This is the worlds leading source of financial content on the web, ranging from market news to retirement strategies, investing education to insights from advisors.
Forex Forever!

Should Social Security Be Privatized? An Unbiased Review

Author: Ethan Taylor

A decade ago, the push to privatize Social Security looked dead in the water. Fresh off his re-election, then-President George W. Bush put the issue at the top of his second-term agenda. Even so, he couldn't get enough votes in Congress to turn his vision into a reality.

However, the 2016 Presidential campaign is proving that not everyone has given up on the notion. Several GOP candidates, including Governor John Kasich of Ohio and Senator Rand Paul of Kentucky, want to allow workers to put at least some of their payroll tax dollars into accounts that they own and control.

A Program in Peril

Perhaps it's not surprising that some on the right are still hoping to fundamentally reshape Social Security. One of the primary arguments for privatization is that the only way to keep the program solvent is to increase the rate of return on payroll deductions. And Social Security's fiscal health is in worse shape today than it was back in 2005.

The current system is essentially an intergenerational transfer of income. The money that active workers put into the program through the payroll tax helps pay the benefits of today's retirees. (See Introduction to Social Security to learn more.)

To date, the pay-as-you-go model has worked pretty well because there have been more than enough Americans in the workforce to pay retirees. For a number of years the program took in more than it was paying out, generating a sizable reserve that still exists today. The program invests these extra dollars in Treasury bonds, generating additional interest income for its coffers.

But demographic shifts are throwing a wrench in the system. The ratio of workers to retirees is dropping, and by 2020 the Social Security Administration projects it will start running annual deficits that will cut into its reserves. That yearly shortfall is expected to last for the duration of the program's 75-year forecasting period.

The SSA estimates that its surplus will run out by the year 2034, at which point it will only bring in enough revenue to pay about 75% of scheduled benefits.

Figure 1. The Social Security Administration estimates that program expenditures will start to exceed income in the year 2020.

: Social Security Administration

The solution, some say, is to let workers divert part of their paycheck toward private investment accounts that they control. They could use the funds to purchase some combination of stock, bond or money market funds, depending on their risk tolerance and objectives.

Once workers hit retirement age, they could choose to purchase an annuity that would provide a lifetime stream of income. Any funds not withdrawn or used for an annuity could be handed down to their heirs.

The advantage, advocates say, is that individually directed investments have the ability to vastly outperform the centrally managed trust fund, which by law can only invest in Treasury bonds. Historically, stocks have generated an annual return of roughly 10%, on average. Treasuries, which are backed by the full faith and credit of the U.S. government, generally return less than bonds, which have an average yield of about 5.5% per year.

In theory, then, money that's socked away in a private account has the potential to go farther than money put into the Social Security trust fund. What's more, retirees wouldn't have to worry about demographic trends, since their retirement kitty would no longer be tethered to the size of the current workforce.

Of course, there's another reason that many Republicans embrace privatization. It fits into their overarching narrative that more power should rest with the individual and less with government.

Challenges to Privatization

The basic goal of Social Security is to provide a financial safety net for Americans as they reach advanced age (as well as for those with disabilities that hinder their ability to work). Critics of privatization argue that subjecting those funds to the ups and downs of the market goes against that very objective.

After the country's experience of the Great Recession, Republicans may have an even harder time discrediting this argument than they did in 2005. Can workers mitigate their risk by shifting to more conservative investments as they reach retirement? Sure. But not every American has the financial literacy to do so.

Perhaps an even bigger hurdle is figuring out how to pay for the transition away from the existing pay-as-you-go paradigm. Even as younger workers are given the right to put tax dollars in a personal account, the government still has the obligation to pay current retiree benefits. That gets expensive.

Democrats say the only way to make it work would be to scale back payments to existing Social Security recipients or to raise the payroll tax. The former has been a third rail for those on the left, and the latter is unlikely to gain support from the right.

A gradual transition, which some Republicans have called for, softens the blow somewhat. Under this strategy, workers would start by putting only a small portion of their salary into a private account and then increase their allotment over a period of years. But even that approach isn't without significant costs.

Alternate Approaches

Private accounts aren't the only way to handle the impending shortfall. Other ways to shore up Social Security include raising the cap on taxable earnings to generate more revenue. For 2015, any income exceeding $118,500 is not subject to payroll taxes. On the expense side of the ledger, one commonly floated idea is to rein in liabilities by increasing the retirement age.

Another approach would be to allow the trust fund to become more aggressive in its investments. Instead of solely buying Treasury instruments, some say it should be allowed to use a portion of its assets on stock purchases.

Advocates say it's a best-of-both-worlds approach. First, there's the potential for higher returns. And second, unlike private accounts, you're leaving investment decisions to an institution that knows how to manage risk better than most individuals do.

The Bottom Line

It's still very much an uphill climb for those who want to privatize all, or even part, of Social Security. However, the idea of controlling your own retirement money is one that continues to hold appeal for a segment of voters.

For more on the topic, see Social Security Depletion: Is the Fear Justified?

last five articles

#402 Should I Invest in Stocks During My Retirement?

Author: Michael Smith

Plenty of financial gurus have written about retirement planning – everything you should do before you retire. However, when you reach retirement age that advice becomes a little harder to come by. Once you start relying on your retirement savings for income, how do you invest your money going ... see more

#789 10 Most Shameful Bank Scandals Of 2013

Author: Andrew Davis

By Katherine MunizThis year brought a whirlwind of shocking announcements and news that would go on to affect every corner of the globe, including the number of banking scandals uncovered in some of the world's largest countries, including the U.S. 10. Banks breaking into homes... see more

#293 A Second Look At Bonds

Author: Christopher Davis

If you remember bond drives in school, please raise your hand. There are still a lot of us out there. I recall my teacher holding up a US Savings Bond, encouraging us to tell our parents to buy them. She went to great lengths emphasizing that they were the "the safest investment on earth."... see more

#1577 If Your Company Is Matching 401(k)s, Max It Out!

Author: Christopher Smith

You've probably heard this from your folks when you were growing up: If you would just do what I tell you to do, I wouldn't have to tell you the same thing over and over.In the world of retirement planning, that's what financial advisors are telling their clients when it comes to their 401... see more

#567 10 Ways to Screw up Your Retirement

Author: Andrew Harris

There are many creative ways to screw up your retirement. Let me show you how it's done.Supporting adult children. My wife Jo and I have friends with an unmarried, unemployed daughter who had a child. Our friends adopted their grandchild and are now in their late sixties raising a k... see more