To make the argument concrete, consider a highly simplified example. Suppose an individual’s notional account would equal $100,000 at retirement. If this person’s life expectancy at retirement is 20 years and the annuity draws zero interest and comes at zero administrative costs (simplifying assumptions), the annuity on this account would be $5,000. This sum – the “clawback” – would be deducted from the defined benefit amount, to arrive at the “benefit after clawback”. If the defined benefit (calculated using an inflation-index) would have otherwise been $12,000 per year, it will now be $7,000. Now, if the poverty-level of income is $16,000, this individual’s personal account will need to be sufficiently large (well above $100,000) to allow an additional (lifetime) benefit of $9,000 per year through annuitization.

As time goes on, the size of the clawback would grow, relative to the benefit, because the clawback would be proportional to wages, whereas the defined benefit would be fixed in real terms (i.e. indexed to prices). This would make workers increasingly dependent on the annuitized value of their personal accounts. Moreover, workers will have to pay a fee – to financial firms – to annuitize their individual accounts, a cost that could absorb as much as 10 to 20 percent of their savings (Baker and Rosnick, 2005).[18]

With the size of the after-clawback benefit projected to decrease over time, it is likely that the whole private account will need to be annuitized. And, unless the stock market performs incredibly well, there is a good chance that the annuitized value of the private account will be insufficient to sustain many Americans in retirement.

The groups who are most vulnerable to this kind of shortfall are women and minorities, who make up a disproportionate share of America’s low-wage workers. This has been emphasized by Diana Zuckerman, president of the National Research Center for Women and Families, who argues that “[w]omen depend more on Social Security than men do, because women are less likely to have their own private pensions when they retire” (2004). And, even when they do have pensions, “their pension checks are, on average, half as large as men’s are” (ibid.). Thus, our nation’s low-wage workers are particularly vulnerable because they are less likely to have other forms of saving, pensions, etc., to supplement Social Security in retirement.

Democrats are particularly worried about the impact of privatization on low-income workers.[19] In their view, the president’s plan would shift a disproportionate share of risk onto low-income workers, who may not survive through retirement if their personal accounts lose money. Indeed, some Democrats have argued that these groups would be better off under the current system, which can only pay 73% of promised benefits, than they would be under a partially privatized system that might result in much larger cuts. 

In response, supporters of the Bush plan like to argue that even pre-2042 benefits cannot be guaranteed since the government replaced Social Security surpluses with government IOUs that are “all trust and no fund” (Rich Tucker, Heritage Foundation).[20] Such assertions are designed to scare workers into believing that the government has spent its hard-earned retirement money and replaced it with pieces of paper that the government may not be able to redeem when the time comes:

                        The idea that the problem does not start until 2042 depends on

                        sleight of hand. For several decades, the program, in anticipation

                        of the retirement of Baby Boomers, has collected more revenues

                        than it pays out. The surplus has been banked in a Social Security

                        trust fund. The liberal argument is that when payouts start to

                        outstrip revenues, in 2018, the program can just draw on the trust

                        fund – and it can keep drawing on it until 2042, when it is

scheduled to run out. . . [But these folks] know perfectly well that

the trust fund is a ledger-book entry, and will do nothing to save

politicians from having to raise taxes or cut benefits to meet the

promise of the old-age retirement program (A Guide to Social

Security Reform, Articles, pp. 9 and 24).

It is true that the Trust Fund is a ledger-book entry but it is inaccurate to suggest that the Trust Fund can play no role in funding post-2018 benefits because it is full of empty promises. Against the asset known as the Social Security Trust Fund sits a liability of the U.S. government – a stockpile of non-marketable, interest-bearing government securities. The notion that the government might have trouble redeeming these securities in 2018 – when the revenue shortfall begins – is utter nonsense. The system endured cash deficits when payroll taxes were insufficient to cover benefit payments in the past, including the period from 1957 to 1964 and again from 1971 to 1983, and it can do so again simply by retiring some of the Trust Fund bonds (Sawicky, 2005, p. 11).

