Saturday, January 01, 2005

The Dangers of Partial Privatization

Old Woman On Thin Ice, originally uploaded by Wazdat!.

Gambling With Our Old Age.

“Social Security” The Cato Way, or The Century Foundation To The Rescue.

So, let me get this straight. Social Security is the tax that we pay to ourselves and our children right? We pay the tax when a part of our salaries is withheld so our employer can send that to the Treasury as part of the Social Security Trust Fund. That fund goes to present day people who are retired, right? Part of how much money goes into the fund depends on how many people are working at the time correct? I’m assuming of course, that when I’m taxed it is in a proportion commensurate with my pay. 12% is taken for Social Security. Sometimes the government needs to borrow money from the Trust to keep the machinery going. Well and good so long as it doesn’t take too much. That money goes into government bonds, which are always stable. After all, we are the government. We “pay ourselves first” through taxation, not handouts. Now once, there were 16 people working to every one that was retired right? So, that was 16 benefactors to one recipient huh? And now there are only 2 or 3 to one, is that straight? In about 20 years there will be more people retired than are working? And old people will live longer right? On the face of it, it looks like cash flow problem.

But now I hear that 20 years ago Greenspan figured this was coming and asked for a rate hike to create a surplus. And I hear he was persuasive. We raised the Social Security Tax, (though I hear that folks in my income bracket paid more than their fair share thanks to Reagan) and now have that surplus. And some people say it ought to last us until 2042 give or take ten years. So, what’s the hullabaloo? There was a time when we knew that the money was safe, that there was enough money to last.

Then George Bush gave people who don’t need it, a tax cut, spent like a sailor on a war we didn’t need, among other useless things. Now we have a deficit. Now George Bush says the Social Security sky is falling. That we will run out of Social Security money around 2018. Or, from the preface of the “2004 Economic Report of the President”:

“Even after the baby-boom generation’s effect is no longer felt, Social Security is projected to incur annual deficits greater than 50 percent of payroll tax revenues. These deficits are so large that they require a meaningful change to Social Security in future years. Reform should include moderation of the growth of benefits that are unfunded and would otherwise require higher taxes in the future. However, the benefits promised to those in or near retirement should be maintained in full. A new system of personal retirement accounts should be established to help pay future benefits. The economic rationale for under-taking this reform in an era of budget deficits is as compelling as it was in an era of budget surpluses.”

And he concludes with:

“The Nation must act to avert a long-foreseen future crisis in the financing of its old-age entitlement programs. The crisis results mainly from the fundamental demographic shifts to lower birthrates and longer lives rather than the impending retirement of the baby-boom generation. However, the scope for enacting meaningful reform will disappear as the baby-boom generation begins to retire and an ever greater share of the population sees its current income arrive in the form of a government check. The design of the Social Security program has failed to keep pace with emerging demo-graphic realities. The benefits promised to those currently in or near retirement must be honored, but a new course must be set to ensure that Social Security is viable and available to Americans in the future. To do nothing at this point to restrain the growth of entitlement programs would bequeath to future generations an increasing tax on their income to support Social Security. The only way to avoid such an outcome without reducing the living standards of future retirees is to save more today. Greater saving will increase the capital stock and increase the productive capacity of the economy so that it can support those higher payments. The combination of reducing the projected cost of taxpayer-financed benefits and shifting the revenues into personal retirement accounts provides the best mechanism for achieving that result.”

He means “everything will be gone”, even the surplus George? What then, poverty? Yeah George, then that deficit will be real!

Well, serious problems require drastic solutions, and – I must say, this one’s a doozy! Now, we are supposed to have a portion of our Social Security allotment put into a private account to invest it into stocks and bonds! And there, the good and honest stockbrokers and middlemen will invest our money into the good and honest corporations that will take care of themselves good and honestly, and keep our money good and honestly snug an’ cozy!

