The Trouble with Social Security Reform

The author says that the reform debate of Social Security has two opposing views, neither of which would actually reform the existing system.

The debate about Social Security reform has two sets of forces pulling in opposite directions. Some reforms would incorporate Social Security into the social safety net. Others would change Social Security into a personal savings account.

Ironically enough, neither change actually reforms the existing system. Both reforms rewrite the concept of the system. Today, Social Security is in theory old-age insurance without which the vast majority of Americans would be unable to retire without fear of outliving their assets. Social Security is not an anti-poverty program, nor is it a personal savings account.

Life expectancy creates an unmanageable uncertainty for people who want to retire because no one can ever know how much savings they will require. People may live for very long periods of time. Insurance spreads the risk of an extended life over a large population. Insurance mitigates the risk by injecting a small income stream over the retiree’s lifetime. Insurance is meant to augment savings, not replace it. It is an expense, not an investment.

What is lost in the Social Security reform debate is that when we change Social Security from old-age insurance we are giving-up something that is not readily available elsewhere. There is no private or public market old-age insurance for the vast majority of Americans. On the other hand, we have many government run programs in the social safety net. We have many privately run savings accounts, ranging from 401Ks to IRAs.

In terms of public policy, reformers should be required to explain why we should turn something that isn’t otherwise available to a wide range of Americans into something that we already have. Moreover, they should be able to explain why they believe that the new Social Security would provide these services better than the existing offerings.

In the case of privatization, this reform changes the concept of Social Security from insurance to a savings account. These are not the same thing. Insurance manages risk, old-age in the case of Social Security. Savings accumulates wealth. These retirement planning tools complement each other like bacon and eggs. Replacing Social Security in this mix with a personal account is like trading the eggs for sausage.

The focus of the debate about privatization should be whether savings by itself is better than a combination of insurance and savings. There is a significant difference in cost. With insurance, the system needs to allocate resources only for those who actually live to retirement. With savings, the system needs to force society to allocate enough resources for the retirement of every individual.

Separately, someone needs to explain why a new Social Security would do a better job than a tax subsidized alternatives like 401Ks and IRA. Specifically, how can a new Social Security outperform accounts that enjoy a tax subsidy?

In response, many would argue that Social Security is a terribly over-priced insurance. It is. Younger workers expect to contribute more than they expect to collect. It is a terrible way to prepare for retirement. It is spending a quarter to buy a dime. And yes if you put your contributions into a private account you would have more money in retirement than Social Security provides.

Beware. When these supporters say that younger workers would be better off putting their money into a private account, it is true, but it is a half truth. When someone says that a private account will do better than Social Security, it is a comparison of a private account without legacy costs to Social Security with legacy costs. It is a race where one contestant is wearing lead boots.

Legacy costs are the benefits promised to people who have contributed to the system over the years. These benefits need to be paid over decades. Unfortunately, once payroll taxes go into a personal account, Social Security will not have any resources with which to pay those costs.

This is where the half-truth becomes a whole lie. Reformers hide the fact that their plans shift the legacy costs from payroll taxes to higher income taxes. Here is the problem with privatization. The only way that younger workers are better off is to the extent that the system reneges on promises to pay legacy costs.

Virtually all versions of Social Security reform change Social Security in a way that it is less able to do what it needs to do. Social Security is the only way that most Americans can manage the uncertainty of life expectancy. Giving up what we can’t get elsewhere for what is relatively easy to find, does not make sense.

About the Author

Brenton Smith (A.K.A. Joe The Economist) writes nationally on the issue of Social Security reform with work appearing in Forbes, FedSmith.com, MarketWatch, TheHill.com, and regional media like The Denver Post.