The government does not need outside buyers for these bonds. Indeed the bonds are non-marketable, which means that the government cannot look to private citizens, institutions or foreigners to purchase them. Only the U.S. government can buy them back, and it will do so simply by reducing both its liability – the non-marketable bond – and the balance in the Trust Fund.[21] It would, quite literally, take an act of Congress to prevent this from happening.[22]

And, as David Kaiser, Professor of Strategy and Policy at the Naval War College, has emphasized, such an act would probably be unconstitutional. As he points out, Section 4 of the 14^th Amendment to the US Constitution reads:

            The validity of the public debt of the United States, authorized by

law, including debts incurred for payment of pensions and bounties

for services in suppressing insurrection or rebellion, shall not be

questioned (2005, p. 1).

Thus, Kaiser suggests that “[i]f the Trust Fund should ever have trouble collecting on its assets, the AARP, or some other citizens’ organization, should file suit under this provision to force the Supreme Court to reaffirm the validity of the Federal Government’s obligation to the Trust Fund” (ibid.)

In sum, the president’s plan calls for both voluntary and involuntary reductions in benefits. The former are incurred only by those who choose personal accounts, but the latter are envisioned for all as inflation-indexing replaces wage indexing in the calculation of defined benefits. Americans must understand that if “Plan 2” succeeds, they will suffer benefit cuts. Indeed, if the president’s plan succeeds, the guaranteed benefits of every worker under age 55 will be lower in the future – and this is true whether they opt for a personal account or not.

Transition Costs and the Explosion of Debt

The portion of current payroll taxes that gets diverted to personal accounts won’t be available to pay current retirees. As a consequence, the government recently announced that it would borrow huge sums in order to help pay for adding personal accounts to Social Security.[23] These costs – estimates range between $1 and $2 trillion dollars – are considered “transitional” because, as current retirees begin to die, costs decline, disappearing altogether (along with beneficiaries) over the longer term.

Both those critical of and those supportive of the president’s plan have raised concerns about the costs associated with transforming the system to include personal accounts. Critics (mainly Democrats) argue that the president's privatization scheme is fiscally irresponsible because it adds hundreds of billions to the federal deficit and, ultimately, trillions to the national debt.[24] Tom Davis R-VA offered a less hostile critique, suggesting that “[f]loating a bond issue of a trillion dollars is not the message you want to send to the markets right now” (Froomkin, 2004).[25] Finally, Alan Greenspan, who has been generally supportive of the president’s plan to introduce private accounts, has admonished the White House, arguing that increased spending to finance the transition to personal accounts may put the federal budget “on an unsustainable path, in which large deficits result in rising interest rates and ever-growing interest payments that augment deficits in future years” (quoted in Hays, 2005).

Others have simply questioned the logic of selling bonds to help facilitate the purchase of stocks, noting that when the government floats bonds in order to finance the transition to a partially-privatized system, it means that investors are exchanging stocks – those being sold to individuals who will hold them as assets in their personal accounts – for newly-issued Treasury debt. This begs the question: why would investors agree to add over $1 trillion in long-term government debt to their portfolios if the stock market is expected to outperform government bonds over the long haul? The implication, as Krugman points out, is that “politicians are smart – they know that stocks are a much better investment than bonds – while private investors are stupid, and will swap their valuable stocks for much less valuable government bonds” (Krugman, NYT, 2005).

The Short-Run Bubble Effect and Longer-Term Prospects for Stock Market Growth

While it is not difficult to envision stocks outperforming bonds over the long-haul, it is quite conceivable that stocks will generate even larger short-term gains, as tens of millions of Americans begin buying shares for their personal accounts. The prospect of a sudden surge in the demand for shares has raised concerns about the possibility of a short-term bubble in stocks prices – a consequence of too many dollars chasing too few shares.[26] If privatization puts upward pressure on stock prices, those who already own shares of large cap stocks and those who manage the transactions would reap significant gains, while today’s youth would suffer lower rates of return, as they buy into the market in the midst of a stock-price inflation. Thus, as Kenneth Apfel, Social Security commissioner from 1997-2001 suggests, Bush’s proposal calls for “a radical restructuring that’s not in the interests of the young and old alike” (Apfel, 2005).