That’s assuming that your 65-year-old grandmother knows her way around things like stocks and bonds! Now maybe she does. That would make one of the lucky few that could do it. There is an element of roulette in playing the stock market. As long as a company does well, then so will you, but if it doesn’t you won’t do so hot. And stocks could shoot up, and dive down! Will anyone, at 75 have the instinct to maneuver in a timely fashion? The level of uncertainty will be staggering. And you know who loves old people with uncertainties? Scam artists! Stock scams are as old as the Rockies, and wiser people than your grandmother got taken!

But maybe the biggest scam of them all is this whole idea of Social Security being at all in danger. Don’t get me wrong. At around 2042, even the surplus will run out. Then we will have a real deficit! We’d better start birthin’ babies! But…

Maybe the solution need not be as drastic as the Bushies want it to be! That four-plus-one word, the one that Bush would rather wash his mouth out with battery acid than say - taxes, would not be so bad if introduced and gradually raised only slightly, we could overcome the shortfall. And we need more jobs people, a little less “outsourcing,” and more “insourcing.” Get rid of the tax incentives to take our jobs abroad! Businesses should start front-loading business ventures with things like safety and healthcare. Ethical behavior is the best lawsuit repellant.

Why then, are the neocons so insistent?

It has to be that they simply need to find another way to make money. Let’s look again at the problem and then at the solution they propose.

It’s a given that under the present circumstances, the money taken out of Social Security in 20 years will be more than that which is put in. I agree. Yet the neocons seem to think that the only alternative to their solution of privatization is either massive cuts in benefits, or massive taxation. But that is disingenuous, because 20 years will give us time to make more gradual changes in all these areas so that neither would be painful. Also, if those of the higher income brackets were to once again pay their fair share, and if (under a Democratic administration), we were to conclude our costly occupation of Iraq in a just manner, we would be slightly more ahead of the game than we are now!

Nothing made sense to me about the “Chicken Little Hawk’s” “problem” and their “solution”. I wanted to get at the root of their thinking, and who better to show me where the genesis of these crazy ideas came from than that bastion of neocon thinking, The Cato Institute.

Now let’s look at their “solution” to the “problem”: Partial privatization of Social Security means that the government would transfer a portion of our money into private accounts that could then be invested by the holder into stocks. This is supposedly beneficial to pensions. The reasons given are:

1. The American people seem to “know” instinctively that returns from a privately invested account would be better for them rather than the “alleged investment of pay as you go” in Social Security we have today. They say that the Trust Fund of Social Security is not real. To quote address given by the Cato Institute’s President Edward H. Crane before the S.O.S. Retraite Sante on December 10, 1997:

“To repeat, in the United States the payroll tax is not invested, just as it's not invested in most Social Security systems around the world. It goes directly into payouts to current retirees, with whatever excess there may be going to help finance the federal government's deficit spending. The government leaves "Special Treasury Notes" in a so-called Trust Fund when it purloins these excess funds, but to see that the trust fund is a fraud, one need only consider the options facing the government whether these "bonds" are in the trust fund or not. In the year 2010 or sooner, by our estimates, the cash flow from payroll taxes will be insufficient to meet the benefits due current retirees. Assuming the government will live up to its obligations (there is good reason to believe it will not, but for the sake of argument we will give it the benefit of the doubt), once the system's cash flow turns negative and the Social Security Administration turns to the national government for help, the government can come up with the necessary funds by: 1.) increasing taxes; 2.) increasing borrowing; 3.) reducing benefits; or 4.) reducing other government spending. Now suppose the Special Treasury Notes are presented to the national government by the Social Security Administration for redemption to make up for the shortfall. The government, in order to raise the funds to redeem the bonds is faced with precisely the same four options as if there were no trust fund at all.

