Social Security Advisory Council

Earlier this month President Clinton's Social Security Council made a startling recommendation: that individuals be allowed to put a portion of their payroll taxes into some kind of personal savings account like an Individual Retirement Account, with Social Security benefits being reduced accordingly.

Moreover, the group that made this recommendation is not some wild-eyed bunch of right-wingers, intent on destroying Franklin Delano Roosevelt's legacy. Rather, they are a thoroughly mainstream group of pension experts who, perhaps for the first time, took a sober, non-ideological look at the financial underpinnings of the Social Security system and were willing to say that the emperor is not wearing any clothes.

For decades the Social Security Administration has periodically convened advisory councils to review the operation of the Social Security system. These councils are usually composed of academics with expertise in the field of pensions and annuities. Until this year none has drawn any attention from the press and their reports were read only by specialists. But this year's advisory council report drew extraordinary attention, with several days of front page coverage in all of our nation's newspapers.

For the first time, an official body of the Social Security system dared to suggest that the system be privatized, at least in part.

The reality is that the Social Security system is sinking under its own weight. The level of benefits paid to past and current retirees simply cannot be sustained at anything close to existing tax rates. Tax rates would have to rise sharply for future employees just to keep the system going as is. An estimate published a few years ago predicted that future employees would have to pay 84 percent of their wage income in taxes to keep the entire federal entitlement system going.

Nevertheless, there was a group in the Council that argued that a little tinkering would keep the system going indefinitely. But these are the same people who told us that the 1977 and 1983 Social Security tax increases would also keep the system going indefinitely. If their head-in-the-sand approach is followed, we can safely predict that within a short time it will become apparent that it too will be inadequate.

These critics claim there is no imminent danger to the Social Security system that requires action today. The trust fund will have enough money to pay benefits until 2029, they say. While this may be true on paper, it overlooks a key fact: beginning in 2012 current Social Security tax revenues will no longer be adequate to pay current benefits.

This is the day of reckoning because there is, in fact, no Social Security trust fund to draw down. It is a fiction of accounting. All of the money supposedly invested in the fund has been spent, replaced by government IOUs, in the form of Treasury bonds. While these bonds can indeed be cashed in to pay benefits, the federal government will have to provide the cash needed to pay them off, which will require a sharp increase in federal income taxes.

So, we are left with a simple trade-off: higher taxes or lower benefits. Since any meaningful reduction in benefits for current retirees is politically impossible no matter how morally justified, the advisory council at least faced the fact that benefits for future retirees must be reduced. But the council gave future retirees an even better opportunity. By allowing them to invest their savings in the stock market, which historically has earned a higher return than the bond market, over a 40-year working life a worker can likely achieve a level of retirement income equivalent to or even better than that received by today's retirees.

In effect, Social Security will evolve the same way that private pensions have over the last 20 years. Defined benefit plans (like Social Security) have been systematically replaced by defined contribution plans (like 401(k)s). Even the federal government has gone this route with its own employees. Since 1983 new federal workers have had to save for their own retirement and no longer receive a fixed pension at retirement.

It is only right that Social Security move in the same direction.