The Risks of Privatizing Social Security

The author says that the notion of privatizing Social Security will not improve the financial prospects of the program.

“Politics is the art of postponing decisions until they are no longer relevant.”

After three years of researching Social Security, I have finally reached the conclusion that privatizing any or all parts of Social Security will not improve the financial prospects of the system as promised by its many proponents. Privatization has fallen victim to the art of politics. It is no longer relevant.

I am completely unpersuaded by the traditional objections to the privatization of Social Security. On the contrary, my concerns deal with whether the change is sound policy. Moreover, I simply don’t believe that it is affordable anymore because of the structural changes to the system which have occurred over the last 10 years.

Privatization does not reform Social Security. Privatization changes the role that Social Security plays in our lives. Privatization would transform Social Security from conceptually old-age insurance to a system of forced savings. These are very different things.

In terms of policy, I do not see the point of changing Social Security from insurance which I can’t buy in the private market to a personal savings account which I already have in abundance. The only proxy in the private market for Social Security is an annuity which is generally expensive to buy.  On the other hand, I have an IRA, ROTH/IRA, 401K, and a SEP.  I do not understand the reasoning behind making Social Security into another flavor of the alphabet soup of retirement planning.

The sell-side of this idea will tell you that not everyone has prepared for retirement.  Ironically enough, this reasoning is an argument for insurance rather than savings.  Savings must cover how long you might live, where as insurance only needs to cover how long you actually do live. (A longer discussion of insurance vs savings is found here.)

The sell-side of this idea will tell you that it is possible to make more money in the stock market than in Social Security. While it is true, the comparison is not honest. Social Security carries legacy costs which cause the poor return. The market does not reflect this financing burden. So the comparison is only valid if the costs of the past go away – they don’t.

What are legacy costs? They are the benefits of existing retirees which are fulfilled with current payroll taxes. If we redirect the payroll taxes of workers from Social Security to private accounts, how will you pay the existing benefits?  Privatization in general replaces the money with subsidies from the General Fund.  In other words, privatization changes the pocket which pays for Social Security.

The consequence of this strategy is clear: higher income taxes or cuts to other government services.  Your income taxes must increase directly proportionally with whatever payroll taxes that go to private accounts because most of the plans that offer an element of personal ownership come with a clause to protect the existing retirees. Since existing payroll taxes will not fully cover the cost of these benefits, the increase in Social Security income taxes will be higher than the Social Security payroll taxes put into your personal account.  Basically your private account is great, but it is likely that the entire balance will be lost to higher Social Security income taxes.

When the sell-side of this idea tells you that the SSA has said that privatization will make Social Security solvent, it is not completely honest.  Generally they point to studies from 2005.  In a different example, JustFacts.Org says, “As evidenced by analyses conducted by the chief actuary of the Social Security Administration and a bipartisan presidential commission, proposals to give Social Security an element of personal ownership are generally structured to strengthen the program’s finances.” The evidence is a proposal scoring completed by the chief actuary in 2008.  The proposal contained a 4.1 trillion dollar subsidy from the General Fund.  If I hand you 4.1 trillion dollars, yes it will strengthen your financial position.

There are two major structural shifts in Social Security that are generally ignored by the sell-side.  First, the imbalances of the system are growing rapidly.  The 2008 study was based on data from year-end 2006.  The short-term financing gap has doubled since that time.  Second, the system stopped generating excess cash in 2010.  So there is no excess cash in the system to invest.

Research from 2005 is at best irrelevant.  According to the Academy of Actuaries, the cost to privatize Social Security is reasonably considered to be roughly $10 trillion, more than double the cost projected in the research from 2008.  The phrase in football is throw where the receiver will be.  The sell-side on this policy is crafting the play around where the receiver was 5 plays ago.

The second shift in the dynamics of Social Security is a little more serious.  In 2005, Social Security created excess cash which was subsequently invested in government securities.  At the time, it was possible to create economic value by investing the excess cash in more productive ventures.  It wasn’t a lot of money, but at least it was real. Today, the system collects less in payroll taxes than it expends in benefits.  Any money that is pulled away from Social Security for more productive ventures, will be offset dollar for dollar with increases in government borrowing from the public markets.  It is a complete wash.

Finally there is the problem that no one discusses: adverse selection. In terms of Social Security and privatization it means that the first people to leave Social Security for a personal account will be the system’s most profitable participants.  In the case of Social Security, the most likely candidate to leave is the single high-wage worker. If this selection process occurs, a transition from Social Security to private accounts will not make Social Security more financially sound.  It will set the stage for an implosion.

This idea may have had some merit 20 years ago, but today it seems to be a questionable policy decision that we can’t afford.  What does the younger American, for example our kids who have no vote in this matter, get for $10 trillion dollars.  They get the privilege to save for their own retirement.

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,, MarketWatch,, and regional media like The Denver Post.