Private Investment As Social Security example essay topic

The United States Social Security system contributes to the well being of all Americans by providing a basis of retirement income for the elderly relieving their children of the burden for their support. It is America's costliest, biggest, successful, and most popular domestic program. Its coverage is nearly universal, with 92% of individuals over sixty-five receiving benefits (Twentieth Century Fund 10) and it has been a huge factor in keeping the majority of senior citizens above the poverty line. However, the Social Security system needs to be reformed. As of now, the Social Security Trust Fund has a surplus. But because of demographic changes, the annual benefits paid to retirees will exceed tax revenues around 2012 (Twentieth Century Fund 17).

Some individuals and organizations have advocated converting public pension programs from pay-as-you-go government-run systems into individually capitalized privately owned retirement systems (Crane). They believe that the higher rate of return will help increase the retiree's incomes as well as encourage saving and investment, which will then, in turn, stimulate growth. Unfortunately, as most investors know, the higher the chance of larger returns, the higher the risk of losing money. In light of the stock market's recent success, privatization seems like a very attractive alternative to our current system. In fact, many polls show that the public is slowly moving in favor of privatization. However, by taking a closer look at the actual pros and cons of privatization show that this system leaves much to be desired.

In the current system, workers contribute to a trust fund from which benefits are paid. Social Security is financed equally by employer and employee, is portable from job to job, and adjusts benefits to inflation. The benefits are also work-related and progressive. This feature gives all Americans a chance at retiring above the poverty line.

However, it is important to remember that Social Security is not a needs-based welfare program. Benefits are paid in return for contributions made during working years - a pay-as-you-go system. Today's workers pay for today's beneficiaries. The remaining balance goes into a trust fund (or is taken out of the trust fund depending on the balance). As of now, Social Security taxes bring in more revenue than the system pays out in benefits.

However, starting in around 2012, the oldest baby boomers will retire reversing the situation. At this time, the government will start paying out more benefits then it will collect in taxes. To continue paying Social Security checks on time, it will have to begin drawing on the original capital in the trust fund. Unfortunately, this trust fund amounts to nothing more then a huge IOU. The federal government has been using the trust fund to disguise the size of the federal budget deficit.

It borrows money from the fund to pay for current operating expenses and replaces the money with government bonds. Though the money is not actually there, the Social Security trust fund is categorized as an asset in the federal budget. This is a convenient way for politicians to hide the problem from the public until it is too late. When this trust fund surplus is exhausted, the government will have to rely on payroll taxes to finance all promised benefits. Payroll taxes will have to increase dramatically as the baby boomers live longer (improving medical technology). This could lead to a vicious circle where the high taxation would eventually become an incentive not to work.

Many believe that privatization is needed to ward off this crisis. The privatization of the Social Security has been gaining support among the public as the stock market charges up to new highs. Private companies would not suffer many of the glaring weaknesses of the state-provided Social Security monopoly problems, political influence, lack of choice, innovation, and accountability to customers (Economist 4). Supporters believe that the returns from a privately invested pension plan would also be significantly higher then one would receive from Social Security. Investing these payroll taxes would give economic growth a significant, possibly permanent boost. Many people also assume that private firms will be more cost-effective and efficient then the government.

In actuality, total administrative costs for Social Security are less then 1% of total incoming revenue. Private administrative and management fees for financial portfolios would be many times more expensive then the administrative costs of Social Security (TCF 40). Chile, which is often portrayed as the ideal model for privatizing Social Security, has administrative costs that average around 18% of total contributions or 3% of each investor's income (Economist 15). The Chilean model also shows that returns might not even be as high as most project.

In Chile, if a fund's return within a twelve month period is below two percent the average for all funds, it must make up for the difference with its own capital. There is no incentive for outperforming the market (As opposed to the vast number of fund managers trying to beat the S&P Index Funds in the U.S. ). As a result, most of the funds in Chile are very similar, robbing Chileans of their ability to make significant changes to their portfolio in response to their risk profile as they get older (Economist 15). Privatization also increases the amount of risk placed on the individual. Though privatization schemes vary, almost all allow participants to choose how their account is managed. This dangerously transfers the risk of poverty from the whole workforce to the individual.

This could threaten the Social Security's success in keeping the elderly out of poverty. It is wrong to assume that millions of workers who have never invested before would be able to make informed investment decisions. Poor investment decisions would mean that the elderly would have to rely on need-based programs such as welfare robbing them of their dignity and burdening both their children and the government. Not only would many workers have to worry about retiring when the stock market is low, a greater number of them could find themselves simultaneously trying to support their aging parents raise their children (TSC 40).

We have been assuming that privatization will improve retiree's circumstances as long as stock markets maintain their steady growth. However, privatization in itself holds no guarantee that overall national savings will increase. In fact, workers engrossed by promises of overly optimistic returns could reduce their other savings. Furthermore, if the revenues the government received through Social Security were routed away from treasury bonds and into private securities, the government would need to borrow an equivalent amount of money on the private market to meet its budgetary obligations. It could no longer borrow from the Social Security trust fund. This would take back from the private sector as much money available for private investment as Social Security put in.

There would be no net change in capital investment. The tremendous transition costs that privatizing even a small part of Social Security would make it politically extremely difficult to institute any positive change. To change from the current pay-as-you-go system, a generation of workers would lose their state pensions but still have to pay for the pensions of their parents. It is also very difficult for older middle age workers to save enough for a sufficient private pension. The government would have to significantly increase payroll taxes, incur a huge government debt, or reduce promised benefits to cover this transition. For each dollar that is put into private accounts, the government would have to find another dollar someplace else to cover current obligations.

This could either put the government deeper into debt or it would raise payroll taxes even higher making current workers pay for both their own retirement funds and their parent's. Privatizing would also make the Social Security system much less progressive widening the gap between low-income and high-income workers. Without extensive financial education, low-income workers would have a much smaller return on their Social Security investments, leading to smaller retirement incomes. In addition, privatization would also be no guarantee of a secure retirement. If workers placed their savings in a badly invested fund, they would be out of luck and be left to fend for themselves. The lack of a progressive system and the increased risk in losing one's retirement funds would undoubtedly cause many people to follow below the line of poverty.

What is Social Security without the security Given the large number of well-educated, seasoned investors, who were taken in with the savings and loan scandal or speculation in derivatives, it seems inevitable that many ordinary people will lose out to tricky marketing schemes. One by one, the benefits of privatization more competitiveness, choice, innovation, accountability to customers, lack of political influence seem to give way to the liabilities increased risk, less progressiveness, huge transition costs, increased administrative costs, and increased liability to workers. The current system, despite its defects, has been able to weather over sixty five years of changes. It is progressive - it provides higher percentage returns for poorer workers than for wealthier workers - and it is universal no one can default on Social Security and almost everyone is covered.

Together with pension and personal savings income, Social Security is an essential part of most peoples retirement income. The transaction costs in transferring to a private system are also too big to be feasible. Privatization, as appealing as it might seem on some levels, is neither stable nor universal in its coverage and should not replace the current Social Security system.