Thus, when the American government officials smugly point to the approximately $2 trillion in accumulated Special Treasury Bonds that are expected to be in the trust fund by 2010 and tell us that this will help finance the system until 2029 and that therefore there is no crisis, they are being disingenuous, to put it kindly. There is no trust fund in the United States and the crisis is at hand, particularly for younger workers who face the prospect of negative rates of return on their payroll taxes over their entire working lives.

Which brings us back to the intuitive notion that a private account will, in fact, do much better than what Social Security promises, not to mention what it will be able to deliver. One of the best ways to see what an incredibly bad investment Social Security is compared to various alternative investment portfolios is to look at the Cato Institute's Social Security Web site at That site has an interactive calculator prepared for us by KPMG Peat Marwick which allows the user to assume whatever rates of return on stocks or bonds he projects, what percentage of each asset he'll have in his portfolio, and what the expected inflation rate will be. The opportunities to accumulate significant retirement assets and income, using very conservative assumptions, are clear from the calculator. While the comparison to Social Security won't be meaningful to a French user, the exercise with respect to what it takes to accumulate desired retirement assets is quite enlightening and I would invite you to visit our Social Security Web site.” *

2. The private account would’ve supposedly given a better return on the investment had we already been on partially privatized Social Security:

“To cite just one analysis in the study for workers born in 1950, using prospective rates of return on stocks and bonds that are lower than the actual returns thus far during their working lives, a low income worker can expect $631 per month from Social Security. Had he instead invested his payroll tax in a 50-50 mix of government and corporate bonds, his monthly income would have been $1,069. Had he invested in a stock portfolio of 75 percent large capitalization companies and 25 percent small capitalization companies he would have received a monthly income of $2,419.” *

Supposedly for higher income workers life would be even better:

“For high income workers the results are even more dramatic. Social Security would provide $1,562 a month, a bond portfolio $4,585 a month, and a stock portfolio $9,972 a month -- that is about $120,000 a year. Plus, the investor in the private accounts owns the corpus of the money paid in, which is not the case with Social Security. In other words, the private option is clearly the preferable option.” *

All well and good. One problem: Just as one is not allowed to drive a car without proper training due to safety concerns, one cannot invest in the stock market without proper training for reasons of economic safety. Someone said that we now have a population of near 53 million. What are the odds that in about 20 years, enough of them will be properly checked out on operating a privately invested Social Security account? And what about people who through some misfortune either start working later in life, or must leave their employment earlier, and cannot find a job? I’m not optimistic.

Given the fact that the market does fluctuate, privatization means you are betting your retirement on whether or not you judge the proper time you sell your shares. One day, or two, can make the difference for your whole future. According to the Century Foundation’s Idea Brief: “Twelve Reasons Why Privatizing Social Security Is a Bad Idea” by Greg Anrig and Bernard Wasow:

“Privatization advocates like to stress the appeal of “individual choice” and “personal control,” while assuming in their forecasts that everyone’s accounts will match the overall performance of the stock market. But studies by Yale economist Robert J. Shiller and others have demonstrated that individual investors are far more likely to do worse than the market generally, even excluding the cost of commissions and administrative expenses. Indeed, research by Princeton University economist Burton Malkiel found that even professional money managers over time significantly underperformed indexes of the entire market.

Moreover, a number of surveys show that most people lack the knowledge to make even basic decisions about investing. For example, a Securities and Exchange Commission report synthesizing surveys of investors found that only 14 percent knew the difference between a growth stock and an income stock, and just 38 percent understood that when interest rates rise, bond prices go down. Almost half of all investors believed incorrectly that diversification guarantees that their portfolio won’t suffer if the market drops and 40 percent thought that a mutual fund’s operating costs have no impact on the returns they receive. “ **

In his address, Mr. Crane seems to gloss over that reality:

“Critics, of course, speak of the market risk of a fluctuating stock market. It's worth noting, therefore, that for all 30 year periods in the United States dating back from 1802 until the present, stocks have outperformed bonds 99.5 percent of the time. And overlooked in the discussion of market risk is what seems to me to be the much greater political risk of increased taxes, delayed retirement, and reduced benefits. With a private system, the citizen controls the assets. With a public system, the politicians are in control, and I know of no country where that is not a risk.” *

Once more Mr. Crane, in small doses, we can take all these things!

