EVENTS

Date:	Tuesday, March 29, 2005
Time:	12:00 PM -- 2:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

March 2005

A New Approach to Personal Social Security Accounts

 This summary is available here in Adobe Acrobat PDF format.

Personal Social Security accounts would transform Social Security, at least in part, from a program of income transfers from workers to retirees to one of genuine savings and personal property. Current proposals, however, have generated several concerns and objections. To many people the accounts seem complicated, risky, and unfamiliar. And because the personal accounts would be funded by diverting payroll taxes away from the U.S. Treasury, some have asserted that they would aggravate, rather than alleviate, the government's deficit problems. At a March 29 AEI conference, experts considered a new approach to Social Security reform proposed by AEI resident fellow Alex J. Pollock. Under this approach, personal accounts would be established with government bonds issued directly to individuals rather than, as at present, to the Social Security Trust Fund (an internal government account). Tax revenues would not be diverted from the Treasury, but the Treasury's Social Security debt would become real assets owned by citizens. Personal Social Security accounts of this form would have all of the economic and social benefits of those in the current proposals--but would have a simple financial structure and low-cost operations and would not impose financial risks on households.
 
Alex J. Pollock
AEI

Linking ownership of property to liberty in a free society is deeply embedded in the American political philosophy, going back to the ideas of John Locke and the Founding Fathers. Personal Social Security accounts as vehicles for the expansion of ownership are therefore very much in keeping with American tradition. With the aim of continuing to expand ownership of financial assets in America, policymakers should seek to make such accounts a reality.

Along with the philosophical underpinnings of personal accounts are significant financial considerations. Finance includes the following three components: cash, which is the underlying reality; financial instruments, which distribute contract rights and risks among instrument holders; and accounting, which is an abstract representation of cash and financial instrument holdings.

In the discussions of personal accounts, all proposals so far have begun with diverting cash from Social Security taxes, resulting in a diminution in receipts by the Treasury Department. The Treasury Department would then have to make up the shortfall by selling more debt, perhaps to international investors, which might pressure the bond market and the dollar.

From an individual’s point of view, having a personal account starting with cash raises several issues as well. How to invest the cash balance is a potentially intimidating proposition, as it forces individuals to make investment decisions that pose risks. Some have also argued that a system of personal accounts might diminish the government’s obligation to the Social Security program, which they see as an inviolable social contract. Expressed as a percentage of funds employed, the cost of administering such accounts is potentially high, and some worry about creating a windfall for Wall Street. The confluence of these complications has led the administration to suggest postponing implementation of personal accounts until 2009.

Currently, the mandatory savings function of the Social Security system works as follows: Social Security taxes are collected by the Internal Revenue Service and deposited in the general fund at the Treasury Department, where they are spent on benefits but also on other federal programs. All the cash is spent; nothing is saved. Upon receipt of borrowed or “invested” Social Security funds, the Treasury issues bonds to the Social Security Trust Fund. The bonds simply represent Treasury liabilities held indirectly for the public.

I suggest creating personal accounts without diverting any cash from payroll taxes. This could be done by changing the current structure in one key respect: the Treasury could issue bonds directly to personal accounts, bypassing the Social Security Trust Fund. This would create a personal account by putting a financial instrument in it, not cash. The trust fund is an unnecessary “middle man” between the citizens and the U.S. Treasury. Cutting out this middle man makes the relationship much clearer and more honest.

There are perfect Treasury bonds for these accounts: Treasury Inflation Protected Securities (TIPS). Inflation poses the largest threat to retirement savings, and these default-free instruments fully protect against that threat, thereby minimizing risk.
 
This should be a purely voluntary program; individuals could elect to remain in the current program or receive TIPS in their personal accounts instead of future benefit payments of equal economic value. After a certain restricted period, individuals could choose to reinvest their assets in other financial instruments, taking on more risk if they see fit. Ownership through personal accounts would also allow for account holders to bequeath their assets to future generations.

What about the trust fund? First, if the bonds in the trust fund are meaningful, think how much more meaningful they would be in a personal account. Second, if the trust fund is not economically meaningful, one should not mind its long-run disappearance. Third, if the significance of the trust fund is only the legal ability to pay benefits under the law, the adoption of reform will require changing the law in any case.

This proposal would result in greater and more widely distributed ownership of financial assets among American households. It would provide assets with very low risk and with the ability to pass them on to future generations, while establishing, for those who worry about the government’s obligation, a more understandable financial relationship between government and citizens. Treasury securities are much more inviolable contracts than are off-balance sheet future political promises.

Given the chance, the majority of Americans would prefer to accumulate assets they actually own. They should be given this choice.

