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May 1, 1996

Federal Reserve Bank of Cleveland

A Siinple Proposal for
Privatizing Social Security
by David Altig and Jagadeesh Gokhale


an area as contentious as federal
budget policy-witness the tortuous
road to the just recently settled budget
for fiscal year 1996-lawmakers agree
about one thing: The Social Security
system as we know it is unsustainable in
the long run. Unfortunately, this recognition has yet to yield any concrete action.
The system remains the proverbial third
rail of budget politics-touch it, and
your political life is over.
These observations would be of minor
interest if Social Security amounted to
small fiscal potatoes. Obviously, such is
not the case. The Social Security system
today stands as the largest single element
of U.S. fiscal policy. Yet, despite its size,
the program has received scant mention
during recent budget and election-year
debates on the nation's economic priorities, and is nowhere to be found in the
budget-balancing proposals emanating
from Congress and the President.
It would be grossly inaccurate to interpret this lack of attention as evidence
that all is well. Far from being on secure
financial footing, Social Security's longterm prospects seem shaky at best. Because the program is largely based on a
pay-as-you-go setup, most current worker contributions (that is, payroll taxes
withheld) are immediately transferred to
current retirees in the form of benefits.
Furthermore, because the limited surplus
of trust fund income relative to benefits
that does eXist must, by law, be exclusively invested in government securities,
ISSN 0428-1 276

the excess revenue is essentially available for current government spending. 1
Under such a structure, all current contributions are consumed (by either the
government or Social Security recipients), rather than invested in private productive assets. In essence, the pay-asyou-go nature of the system makes
future retirees dependent on the willingness and ability of future tax-paying
generations to provide retirement support by sustaining the system at whatever cost.
That the cost will be high in the coming
years is almost guaranteed by the impending retirement of the baby boom
generation. Indeed, its oldest members
are expected to begin retiring just 12
years hence. Although official projections show that the system will not be
bankrupt until the year 2030, its unfunded nature implies that taxes will
have to be increased or benefits reduced
much earlier to match trust fund incomes with outlays. To compound the
problem, as discussed in earlier issues
of this Economic Commentary series,
the current setup may be contributing to
lower domestic saving and investment
rates and hence to slower productivity
and wage growth. 2
Neither of the two commonly considered
methods of restoring the trust fund to
long-term solvency seems attractive. The
option of gradually increasing contribution rates to meet future benefit obligations would probably result in impossibly


Official government projections show
that with no change in policy, the U.S.
Social Security system will be bankrupt in the year 2030. Lawmakers
generally take the approach that
meeting future benefit obligations will
require a gradual increase in contribution rates or a reduction in future
outlays-both politically unpalatable
moves. But there is a third, more efficient alternative-privatizationthat could protect the benefits of current and soon-to-be retirees while
ensuring a secure old age for younger
workers and their children.

high burdens on younger workers as the
progressive retirement of the baby
boomers commences early in the next
century. The other option, of course, is to
reduce future outlays by cutting benefit
levels or increasing the normal retirement age. With either of the latter alternatives, however, current workers
unfairly receive low (or even negative)
returns on their past contributions.
Is there a third way out of the Social
Security quagmire? Surprisingly, the
answer is yes: Shifting to a privatized,
funded, and contribution-based system
may be a way of providing undiminished
benefits to current retirees while simultaneously preserving the promise of a
secure retirement for today's workers
and their descendants.
This Economic Commentary presents
such a proposal. The plan itself incorporates the "no harm, no foul" principle;
that is, reforming the U.S. Social Security system is feasible only if all participants can reasonably anticipate that they
will be at least as well off under the
alternative plan as they are under the
existing system.

"No Harm, No Foul": The
Pareto Efficiency Principle
In everyday language, the idea of efficiency is related to the absence of waste.
In the language of economics, waste is
defined by the answer to this straightforward question: Is it possible to reallocate
resources in such a way as to make at
least one person better off without harming anyone else? If the answer is yes,
there is scope for improving individuals'
well-being by putting the economy's
scarce resources to more efficient use.
Such welfare-enhancing reallocations are
considered to be "Pareto improving," a
label derived from Vtlfredo Pareto, the
Italian economist who developed this
principle of economic efficiency. An
equilibrium-which is really just a statement about the allocation of resources
given a particular set of prices for goods
and services-is said to be "Pareto efficient" exactly when it is not possible to
shift resources so as to make at least one
person better off without making anyone
else worse off.