Now we go to the economic “benefits” of privatization:

“We asked the noted Harvard economist Martin Feldstein to undertake a study for us that would estimate the economic impact of privatization in the United States. Feldstein, who was formerly Chairman of the Council of Economic Advisors under President Reagan, concluded that the present value to the U.S. economy of investing the future cash flow of payroll taxes in real assets would be on the order of $10 to $20 trillion. That would mean a permanent, significant boost to economic growth.

I would add that in the world economy of the Twenty-First Century, those nations that choose to adopt a fully funded private retirement scheme are going to be in a much more competitive situation than those that choose to stay with the government-run pay-as-you-go system. It is particularly significant both from the standpoint of geopolitics and the international economy that China is giving serious consideration to adopting a Chilean-like private Social Security system as we meet here today.” *

And what if it reduced national saving? People are not businesses. Family members will not conduct themselves as businesses. Will they feel themselves to be as stable as government does, or in fact – businesses?

Lets go back to the Mssrs. Anrig and Wasow:

“But privatization is actually more likely to reduce than increase national savings. Diamond and Orszag point out that evaluating the overall effect on national savings requires taking into account the likely responses of government, employers, and households. Historically, neither the government nor businesses have changed their spending levels consistently in response to large changes in deficit levels. But households that consider the new accounts to constitute meaningful increases in their retirement wealth might well reduce their other saving. Diamond and Orszag argue, “If anything, our impression is that diverting a portion of the current Social Security surplus into individual accounts could reduce national saving.” That, in turn, would further weaken economic growth and our capacity to pay for the retirement of the baby boomers.”

Maybe these people know your grandmother better than the neocons do.

How will they do the transition? By dealing once again in fallacies:

“In any event, Greenspan made clear that in his view there is no net cost in a transition to a fully funded system. The reason for that being the fact that an unfunded liability is a liability, just as direct national debt is a liability of the government. Whether that liability is implicit or explicit should really not make a difference.”*

What “unfunded liabilities”? Every penny is accounted for. What surplus is left goes immediately to utilities and administration.

“The notion of ‘unfunded liabilities’ in certain programs is based on the arbitrary assumption that certain designated revenue sources should pay for certain classes of government expenditures. The story that Social Security and Medicare should be paid for out of payroll taxes and their trust funds is not a recent creation of critics of those systems. It has been around for decades. But why? Revenues and expenditures are ‘fungible,’ meaning that a dollar is a dollar is a dollar. In fact, today’s Social Security surplus flows right into the pot with other revenues, while a significant portion of Medicare costs already are paid for out of general revenue. The real question is not “will the designated revenues be enough to pay for the designated programs” but ‘will we have enough income to afford to keep the promises we have made?’

There is no question that the nation’s gross domestic product will be sufficient to meet all of our Social Security promises forever, leaving lots of income for increasing the prosperity of the young. In general, the outlook for economic growth is good. Our average income per person in 100 years is likely to be much, much higher than it is today (more than four times as high). Social Security benefits are predicted to rise from about 4.5 percent of our GDP to about 6.6 percent over the next century. Even though such long predictions are very uncertain, this one should leave us sanguine: if incomes in 100 years are only twice their present level, and incomes of the old rise from 4.5 to 6.6 percent of income, that still leaves us with $1.96 for every dollar we have today, after Social Security obligations are taken care of. We can continue to keep our modest Social Security promises, and young families still will be much better off than families are today.” ***

As for the method of transition itself, it is true that it would be more palatable if corporate welfare were cut out, but people most people would have few questions about what else is proposed by Cato:

