Managing the Transition to Private Investment

The major political challenge to effective Social Security reform involves managing the transition costs from a 100-percent government-funded system to some form of privatized investment. Critics argue that the reduced payroll taxes coming from workers who elect to start managing their funds privately would cause a shortfall to the Social Security trust fund that pays benefits to current retirees and those workers who do not opt out of the system. How could this shortfall be made up?

Studies conducted by the Cato Institute and other researchers have shown how transition costs to a privatized pension system can be managed. Partial privatization would allow workers to either shift a portion of the money they normally pay in Social Security taxes into a privately managed and owned account or remain in the Social Security program. In the first year of partial privatization, an estimated 50 percent of workers would elect to opt out of Social Security in favor of privatized accounts. The following year the number would increase to 75 percent and finally reach 90 percent in the third year. In less than 15 years, Social Security would begin enjoying surpluses and within 40 years, $770 billion surpluses would be created per year (Table 2 is not available in the online study. Please order the study for full content).

A variety of proposals have been made that outline how to finance the transition costs which arise when people start withdrawing a portion of their payroll taxes from Social Security and investing it in private accounts. Most of these proposals require the employer portion of the payroll taxes to continue to be paid into Social Security until the transition costs are fully paid in 20 to 30 years. As Table 2 shows, additional funds would come from expected government surpluses and sale of government bonds and assets. The exact proportion of each source of transition financing will depend on economic conditions such as growth rates, interest rates, and feasibility of asset sales.

The speed with which the United States could expect to move into a totally privatized retirement program is ultimately dependent on both economic and political factors. The advantages of partial privatization include first building public acceptance and confidence through demonstrated results and care for current beneficiaries. The experience of other countries that have already instituted privatized pensions has been that over 90 percent of the workers convert to the private program within just three to five years.

Government’s ability to raid the Social Security trust fund would be lost once the country made the switch to privatized accounts, resulting in improved fiscal discipline and a sounder economic footing for retirees. The increased saving and investment would also fuel a new boom in economic growth.