By Henry K. (Bud) Hebeler

12/15/04

There are two basic paths that the private accounts could follow. The first is to say, "It's your money, do as you want with it after X age." This would be a fantastic benefit for both the government and most tax payers in the long-run because they both then enjoy the advantage of lower future government obligations. However, this is really a problem for low-income workers.

In part, it’s a problem for low-income workers because low-income workers get a lot more per payroll tax dollar than high-income workers from Social Security. A low-income worker gets about 90% of "Averaged Indexed Monthly Income," and a high-income worker gets about 35%. So even though both have the same payroll tax rate, the benefits are proportionately larger for the low-income worker. That's why it's called a "social" program.

So why is that a problem for the low-income worker? For each dollar of Social Security tax, the low-income worker gets 2.6 times the benefit. (90%/35%) But a dollar of tax taken away from Social Security reduces the low-income workers benefit 2.6 times as much as the high-income worker. When this dollar of tax is turned into an investment for private accounts, the low-income worker is going to need a lot higher return from investments than a high-income worker to get back the Social Security benefit that was lost. It may even be an unattainable return except for those who choose a risky investment path and then get lucky early in retirement and enjoy a happy ending. But risk and low incomes are unhappy partners.

If there’s freedom to choose between unhindered use of private accounts and the current Social Security’s benefits, it’s unlikely that there would be many low-income participants because they would almost certainly choose something with guaranteed large benefits compared to something that would require high risk investing and a potential bear market around retirement time—or worse yet, right after retiring. Reduced investment values shortly after retiring are extremely painful because the opportunity to go back to work and recover lost benefits is virtually nil.

The second path is to try and duplicate some of the benefits that Social Security offers to make it more palatable. This is what will really drive up the need to seek risky investments. Think about it: This would require inflation protected escalation and some very generous spousal benefits. Can you imagine the return that would be required to provide 50% more for a low-income spouse in addition to payments for the working spouse? Then there is the fact that 100% of the benefit goes to the low-income spouse when the other spouse dies. This means that there will have to be some national insurance program in order to spread the risks from an early death in addition to the high returns.

Turning the people loose with their own money has other hazards. This is especially true for those who don't know much about investing. Even those who know some of the rudiments of investing seldom have any knowledge about metering retirement withdrawals so that the accounts have a reasonable chance of providing sufficient income till death. Even financial scholars often get such projections wrong when they don’t count investment costs, use optimistic return information, make no provision for reserves, and rely on exhaustion analysis. Remember, Social Security keeps paying no matter how long you live, and future generations are going to live a lot longer.

So the obvious next step is to consider annuitization. The private account would either be converted to a fixed or inflation-adjusted annuity or otherwise a variable annuity with benefits recalculated annually depending on the remaining balance. Annuities are the province of insurance companies or the government, but they can also involve mutual funds. In Marty Feldman's talk at the conference on the Future of Social Security, he suggested that mutual funds would be willing to base some income guarantees using the derivatives markets for putts and stripped TIPs. This, of course, assumes that there are enough people willing to take the other side of those bets. Whatever the form of the annuity, there will be costs that can't be ignored and financial industry lobbying beyond belief.

Then there are a raft of other questions—none of which are likely to have happy endings. Should private accounts be subject to withdrawals for medical or college expenses? Should people be able to opt out of the program? Should ex-spouses be entitled to some of those funds or the income from it? Should there be special tax exemptions as with the rest of Social Security? What kind of surveillance and controls will the government offer? How will private accounts affect tax return complexity particularly if people can opt out of the program or later opt back in?

In the final analysis, private accounts will have to be obvious winners to low-income people. This means that there will have to be a virtual certainty that reasonable returns from relatively conservative investments will give better benefits for workers and their spouses than whatever will be the future Social Security benefits. In order for that to happen, future Social Security benefits will have to look a lot less promising. For example, Social Security payments would be less, start later, and would be higher taxed.

The situation would not be unlike a company deciding how to structure early retirement offers to encourage people to retire early. They use a carrot and stick approach. The carrot is a severance package. The stick is the threat that employees are uncertain to retain their jobs if they don’t take the offer. The stick to encourage private accounts would be very high certainty that Social Security was going to cost more and pay less. But if that’s what is needed, why not just tighten up Social Security in the first place?

Why don’t we hear more about an alternative that would have both the major benefits of private accounts AND our existing Social Security benefits? That alternative is, of course, for the Social Security Trust to invest in stocks directly, not through individuals with private accounts. If the government believes stocks can solve the problem for individuals, they certainly should believe that the government should be able to solve its own problems by investing wisely and maintaining a steady course through ups and downs of the market—just like financial advisors would like to think their clients should behave, but most often don’t.

None of this gives me much confidence that any but the rich are going to like private accounts, and there aren't enough rich voters to outnumber the poor ones. I think that whoever exposes some of those answers will have an incredible influence on whether we'll have private accounts, and if so, how they will be structured.

I'm hoping that a number of journalists and financial analysts will have future articles that cover some of these points. Let’s start with more talk about how the Social Security Trust could overcome perceived impediments to investing in stock itself. Then, perhaps analysts could estimate the returns that would be necessary to make private accounts competitive with Social Security’s benefits for low-income workers. That would be followed by examining how much future Social Security benefits would have to come down in order to match the performance of reasonably conservative private accounts.

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