investments in stocks and bonds. The investment accounts would be limited to highly diversified mutual funds, or even index funds, and the transactions costs would be kept to a minimal 0.3 percent.

So far so good.

But to make sure there is enough incoming payroll tax to support promised benefits, Social Security benefits guaranteed under the present system would be cut slightly for each dollar the individual worker diverts to his or her private accounts. More important, future benefits would also be cut by indexing them to the rise in consumer prices rather than, as is now done, to rising wages, which tend, over time, to outpace inflation by a significant margin.

Indexing to prices may look sensible to Americans, but the reduction in future benefits from the present plan is likely to be severe. By 2075, under the most commonly accepted economic assumptions, indexing benefits to prices rather than wages would mean that benefits would be nearly 50 percent lower than under the current system. Many privatization plans call for such an adjustment.

Will the magic of private investment accounts make up for the reductions? The answer is no. We can compute how retirees fare if they earned the historical average of 4.6 percent a year (after transaction costs) on a portfolio of stocks and bonds. William Dudley, chief economist of Goldman Sachs, has calculated that benefits for a typical retired one-earner family would come to about 93 percent of the projected benefits from the present Social Security system in 2022. In 2075, the benefits would fall to only 77 percent of present-system benefits.

So Americans who think privatization will necessarily preserve their retirement incomes should think again. Most privatization plans involve a decided cut in average benefits.

Still, advocates of privatization correctly point out, these cuts may be less over time than the cuts required to make the present system solvent. Based on the Social Security Administration projections, monthly benefits may have to be reduced to around 67 percent to 75 percent of projected levels.

But by no means is everyone going to earn the 4.6 percent average. The history of private investment unmistakably shows that there is a wide dispersion of results. Some will invest only in bonds, others may choose the wrong mutual fund, or switch from one to another at exactly the wrong times. And some will have the bad luck of retiring in the midst of a bear market. Many workers will therefore inevitably earn less, and some considerably less.

To determine how sensitive retirement income is to the rate of investment return, Mr. Dudley worked out some calculations under Reform Model 2. The results are stunning.

If a worker earns just the respectable expected bond rate of 3 percent a year, or 2.7 percent after transactions costs, then the typical one-earner family will retire on only about 58 percent of the projected benefits under current law. If the investor earns zero over time, which may well occur for some investors, the projected retirement benefit is only a little more than 38 percent of the current benefit. These are considerably worse than the projected adjustments needed to bring the present system into balance.

And there are other costs to privatization. Consider the potential impact from borrowing as much as $2 trillion, which many experts see as the projected transition costs to cover the gap that would arise in payments to current retirees and those retiring soon once workers started diverting into private accounts some of the payroll taxes used to pay benefits. Financial markets may not absorb that debt without interest rates rising and the dollar falling.

As the privatization arguments are clarified, the ultimate decision Americans will have to make is over the purpose of the public pension system. Social Security was originally intended to guarantee a minimum retirement income for workers. For all the alarm over Social Security, the present guaranteed system can be fixed with only moderate tax increases and through less harsh benefit reductions, particularly if Americans are prepared to raise the official retirement age slightly to reflect generally longer life spans.

The privatization plan the Bush administration is leaning toward, in contrast, will divide people into winners and losers. It may make some workers better off in retirement, and may well reduce costs somewhat to government, if all goes well. But a significant number of American retirees will do poorly.

Jeff Madrick is the editor of Challenge Magazine, and he teaches at Cooper Union and New School University. His most recent book is "Why Economies Grow" (Basic Books/Century Foundation). E-mail:

Copyright 2004 The New York Times Company


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