But the young need relatively high rates of return in order to compensate for the cuts they would suffer under the president’s plan. And the president insists that the stock market can deliver these rates, telling Americans that “[p]ersonal accounts are a better deal,” because “your money will grow, over time, at a greater rate than anything the current system can deliver” (State of the Union Address, 2005). Specifically, the White House has projected a 6.5 percent real return on private accounts. At this rate, private accounts are projected to yield returns high enough to cover projected fees plus inflation, thereby raising the income and consumption of future retirees.

But, as his critics point out, retirees may actually end up with less if the stock market fails to perform the way the Administration implies that it will. For example, Paul Krugman, a vocal opponent of Bush’s plan, points out that equity serves only as a potential source of future revenue. Equity is a claim on corporate income that provides gains when: (1) the corporation pays cash dividends or initiates stock buybacks, or (2) rising stock prices yield capital gains. Thus, Krugman notes that the Administration’s projected 6.5 percent return is possible only if, in addition to the 3 percent currently coming from dividends and buybacks, inflation-adjusted stock prices increase by 3.5 percent. In the short run, Krugman admits that this is clearly possible. But the Bush plan requires these high rates of return “for at least the next 75 years” (Krugman, 2005, NYT). The problem, he points out, is that the Trustees’ own assumptions about growth, inflation, etc. make this a highly dubious outcome.

If, as the Trustees project, the economy slows from its historic 75-year average growth rate of 3.4 percent to a rate of only 1.9 percent over the coming 75-year period, it will be virtually impossible for shareholders to earn an inflation-adjusted 6.5 percent rate of return in the stock market. With such low growth rates – and hence low profit growth[27] – cash dividends and stock buybacks will account for an increasingly small portion of the total yield on stocks. This, of course, places an ever increasing burden on the portion derived from capital gains. But this would require an increase in stock prices that outstrips profits for the next several decades, something that would push the average price-earnings (P/E) ratio to five times its current level.[28] Thus, based on the Trustees’ predictions about the future course of U.S. growth, Krugman argues that an after-tax annual rate of return on the order of 6.5 to 7 percent “is mathematically impossible” (ibid.). He is also quick to point out the irony in this conclusion: “if the economy grows fast enough to generate a rate of return that makes privatization work, it will also yield a bonanza of payroll tax revenue that will keep the current system sound for generations to come” (ibid.).

Administrative Costs and the Windfall for Wall Street

Under the current system, less than one cent out of every dollar paid into Social Security benefits goes to pay administrative costs. In contrast, privately managed retirement accounts, like those in Chile and England, “waste 15 cents of every dollar paid out in benefits on administrative fees” (ibid.). Thus, critics maintain that the costs of administering more than 100 million small, private accounts “could dwarf Social Security’s administrative overhead, which currently amounts to less than 1 percent” (Dreyfuss, 1996, p. 3).

The president insists that his plan would contain these costs, estimating that only about 5 cents of every dollar paid out in benefits would go to money managers. But even if the president succeeds in limiting the fees that financial intermediaries can charge to administer personal accounts, Wall Street stands to gain $940 billion or more (in present value terms), according to University of Chicago business school professor Austan Goolsbee.[29] Goolsbee’s findings fueled criticism from Democratic Presidential Candidate John F. Kerry, who claimed that the president was pushing privatization in a quid-pro-quo move designed to benefit Wall Street donors who contributed generously to his campaign – a claim that does not appear to be farfetched.

