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Why Privatize Social Security?

Washington, D.C. — As Congress considers proposals to privatize Social Security, a word of caution comes from Urban Institute economist Lawrence Thompson.

In a new book, Older and Wiser, Thompson points out that privatization by itself will do nothing to reduce the costs of supporting the baby boom generation in retirement. While there are advantages to a system of individual retirement accounts, he stresses, there are also some serious drawbacks that must be considered.

A consultant on pension reform to the International Labor Office and the World Bank, Thompson is a former deputy commissioner and chief operating officer of the U.S. Social Security Administration.

Determining the Costs of Retirement Security

Thompson notes that a major source of confusion in the current public debate "is the failure to distinguish between the actual cost to the economy of the pension program and the social insurance contributions that are levied to finance these costs."

He says that the cost of supporting retirees is equal to the resources they consume, just as the cost of a retirement program is reflected in the benefits it pays. These benefits, he says, are the major way the program affects the economy:

"If an aging society is causing these costs to rise to undesirable levels, adjustments will most likely require raising retirement ages and reducing retirement benefits. Changing the way pensions are financed changes the distribution of the costs, but doesn't necessarily change their magnitude."

Thompson explains that under certain conditions advance funding of a pension system can result in higher future payments without increased contributions. It is currently possible for the United States to place greater reliance on advance funding without creating individual private accounts, he says, and that should be seriously considered.

Collective and Individual Private Systems Compared

With the Social Security Fund projected to run dry by 2032, many critics of the current system advocate reducing reliance on the collective system and shifting, in part, to individual accounts. Thompson analyzes the challenges that must be overcome if such a system is to provide retirement security as adequately as the current system.

Thompson notes that the current, collective system provides a steady, life-long stream of income for retirees. It also provides protection for survivors and against inflation. In contrast, income from individually funded private accounts, dependent on the vicissitudes of investment markets, would be less predictable and might not last throughout an individual's lifetime.

Depending on investment decisions, income from private accounts also might not keep pace with wage and price increases, while collective systems can respond to inflation with cost-of-living adjustments.

Individual-account systems tend to be more expensive to administer than public systems. They also provide opportunity for management abuse. "Politicians are not the only people who are prone to promise more than they can deliver," says Thompson.

Assessing the Economic Impact of Public Pension Programs

Older and Wiser draws on analysis of pension systems around the world. Avoiding political considerations, the book provides a guide to clear thinking about the economic impact of public pension systems. The book looks specifically at whether public pension systems lower national savings rates, restrict productive labor, and hinder international competitiveness, as critics charge.

Thompson finds that a careful review of recent economic analysis shows there is "no consistent evidence" linking the introduction of public pension systems to declines in national savings rates. In industrialized countries, he finds "no correlation" between the rate of pension asset growth and savings rates. If a country wants to stimulate greater savings, he writes, pension changes alone are unlikely to work. Instead, it's necessary to combine a pro-savings pension policy with a pro-savings tax code, government fiscal surpluses and policies that discourage consumer borrowing.

Thompson also looks at a concern that public pension plans may reduce productive economic activity through their impact on the labor supply. Studies show clearly that people retire earlier when pension income is available, and it probably makes no difference whether the income comes from a collective public program or from a series of individual accounts. Studies also show that giving people a choice between lower benefits at an early age and higher benefits at later ages is not a very effective way to encourage longer work careers. Most people will take the lower benefit available at an earlier age.

The only policy that does keep people working, Thompson concludes, is to increase the age at which all pension benefits are first available. This would include not only the age at which Social Security benefits become available (currently 62) but also the age at which private pensions can be paid and the age at which funds can be withdrawn from individual accounts.

Some critics also contend that public pensions undermine international competitiveness by increasing production costs. Thompson cites evidence that spending on social security programs does not by itself impair competitiveness. "The question," Thompson writes, " is whether the positive impact of these programs is being offset by the impact that financing them has on the cost of doing business in a particular country."

Growing Worldwide Debate over Pension Funding

Older and Wiser is the result of extensive research Thompson conducted on behalf of the International Social Security Association (ISSA). In an introduction to Older and Wiser, ISSA president K.G. Scherman points out that debate over pension reform is taking place on every continent:

"Questioning of the role and function of social security is directly linked to the more general evaluation of the roles of the state and the public sector in society in a period of severe economic and financial constraints.... The current debate, along with economic constraints, has already led to significant reductions in the level of social protection in many countries."

In contrast, debate in the United States is driven not by current economic problems but by anticipation of a fiscal squeeze early in the next century. Congress needs to take corrective action to adequately fund Social Security and Medicare as the U.S. population ages and the ratio of workers to retirees declines.

Into the increasingly polarized debate over what to do, Thompson injects a dose of dispassionate economic analysis.

The Urban Institute is a nonprofit, nonpartisan policy research organization established in Washington, D.C., in 1968. It seeks to sharpen thinking about efforts to solve society's problems, improve government decisions and their implementation, and increase citizens' awareness about important public choices.