Social Security is going broke. The federal government’s largest spending program, accounting for nearly 22% of all federal spending, faces irresistible demographic and fiscal pressures that threaten the future retirement security of today’s young workers. Only by moving to a system of privately invested, individually owned accounts can a system of secure retirement be preserved.

According to the 1997 report of the Social Security system’s Board of Trustees, in 2012, less than 15 years from now, the Social Security system will begin to run a deficit. That is, it will begin to spend more on benefits than it brings in through taxes. Anyone who has ever run a business—or balanced a checkbook—understands that when you are spending more than you bring in, something has to give. You need to either start earning more money or else spend less to keep things balanced. For Social Security, that means either higher taxes, lower benefits, or both.

In theory, Social Security is supposed to continue paying benefits after 2012 by drawing on the Social Security Trust Fund. This trust fund is supposed to provide enough money to guarantee benefits until 2029, when it will be exhausted. But one of Washington’s dirty little secrets is that there really is no trust fund. The government spent that money long ago to finance general spending and hide the true size of the federal budget deficit. The Trust Fund now consists only of IOUs in the form of bonds—promises that at some time in the future the government will replace that money, which can only be done through collecting more taxes.

Even if Congress can find a way to redeem the bonds, the Trust Fund surplus will be completely exhausted by 2029. At that point, Social Security will have to rely solely on revenue from the payroll tax. But such revenues will not be sufficient to pay all promised benefits. Either payroll taxes will have to be increased to as much as 28%, more than double today’s 12% rate, or benefits will have to be reduced by as much as one-third. (If taxes needed to fund Medicare are included, the total FICA payroll tax may have to be increased from today’s 15.3% to as much as 40%.)

Social Security’s financing problems are a result of its fundamentally flawed design which is comparable to the type of pyramid scheme that is illegal in all 50 states. Today’s benefits to the old are paid by today’s taxes from the young. Tomorrow’s benefits to today’s young are to be paid by tomorrow’s taxes from tomorrow’s young.

Because the average recipient takes out more from the system than he or she paid in, Social Security works as long as there is an ever larger pool of workers paying into the system compared to beneficiaries taking out of the system. However, exactly the opposite is the case.

Life expectancy is increasing while birth rates are declining. As recently as 1950, there were 16 workers for every Social Security beneficiary. Today there are only 3.3. By 2025 there will be fewer than two. The Social Security pyramid is unsustainable.

 

Privatizing Social Security

There is a better alternative. Social Security could be privatized, allowing people the freedom to invest their Social Security taxes in financial assets such as stocks and bonds. A privatized Social Security system would be essentially a mandatory savings program. The 10.52% payroll tax that is the combined employer-employee contribution to the Old-Age and Survivors Insurance (OASI) portion of the Social Security program would be redirected toward a Personal Security Account (PSA) chosen by the individual employee.

PSAs would operate much like current Individual Retirement Accounts (IRAs). Individuals could not withdraw funds from their PSAs prior to retirement, determined either by age or PSA balance requirements. PSA funds would be the property of the individual and, upon death, remaining funds would become part of the individual’s estate.


Social Security’s financing problems are a result of its fundamentally flawed design which is comparable to the type of pyramid scheme that is illegal in all 50 states.


PSAs would be managed by the private investment industry in the same way that 401(k) plans or IRAs are. Individuals would be free to choose the fund manager that best met their needs and could change managers whenever they wished.

Given historic rates of return from the capital markets, even minimum wage earners would receive more than what current workers will get from Social Security. Therefore, in the absence of a major financial collapse, the current Social Security safety net would be required for relatively few people, aside from the disabled and others outside the workforce.

 

The Chilean Example

The idea of privatizing a public pension system is neither new nor untried. Where privatization has been properly implemented it has been remarkably successful. One of the best examples is the experience of Chile.

Chile’s social security system predated ours, having started in 1926. By the late 1970s its benefit payments were greater than its taxes and it had no funded reserves. On the advice of Nobel laureate Milton Friedman and other free-market economists, Chile decided to privatize its system.

The success of Chile’s public pension privatization can be measured in many ways. Chile’s private savings rate is 26% of GDP, compared with 4% in the United States. The infusion of capital into the private sector has contributed in large part to Chile’s phenomenal 7% annual economic growth rate over the past 10 years—a rate that is double ours.

But most importantly, beneficiaries are receiving much greater benefits. Since the privatized system became fully operational on May 1, 1981, the average rate of return on investment has been more than 12% per year. As a result, the typical retiree is receiving a benefit equal to nearly 80% of his average annual income over the last ten years of his working life, or almost double what U.S. retirees are receiving from Social Security after they retire.

 

A Texas Example

A loophole in the Social Security law once allowed states and municipalities to exempt their government employees from the Social Security system. In 1981, three Texas counties opted out of the federal system and created their own private retirement program. Under the private plan, employees paid the same amount of taxes, but instead of being funneled to Washington D.C., it went to a private insurance company that had competed for the right to invest that money (while guaranteeing a rate of return). To date, the private system has outperformed its federal counterpart. Some years have shown returns on investment of 12%, as opposed to an average of 2.2% under Social Security for a worker born in 1950.

 

What Michigan Can Do

In 1997, Oregon became the first state to pass a resolution asking that it be allowed to design a privatized alternative to Social Security for workers living in that state. Oregon based its request to opt out of Social Security on waivers that it has received to design its own welfare and Medicaid programs. Michigan could do the same. The American Legislative Exchange Council (a nonprofit legislative organization) has adopted the Oregon resolution as model state legislation.

Social Security privatization is an idea whose time has come. For our children’s sake, it could not possibly have come too soon.

Editor’s Note: How does Social Security compare to what you could earn from private investment? You can check it out for yourself at www.socialsecurity.org. This Web site contains an interactive calculator which allows you to compare future Social Security benefits to what you could receive through a privately invested system.