“From my standpoint, by far the best way of funding the transition to a private system is by cutting government spending. In the U.S. we spend, as an example, more than $70 billion a year on what we call corporate welfare, subsidizing giant corporations at taxpayer expense. Then, too, there are many departments of the national government, ranging from education to commerce to energy, that are simply not a national responsibility in America's federal system of government. Eliminating just one-quarter of the activities the national government should not be engaged in would finance the transition.”*

Now, I have a problem with few of these items in the area of cuts. Energy, education, commerce are not national responsibilities in our federal government? Energy, for one, is a question of geopolitical importance. Education is something that requires guidelines and funded mandates. Commerce requires at the least federal regulation and enforcement, especially in the internet age. Anyway, to continue:

“Second, the national government has many other assets that should be privatized, as was done in Chile to help finance their transition. AMTRAK, the money-losing national rail system should be sold to private investors. The government owns 50 percent of the land west of the Mississippi River and much of that should be sold to private investors who would likely manage it in both a more productive and ecologically sounder manner than do the bureaucrats in Washington, D.C.

Another means of smoothing the transition would be to invest privately only ten percentage points, leaving the remaining 2.4 percent to help fund current retirees. Extending the retirement age by six months a year up to age 70 for those who stay in the system would also provide substantial revenue relief while reflecting the increased longevity of the population.”*

But that 10% could turn out to be very costly to the next generation that goes to work in about 15 years according to the Congressional Budget Office’s “How Pension Financing Affects Returns to Different Generations”:

“To move to a funded system in one generation, either workers have to pay double, some generation must receive no benefits, or some balance of increased payments and reduced benefits must occur. In a simple ex-ample (shown in Table 3), workers could pay both $10 to current retirees and $10 into their own account as the system moves to a funded basis. A more gradual transition could spread the burden over more generations, but the total burden would be the same. In other words, to raise the rate of return for future generations by moving to a funded system, some generations must receive rates of return even lower than they would have gotten under the pay-as-you-go system.” (1)

So there it is. Nothing that the neocons put up makes any sense. Nothing but one thing, someone stands to make money! And that somebody would be entrepreneurs in the investment field. With an entire generation as a market the investment firms will find ways to fleece the elderly again. (That’s you and me in 20 years, for those of you in my generation.)
So finally a one-two punch from The Century Foundation:

“Among the one hundred best stock mutual funds, management fees range from 0.2 percent per year to 1.4 percent of the asset value of an account. The average is near the high end of that range, however, and many mutual funds charge substantially more. Smaller accounts require proportionately larger management fees because many costs such as gathering and mailing out information do not depend on account size. Indeed, most mutual funds actively discourage small accounts by setting a minimum opening deposit of $1,000 to $3,000.

Experience in the United Kingdom offers a warning about what the future could bring regarding management costs. Workers there have been allowed to open private accounts starting in 1988, since which time management fees and marketing costs among financial intermediaries have eaten up an average of 43 percent of the return on investment.”

So there. The small investor is really not worth considering unless he already has a firm foundation that the roulette wheel of funded pension cannot guarantee. But it would be a great market to get into. Any IPO’s for brokerage firms?

* Edward H. Crane “The Case for Privatizing America’s Social Security System” for The Cato Institute.

** Greg Anrig and Bernard Wasow “Twelve Reasons Why Privatizing Social Security Is a Bad Idea” For The Century Foundation

*** Bernard Wasow, “THE ‘Unfunded Liabilities’ Ruse” for The Century Foundation

(1) CBO LONG RANGE FISCAL POLICY BRIEF “How Pension Financing Affects Returns to Different Generations”

The Cato Institute "The Case For Privatizing America's Social Security

The Century Foundation "Twelve Reasons Why Privatizing Social Security Is a Bad Idea"

Social Security Privatization: Eleven Myths

Pension Financing Affect Returns to Different Generations - PDF

2004 Economic Report of The President - PDF

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