This definition of efficiency means much
more than merely expanding output or
increasing the average worker's income.
From an economic perspective, inefficient fiscal policies offer the opportunity
for a free lunch. From a political point of
view, they suggest the possibility of
reform in which there are no necessary
losers. Pareto-improving policies thus
have the dual advantage of being economically sound and politically feasible.
Is a Pareto-improving reform of the U.S.
Social Security system possible? We suggest that it is, with one caveat: We adopt
the position that, at its core, Social Security is a pension system. This is an admittedly restrictive view, because Social
Security also plays a role in redistributing
income from rich to poor households of
the same generation and in providing
public insurance against macroeconomic
shocks across generations. 3 We treat
these goals as auxiliary to the central purpose of Social Security and assume that,
to the extent they are desirable, these
needs can be met through alternative
fiscal programs.

• The Problem with
an Unfunded System
Consider the case in which Social Security is strictly a pay-as-you-go proposition-that is, there is never any excess
of current taxes over current transfers.
(As explained earlier, this for the most
part describes the U.S. system.) The rate
of return on worker contributions is then
tied to the growth rate of the payroll tax
base. More specifically, the return that
can be sustained depends on the growth
of both wage income and the workingage population relative to the retired
Given that the share of working-age individuals relative to retirees is projected
to decrease over the next several decades
-and recognizing that this trend is not
likely to be offset by an acceleration in
wage growth-the return that future
retirees can expect to realize from Social
Security is significantly lower than what
they could earn from private pension

These observations were discussed in
more detail in a previous Economic
Commentary. 4 The authors of that article calculate that, under reasonable economic and demographic assumptions,
the inflation-adjusted rate ofreturn for
future beneficiaries of the current system
will fall below 2 percent. This is much
lower than, say, the real return on longterm government securities. Simply put,
recent and prospective developments
make participation in an unfunded pension system a bad deal for both current
and future workers.


Why Privatize?

From a purely theoretical perspective, the
problems inherent in an unfunded payas-you-go plan could be resolved by fully
funding future payments, but retaining
the public character of the system. In
such a world, trust funds would continue
to accumulate in the form of government
securities. Because the return to such
securities is determined by the market,
future recipients would be guaranteed
fair compensation (adjusted for risk) for
their Social Security contributions.
Two problems arise with such a plan.
First, because the system has until now
been essentially unfunded, there remains
the issue of satisfying the claims of those
who are currently retired (or who will be
retired in the near future). Second, for
future retirees to actually receive the
return implied by the trust fund investments, the government must use the
accumulated income wisely. If trust fund
contributions are employed merely to
finance more current consumption-as
opposed to being invested in productive
public assets-the tax base will not
expand sufficiently to honor the debt at
existing tax rates. The result will be a
greater future tax burden on all citizens.
Some of this burden may fall on future
retirees, representing a back-door taxation of benefits.

Private saving vehicles, such as equity or
corporate bonds, do not suffer from this
weakness. The investments that they
back are visible, and private firms do not
have the generalized power of taxation
that could, even inadvertently, obscure
losses resulting from unwise choices.
Furthermore, well-diversified portfolios
of private assets have an established
track record. For this reason, we believe
that a funded, privatized system is the
only viable option in the long run. The
balance of this article sketches the outline for such a reform.


Can We Do It?

The problem that has to be resolved is,
how do we determine the appropriate
cutoff age below which workers are
shifted to the privatized plan? The "no
harm, no foul" principle prescribes two
conditions that must be satisfied in converting to a private system. First, because
retirees and those close to retirement
have already passed the bulk of their high
earning and saving years under the
assumption that they would receive
Social Security benefits, most of them
would be unable to adjust their future
saving behavior to ensure retirement
security if that promise were abrogated.
Hence, efficiency requires that the current system's obligations to today 's older
generations be met under the new plan. A
portion of these obligations can be
financed from the contributions of older
workers who are in their pre-retirement
years and who are still contributing to the
system. The remaining obligations must
be met out of the contributions of
younger workers who will be shifted
over to the new plan.
The second condition is that the accumulated value of young workers' future
contributions to the privatized plan (net
of the amount devoted to older generations) must, at the time of retirement, at
least equal the present value of benefits
that they would receive under the current
system. Satisfying this condition is essential to conform to the "no harm, no
foul" principle.