The serious push for privatization began over a decade ago, with a coalition of conservative ideologues (neo-cons) and Wall Street money managers, determined to dismantle Social Security and replace it with a system of individual retirement accounts. Around this time, the Washington Post predicted that “[b]y 2010, more than $4 trillion a year could be pumped into the stock market from Social Security account plans, generating as much as $44 billion in annual fees for Wall Street under the personal security account plans” (Fromson, 1997). State Street Bank & Trust, a little-known Boston firm, which specializes in the management of smaller accounts, was one of the many firms that wanted a piece of the action. It had its own privatization agenda, but it also began to seed “other research groups with about $100,000 in grants – including about $20,000 to the libertarian CATO Institute’s privatization project” (IAF, 2001).

The mutual-fund industry, which was also poised to capitalize on this opportunity, began “funneling millions of dollars in seed money to think tanks, ‘grassroots’ organizations, and politicians friendly to the ideas of privatization” (Dreyfuss, 1996).

To realize their goal of privatization, these investment companies needed two things – politicians willing to promote their cause and the capitulation of the American public. In the run-up to the 1996 Presidential election, fund managers and heads of major investment banks began greasing the palms of the Democratic and Republican nominees.[30] And, while neither candidate adopted privatization as part of his political agenda in the mid-nineties, Wall Street brokers were not dissuaded.

In the run-up to the 2000 election, Charles Schwab, Dan Cook[31] (Goldman Sachs) and Richard Gilder (a stockbroker) were busy “pouring money into the presidential campaign of George W. Bush” (Silverstein, 2001, p. 1). And so were scores of other brokers and money managers. In total, Wall Street shelled out $10 million in campaign cash to the GOP (ibid.). By June 18, 2001, Treasury Secretary Paul O’Neil was on board, throwing his shoulder into Wall Street’s push for private accounts. At a luncheon high atop the World Trade Center, he served as keynote speaker, helping participants such as Citigroup Inc., Deutsche Bank AG and Morgan Stanley raise money for a $20 million campaign to support the privatization of Social Security (IFA, 2001).

While Republicans insist that Wall Street does not stand to reap extraordinary benefits from privatization, security brokers and investment managers clearly see things differently, doling out staggering sums to politicians, conservative think-tanks and grassroots privatization campaigns, in the hopes that their dream of charging fees and commissions on nearly 100 million new accounts might one day be realized. And when the conservative Wall Street Journal characterizes the privatization of Social Security as potentially, “the biggest bonanza in the history of the mutual fund industry,” you can be sure there is something to the claim (Dreyfuss, 1996a).

IV. Evidence from Chile and the UK: (Big) Brother Can You Spare a Dime?

It is sometimes said that a fool learns from his mistakes, while a wise man learns from the mistakes of others. In recent years, a number of countries around the world have converted their government-sponsored retirement programs into systems that rely, in whole or in part, on private accounts. The purpose of this section is to examine some of the problems that have emerged as a consequence of privatization. Because Chile and the United Kingdom have had the most experience with privatization – each has had private accounts in place for over a decade – they will be our focus.

The Chilean Experience

Bush’s proposal is modeled on a Chilean reform program put in place almost 25 years ago under the authoritarian government of General Augusto Pinochet. The Chilean experiment ended the multi-contributor insurance program in which individuals, their employers and the government each made financial contributions toward an employee pension. In its place, stands an private system that requires[32] workers to devote 10 percent of their salaries to private investment accounts which they control.

Twenty five years after its introduction, the first generation of Chileans to depend on the new system is beginning to retire, and, despite the relatively strong returns workers have earned on their investments, many of them are finding it impossible to survive on the money accumulated in their private accounts. The clear winners are the Chilean money managers, who charge large commissions and hidden fees for their services. Many middle-class workers, on the other hand, have found that these fees have eaten into as much as a third of their original investment (Rohter, NYT). For example, Dagoberto Saez, a 66-year old laboratory technician, who could have remained in the old system, opted to participate in Columbia’s privatization scheme:

            Colleagues and friends with the same pay grade who stayed in the old

system, people who work right alongside me are retiring with pensions

of almost $700 a month – good until they die. I have a salary that allows

me to live with dignity, and all of a sudden I am going to be plunged into

poverty, all because I made the mistake of believing the promises they

made to us back in 1981 (Rohter, 2005).

