A Proposal for Social Security

President Bush’s Commission to Strengthen Social Security confirmed what thoughtful analysts have known for years: Without substantial reforms, Social Security will not be able to pay the benefits promised to U.S. citizens — at least not without a substantial increase in Social Security taxes, which, of course, would hinder the ability of U.S. businesses and industries to compete.

To close the growing funding gap created by the declining ratio of workers to retirees, the CSSS has proposed three solutions, each of which would enable participants to transfer a portion of their Social Security contributions toindividual mutual fund accounts that invest in both stocks and bonds. While, over the long run, this would produce more revenue than the current practice of investing in government bonds, in our opinion, the high costs involved in this approach would substantially reduce future benefits and would not relieve the government of the enormous cost of transitioning from a pay-as-you-go system to a funded system. This would also put pressure on businesses, especially small businesses, to expend resources directing and managing relationships with financial institutions.

Critically, the CSSS’s proposals would also abrogate Social Security’s most valuable feature — government-guaranteed retirement benefits (or “defined benefits”). Contributions would still be government-mandated, but benefits would be uncertain — dictated by the market value of one’s portfolio at the time of retirement.

We propose an alternative approach that would be a far more effective and fiscally prudent way to maintain current benefit levels and stable contribution rates. Our system, termed “risk diversification through a common portfolio,” would differ from the CSSS proposals in two fundamental ways.

First, it would replace personal accounts with one common account that would invest its assets in a highly diversified indexed portfolio of stocks and corporate bonds. It is clearly inefficient to incur the costs associated with maintaining millions of accounts — thereby transferring wealth from employees and employers to the financial services industry — when, on average, those individual accounts can do no better than the return on one common account. To counter the objection that the resources accumulated and managed by Social Security would become very large and thus create the potential for political manipulation, we propose requiring that a blue-ribbon board supervise the investment portfolio, as has been successfully done in Canada and Ireland.

Second, and more important, our plan would preserve defined benefits. To accomplish this, the U.S. Treasury and the Social Security Administration would enter into a swap agreement, under which the Treasury would pay the SSA a guaranteed rate of return in exchange for the variable return from the market portfolio. The Treasury would assume the risk of investment — a risk it can bear because of its ability to average returns over a long horizon. In this way, all participants in the Social Security system would be guaranteed an identical safe rate of return instead of the capricious return of individual accounts. Any divergence of assets to unproductive investments would cause the government to pay Social Security more through the swap arrangement, acting as a further check on political manipulation.

Our approach would also preserve Social Security’s current progressive benefit structure, which protects poorer citizens from becoming destitute. It is often argued that the higher costs incurred by maintaining individual accounts would be justified because they would allow individuals to construct portfolios to satisfy their individual risk preferences. But this is not a desirable outcome. People of lesser means should not be allowed to gamble with their pensions, and people with sufficient means should be encouraged to accumulate and invest reservesoutside the compulsory public system.

If nothing is done, individual Social Security contributions will have to rise to about 18% of wages by 2060 and to 20% of wages by 2080 — approximately 50% above the current rate —for the system to remain solvent. This would clearly affect the competitiveness of U.S. firms in the global marketplace. On the other hand, we believe that if our proposal were to be adopted along with a small, permanent increase in contributions (we have calculated that a modest 1% increase would suffice even if the long-term real return of the trust fund were as low as 5.25%), it would solve Social Security’s problems for the foreseeable future.