For an individual starting from scratch,
the rate of return from a funded system
will clearly exceed that of the unfunded
scheme. However, if the cutoff age
below which individuals are shifted to
the privatized system is too high (say,
55), some workers would not have
enough remaining years to exploit the
increased private returns, leaving them
worse off than before.
Lowering the cutoff age provides
younger generations with more years to
accumulate their contributions at the
higher private rate of return, but that
must be traded off against the fact that
the liabilities to those who remain in the
current system (which increase as the
cutoff age is decreased) must be
financed out of the contributions of
those who are shifted to the new plan.
Choosing the appropriate cutoff age
requires balancing these concerns.
Calculations using the current distributions of Social Security benefits by age
and sex (assuming a 1.8 percent internal
rate of return on the contributions of
those included in the present system, and
an 8 percent return on investments in
private capital markets) suggest that 42
is the appropriate cutoff age. With this as
the dividing line, 18 percent of the contributions of those age 42 and younger
would be sufficient to provide those age
43 and older with benefits at least equal
to those received under the current system. 5 For younger workers, future benefits may be greater than those offered by
the current system, because their contributions will reap the higher private rate
of return for an even longer period.6


A Plan Worth Pondering

The plan described above suggests that
the objective specified at the outset of
this article is indeed possible: a structural reform of Social Security that
places the system on solid ground in the
long run, and that honors the obligations
to existing beneficiaries. The numbers
may be quibbled with, but the basic
arguments provide a sensible framework
for addressing one of the most important
fiscal issues facing the U.S. economy.

It is worth noting that apart from placing Social Security on a stronger economic foundation without reneging on
current obligations, privatization will
render other, indirect benefits. Current
tax and benefit rules generate several
types of income and wealth redistributions both within and across generations. This weakens the link between
worker contributions and benefits received, harming people's incentive to
work. Transition to a privatized system
would restore this link.
Moreover, under privatization, worker
contributions are guaranteed to be invested in private productive assets rather
than being consumed. The better saving
and investment outcomes that would follow are likely to enhance future productivity and economic growth, and to
translate over time into higher living
standards for young and old alike.


F ootnotes

1. In 1994, workers and employers deposited
about $380 billion in the Social Security trust
fund. Of this, almost $325 billion, representing 21 percent of total federal spending, was
disbursed as benefits to the elderly.
2. See J agadeesh Gokhale, "Should Social
Security Be Privatized?" September 15, 1995 ;
and Jagadeesh Gokbale and Kevin J. Lansing,
"Social Security: Are We Getting Our Money's
Worth?" January 1, 1996.

3. Because benefit payments do not rise proportionately with contributions, the system
implicitly cootains an element of progressive
taxation. In addition, benefits for wealthier
recipients are taxed explicitly.
4. See Gokbale and Lansing, "Social Security: Are We Getting Our Money 's Worth?"
(footnote 2).

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.

S. Our calculations suggest that the rate of
return on U.S. private capital has averaged
about 8.5 percent since 1961 , but to be conservative, we have chosen to use 8 percent.
Contributions of workers above the cutoff age
are assumed to be invested in government
securities, while those of younger workers,
including the portion devoted to paying off
the current system's liabilities, are discounted
at the higher, private rate of return . This,
again, is a conservative position, since discounting these amounts at a higber rate implies a lower present value of contributions
and hence a higher rate at which young workers' contributions have to be diverted to pay
off the system's future liabilities.
6. This is true despite the diversion of 18
percent of their contributions to those age 43
and older.


D avid Altig is a vice president and economist
and Jagadeesh Gokhale is an economic advisor at the Federal Reserve Bank of Cleveland. The authors would like to thank Chuck
Carlstrom and David Weil for helpful com-

ments and suggestions.
The views stated herein are those of the
authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
Economic Commentary is now available
electronically through the Cleveland Fed's
home page on the World Wide Web:

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