His experience is not unique. Inelia Pardo Acevedo, a 64-year-old retired nurse is looking for a part-time job to supplement the $225 a month she draws under Chile’s privatized system. “They fooled me,” she said, angered by the fact that her colleagues who stayed in the old system get “three times as much, guaranteed for the rest of their lives” (Dickerson, 2005). Like Acevedo, hundreds of thousands of Chile’s retirees and near-retirees are discovering that they would have been better off under the old system.

Even Chile’s government officials have conceded that there are serious problems with the new system. For example, Ricardo Scolari, the Minister of Labor and Social Security, admits that “it is absolutely impossible to think that a system of this nature is going to resolve the income needs of Chileans when they reach old age” (quoted in Rohter, 2005). As a result, the government routinely spends billions of dollars in supplemental aid, assisting those whose incomes were not large enough to ensure some minimum security in retirement.

The British Experience

While Americans can learn from the problems that have arisen in a developing country such as Chile, it may be more instructive for them to draw lessons from a large developed country such as the United Kingdom. It is also easier to draw comparisons with the British experience because the U.K. introduced voluntary “personal pensions” as part of a partial privatization scheme. Additionally, the British government switched benefit indexing from the higher of inflation or wage growth to inflation only. Thus, the British framework more closely resembles the model the U.S. government is trying to put in place at home.

The British retirement system has two tiers: a first tier and a second tier. Under both tiers, benefits go to men at age 65 and to women at age 60. The first tier provides mandatory flat-rate weekly benefits (paid by the government) which are independent of earnings. This level of benefits was put in place in 1908 to ensure minimum (i.e. poverty level) benefits to retirees. The second tier, introduced in 1961, provides earnings-related benefits from either public or private pensions.

The introduction of this second tier marked the first phase of privatization, because it gave employers the option not to participate in the public portion of the second tier and, instead, establish a private second tier known as an “occupational pension”.[33] In 1978, the British government introduced the State Earnings-Related Pension Scheme (SERPS), which improved the second-tier public pension by replacing a higher percentage of contributed earnings. Thus, upon retirement, British workers would either receive (1) a small, first tier pension plus a second-tier pension through SERPS or (2) a small, first-tier pension plus an employer-sponsored occupational pension. Under either scenario, workers were protected under a defined benefit plan.

The second phase of privatization came in 1988, when the government allowed workers to voluntarily opt out of either the public SERPS or the employer-sponsored occupational pension and set up tax-deferred, individual accounts.[34] Those who chose to opt out of the second-tier coverage would draw only their small, first-tier pension plus whatever their personal accounts could provide when annuitized.[35] Thus, the U.K. system currently resembles the model envisioned by President Bush, where workers would continue to draw a portion of their benefits from Social Security but would rely more heavily on the annuitized value of their personal accounts.

If we were to measure the success of the British reform simply in terms of worker participation, we would have to conclude that the second phase of privatization was a great success.[36] Roughly 3.1 million people opted out of the SERPS during the first year. And, by the end of the fifth year, another 2.3 million people had joined them in establishing “personal pensions” (Department of Social Security, 1998, Table 26.0). But, of course, success is not so easily judged.

With the passage of time, workers have discovered many of the system’s flaws. First of all, they have come to realize the detrimental effects of inflation-indexing.[37] Since inflation typically increases about one-and-one-half to two percent more slowly than wages, workers who remain in the second tier can expect benefits that are forty to fifty percent lower than they otherwise would have been. Worse, opting out of the second tier hasn’t proven to be much of a safeguard.  