Allan H. Meltzer
AEI

Alex’s proposal is simple, understandable, and effective. Why not make the entire Social Security account private? Why do we need the government as an intermediary in the savings system? Government can do nothing as to the maintenance of the system; it can only deal with redistributing the costs of the system and perhaps run it less expensively than others. It is mostly concerned with redistribution. Those who oppose personal accounts do not want to let go of the money because they want to have something to say about how it gets redistributed. They seem to believe that the current Social Security system provides more redistribution than would private accounts. This conclusion is false as statistically the poor do not live as long as the wealthy and therefore have less time to collect their annuitized benefits. The AARP is the voice of monopolists who want to keep this problem bottled up in the administration.

Promoting private accounts is difficult because much of the public believes they already have personal accounts into which their Social Security taxes are diverted. There must be a significant educational push to show people that this is not the case.

The problem of whether Social Security benefits are indexed to wages or prices must be addressed as well. If we index to prices, inflation will not change the real value of what you have saved. If we index to wages, older generations will benefit from productivity growth to which they did not contribute. While indexing to wages has political appeal in terms of providing a wage-replacement rate, it fails to answer where the money comes from.

A remarkable part of the discussion on the administration’s proposals to reform Social Security has been the reaction to the claim that this system is in a crisis. With a looming fiscal imbalance of nearly $70 trillion, it is unfortunate that the president’s proposals only fix the smaller part of the problem, not Medicare, which comprises a larger share of the shortfall. Those who do not believe this is a crisis need to consider the politics of Congress and its ability to fix the problems.

Alex’s plan is simple: it advocates getting rid of the trust fund and putting the same bonds into personal accounts. Beyond this step, there should be some discussion about what kind of bonds should be deposited and how long citizens must wait to diversify their account. One important characteristic of the proposal is that this system is voluntary, and the accounts can be inherited. It is important to note that those who elect to have private accounts funded by TIPS do not see very much in the way of returns on their bonds--TIPS are likely to pay only 2 or 2.5 percent over inflation. But they certainly receive more than people would likely collect under the current Social Security system. As to risk, there is a bit of risk even with the TIPS; the prices fluctuate up and down, though the fluctuations are not significant.

None of the examples of similar systems of personal accounts around the world seem to be failing in the manner that some members of Congress and the AARP claim. In fact, a critical question to ask is why voluntary private accounts are good enough for other countries and for members of Congress but not good enough for the American public.

Rudolph G. Penner
Urban Institute

Alex’s plan distributes TIPS to the public, which affects the unified federal budget by increasing the amount of publicly held debt. This has to be reflected by an increase in the unified federal budget deficit, an aspect that would be frowned upon by the many deficit hawks in Congress. All plans of this type offset the short-term increase in debt by promising to reduce the future obligations paid by the system in the future. Skeptics worry about politicians of the future being no braver than the politicians of today, and not carrying out the future benefit cuts. There has to be some worry that funding for private accounts will be offset by benefit cuts or tax increases in the future, when instead the cost of private accounts should be paid up front.

Although the amount of assets held by the trust fund is a bookkeeping entry, a kind of accident of history, it is far from sufficient to pay promised benefits. These assets represent claims on resources that are legally dedicated to the Social Security system, and if not as many of those assets accumulate as expected by the system’s trustees, the whole thing will go bust before the current go-broke date of 2041. This is really a legal and political issue, not an accounting one. It depends on the revenue and borrowing ability of the United States. To the liberal defenders of the current system, the dedicated assets represent a political and perhaps moral commitment to the system. Therefore defenders of the system oppose any plan that would reduce those resources.

An interesting question Alex’s plan raises is how much risk taking is appropriate for the individual accounts. Alex’s plan would restrict the accounts to very low risk TIPS in the short term. The president’s plan addresses risk by limiting investment to broad-based stocks and bonds. President Bush also creates a default investment and also has a “life cycle fund” that would reduce risk as the holder ages. The main guarantee of the president’s plan is that a large traditional system would still remain. I do not like how the president’s plan calculates the amount of traditional benefits one receives based not on how much one earns in his or her account, but on the contributions to the account. Essentially the president’s plan regards the diversion of payroll taxes as a loan to the individual, who is then expected to pay back the loan at the time of retirement at a 3-percent real rate of interest. That is a heft rate of interest, and very probably above the rate of return that one would earn on purely riskless assets.

The main question is whether to allow the accounts to contain any risk. The accounts should be allowed to exploit the risk premium in a way similar to what the president has proposed, in a few broad-based investments, without however, providing any guarantee to the rate of return.

It would be wrong to talk about the current system as completely risk free. Most importantly, benefit changes are inevitable in the future; the longer we wait, the bigger they are going to be. This poses a large element of risk. In addition, a person’s replacement rate depends on a whole host of variables: exact income profile, when one earned the wages, the income of a spouse, the rate of wage increases, among others. The fact that the current system contains this risk makes me think it is acceptable for individual accounts to contain quite a bit of risk as well.

AEI research assistant Gordon Gray and AEI intern Michael Wilson prepared this summary.