As Americans grow older, leading longer and healthier lives, many are beginning to recognize that their economic future is under threat. Social security, that safety net of past generations, is fraying rapidly. The system will probably run out of money by 2025 — a deadline that creeps nearer each year. But despite this looming disaster, as recently as two years ago little serious debate existed in the U.S. about privatizing social security as a possible solution. Hardly anyone asked whether privatization could help defuse an economic time bomb that keeps ticking away and could potentially affect millions of retired people if it explodes.

Today, the situation has dramatically changed. In the U.S., a federal advisory panel has recommended investing some social security revenues in the stock market. Similar issues are being hotly debated all over the world. In Europe, for example, countries like Germany and France are looking for ways to avert major crises in their old-age pension systems.

In Latin America, countries from Uruguay to Mexico are grappling with these questions and examining the record of neighbors like Chile which have privatized social security. In addition, many developing countries are contemplating changes in their pension systems, often as part of a wider overhaul of their financial markets. Clearly, privatizing social security is moving to the top of many countries’ agendas as they debate ways to provide for their aging populations.

An important voice in this debate belongs to Olivia S. Mitchell, International Foundation of Employee Benefit Plans Professor of Insurance and Risk Management and executive director of Wharton’s Pension Research Council. In a paper presented at a National Bureau of Economic Research conference — entitled “Administrative Costs in Public and Private Retirement Systems”—Mitchell argues that while privatizing social security would increase some administrative costs, it would also make the system more flexible and offer new services to participants. Among them: the ability to self-direct investments, the possibility of investing in high-return assets and more frequent reporting to participants. As a result, people might be happier with a partly privatized social security system than they are with today’s publicly controlled one.

Rethinking Corporate Benefits

These findings are crucially relevant to businesses. Most large companies, including Fortune 500 corporations, have pension plans for their employees, but in the past these were often designed on the premise that social security would provide a big part of the workers’ retirement benefits.

Today, companies are being forced to recognize that because of the impending social security crisis, the relative share of the public sector’s benefits to retirement incomes will decline in the coming years. “This means corporations will have to rethink the benefits they are offering as part of their defined benefits and 401(k) plans, and they will have to restructure their end-of-work retirement packages,” Mitchell says. In addition, companies will have to educate their employees about putting aside more money for their retirement. “Social security is not going to be as strong a leg of the retirement stool as we used to think,” she notes.

If social security does get privatized in the future, what kind of changes can companies expect to see? According to Mitchell, the social security system has three main components: collecting the money which people pay into the system; managing money while it is in the system; and distributing money to people after they retire. While countries like Chile have tried to privatize the collection mechanism — the country requires individual pension fund administrators to collect money from each worker — that is unlikely to happen in the U.S. It is much less expensive to piggyback on the existing tax collection system although questions are often raised about whether the Internal Revenue Service is as efficient as it might be. The money management and benefits distribution parts of the social security system, however, are potential candidates for privatization, Mitchell says.

Privatizing Investments

The money-management component in the U.S. is at present inexpensive to operate. This is because social security funds can only be invested in government paper. One way to privatize social security is to open up the possibility of investing in other kinds of instruments, such as stocks. This would probably increase administrative costs, but it would also permit higher returns.

“You can make the system anything from very inexpensive to quite expensive,” Mitchell explains. “It depends on how much flexibility you give participants, whether they are allowed to switch money across accounts, whether they have an 800 number, and so on. Typically, the very flexible, actively managed accounts might cost up to 2 percent or even 3 percent of assets a year. However, there are other examples where the cost is maybe 10 basis points a year [0.1 percent] or even less.”

Investing in stocks could potentially help pension plan participants earn higher returns than if their cash were invested only in Treasuries. It would also increase their investment risk, however. While people may not mind investing a part of their money in a company touting the hottest new technology, what if they are unwilling to risk their retirement nest eggs to bet on such stocks?

According to Mitchell, this can be a complicated problem. “When you think about social security funds being invested in anything other than what they are currently invested in, which is a very mechanical investment decision, immediately questions arise about who is going to make decisions over what investments,” she says. “That is part of the issue. The other part is, who bears the cost if the investments turn out to be bad after the fact?” Mitchell says that studies of state and local pension funds have shown that in some cases, political factors come into play in deciding how pension fund money gets invested.

Individual Accounts

One alternative to letting governments — which are prone to political pressure — make investment decisions is to let individuals manage their own accounts. “If you want to invest in a tobacco-free stock, by all means go for it,” Mitchell says. “Someone else might choose only tobacco stocks, based on his own perceptions of risk and returns, and that would be his prerogative in his own individually managed account.” When individuals bear the risks and potentially the rewards of their own investment decisions, they would be much less likely to be at the whim of whatever political issue becomes a hot one.

Another option might be for the government to offer three or four plans and for people to choose among them. “That is the model that the federal employees now have,” Mitchell notes. “They have a simple index stock fund, a broad portfolio bond fund and a government securities fund. Each of those funds is very minimally managed and very low cost, but there are certain constraints. You can’t call an 800 number and change it five times a day. People are not encouraged to try and time the market; they are encouraged to make an investment decision and stick with it.”


Defining a Debate: Three Options to Privatize Social Security

On January 6 the 13-member Advisory Council on Social Security submitted a report recommending that the country consider investing social security funds in the stock market. Seven members of the federal advisory panel believe that if social security funds are invested in individual investment accounts, this would help ensure the fund’s solvency and potentially boost retirement incomes. Critics, especially labor unions, however, are opposed to the introduction of individual accounts. The panel outlined three options:

Maintain Benefits: Under this proposal, benefits would be trimmed by 3 percent and they would be taxed more. Also payroll taxes would be raised in the future.

Individual Accounts: This proposal would require workers to save an additional 1.6 percent of their wages in individual accounts to be invested in stock and bond funds.

Personal Security Accounts: This proposal would require workers to invest a substantial fraction of their payroll taxes in stock and bond funds. A part of the social security tax would be used to finance a flat benefit at the current level of about $410 a month.

Commenting on these proposals, Mitchell says that in reality there are just two plans. “The Maintain Benefits proposal keeps the philosophy of a defined benefit program, while the other two proposals are versions of a defined contribution program,” she says.

Advocates of the Maintain Benefits proposal say that this option will preserve the anti-poverty, income redistribution aspects of social security. Mitchell notes, however, that the government will almost certainly have to raise taxes to pay for reforming Medicare.

As for the other two plans, Mitchell says that both have a flat benefit component and an individual account component. “How big these components are is a matter of political will and compromise,” Mitchell says. “There’s a bigger upside to these plans. If I were designing a system from scratch, I would probably go that way.”