Scandals and fraud have plagued Britain’s money managers, delivering a black eye to the very idea of privatized public pensions. In exchange for their services, financial middlemen often gouged workers, charging “not only an initial fee (including a percentage commission and a lump sum), but also an annual fee on invested funds and a monthly flat fee that is generally indexed according to price or wage increases” (Liu, 1999, p. 36). In some cases, these charges were more than 20 percent of contributions. For an estimated 30 to 40 percent of account holders, fees and commissions are so high that workers never earn enough to recover their principal (ibid.).

To reap these fees and commissions, money managers aggressively marketed their services, indiscriminately recommending personal pensions to every generation of workers. In 1992 a random sample of accounts was audited by the Securities and Investment Board. The audit, which was performed against the objections of the insurance industry, revealed that “a staggering percentage of pensions had been sold to those who would be worse off in retirement as a result” (Cohen, 2005, 3).[38] The findings resulted in a scandal that generated enough of a public outcry that the government was forced to act. In the end, some 1.7 million people “sought and received compensation that ultimately cost the insurance industry £12 billion. In addition, hundreds of millions were paid out in fines and penalties. It was the biggest financial scandal in the United Kingdom to date” (ibid.).

Nearly half of British retirees now qualify for additional benefits under a separate welfare program for the elderly. To avoid this fate, more than 500,000 people decided to opt back into the state plan[39] in 2002-03, and another 500,000 joined them in 2004.[40] Another 250,000 are expected to opt back in this year, a trend that is expected to continue into the future. There is a lesson here for Americans. As Robin Ellison, Chairman-elect of the National Association of Pension Funds in the U.K. recently noted, “[i]t is curious that as we’re moving towards one system, the United States appears to be thinking and moving to the system we’re moving away from” (National Public Radio, Record Number: 200502171004). Perhaps failing to learn from the mistakes of others will make us the greatest fool of all.

VI. Concluding Remarks

As Americans, we used to be entitled to certain things – government-sponsored health insurance, education, and various forms of welfare protection. Increasingly, the government is telling us that we are entitled to nothing. Current and previous Administrations have weakened welfare, unemployment and after-school programs and pushed school vouchers, medical savings plans and private Social Security accounts. And, so far, there has been little resistance to many of these reforms. In particular, younger Americans seem unafraid to “go it alone,” perhaps reflecting a shift in their attitudes toward dependency, work and worthiness.

But before America’s youth throw their support behind the president’s plan, convinced of their ability to provide for themselves in their retirement, they should remind themselves that, they, like their forefathers have done the work, paid into the system and earned the right to receive the benefits they have been promised. And they should recognize that some of their security has already been sacrificed, as scores of our nation’s employers continue to replace guaranteed pensions with 401(k) plans. Acquiescing to the president’s plan would simply remove another leg of the stool, reducing their guaranteed benefits and placing their future security in the hands of indifferent market forces.[41]

Social security is a social insurance system, designed to guarantee a minimum income to our nation’s elderly in retirement. It was never intended to help Americans build financial wealth or create “worker capitalists.” Before they allow the prospects of large financial returns to persuade them to support a plan that may significantly undermine their future well-being, America’s youth should remember that “more than half of seniors receive a majority of their retirement income from Social Security” (Tanner, 2004, 1). If this trend persists, odds are, today’s worker will eventually depend heavily on the benefits paid by Social Security. And, if the British experience has taught us anything, it is that the costs and risks associated with private accounts far outweigh the value of the returns they are likely to generate.

But the current debate should be about more than narrow self-interest. It should about the kind of society we want to have. Are we willing to ensure the security of America’s elderly and disabled or are we content to place their fate in the hands of capricious markets? Will we sit idly by as more and more Americans slide into poverty or will we be forced to act when future retirees find it impossible to survive on the annuitized value of their personal accounts plus their reduced benefit payments? In an ideal world the answers would be obvious – Americans would reassert their commitment to our nation’s largest and most successful entitlement program and just say ‘no’ to the president’s plan.

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