In US policy circles, few proposals are considered as evidently unpopular and unworkable as pension privatization. But privatization is an underrated idea, and progressives who oppose benefit cuts should be fighting for it.
Bear with me here.
Privatization normally means transferring a government function, or entity, to the private sector. But with retirement benefits (or any government entitlement) it can also mean switching a defined benefit, in which something is promised to you (income during retirement, health care, etc), into a private account that you use to buy those services instead. Sometimes, it’s a combination of the two. George W. Bush tried to switch to individual accounts invested in the stock market (in addition to a reduced, guaranteed defined benefit) but gave up in response to public resistance.
Privatization doesn’t have to work like that—indeed, given Bush’s experience, we probably won’t see another administration try the same approach. There are alternatives.
Privatize the back end
Social Security it a defined benefit pension plan operated by the government. In return for their taxes, the government pays people an income when they retire. In this system, the government bears all the risk and administers the program.
It could deliver the same benefits and privatize Social Security behind the scenes. An insurance company could take over administration of the program. Or, less radically, the government could expand its investment universe to include more private-sector options. For many years, Social Security took in more in taxes than it paid out in benefits. The surplus was invested in government bonds. Instead, some of the remaining assets could be invested in the stock market or other private-sector assets, and Social Security would be in a sense privatized without changing what most people recognize about the program.
Privatize the front end
Privatization is also associated with private accounts owned and directed by individuals. This is possible with no involvement from the private sector. Under Social Security’s current structure, people pay taxes in exchange for income in the future. But the program could be rejiggered (pdf) to feature private accounts, where taxes add to an account balance. The government could credit the account according to a rate of return equal to wage growth, and when account holders retire the account would buy an annuity.
This system would provide the exact same benefits (and risk) that people get now, but via private accounts. Or, the accounts could be made more generous. Take Bush’s proposal and limit the investment options to government bonds, or get the government to guarantee a rate of return. A guaranteed return is a great deal for retirees, since it means less risk and better benefits than they receive now, although it’s more expensive for the government and future tax payers.
With private accounts, the system would be much more transparent. Currently, for every $1 a middle-earning couple (born in 1985) pays into Social Security, they can expect $1.01 back in benefits when they retire. That’s not a great return on investment, and it may fall in the future because Social Security isn’t on track to keep paying this level of benefits. If the government cuts benefits enough to make the program solvent they’d only get $0.80 for every $1 they pay in.
Now, it is debatable whether investing in the stock market will improve returns enough to pay for future and existing benefits at current promised levels. But no one can deny private accounts would change the conversation about entitlements. It clarifies what people expect to earn in retirement.
Right now, the relationship between the tax dollars put in and the retirement income paid out is opaque. That is good for fiscal conservatives, because it makes it easier to cut future benefits—indeed, look no further than a Republican proposal to cut payouts unveiled earlier this month. And this is why private accounts should appeal to those on the left who value a generous social safety net.
Politically speaking, reducing an opaque future benefit is much easier than increasing current taxes, which is immediately apparent to everyone. The current benefit formula is complicated. The simplest explanation is that lifetime income is indexed to wage growth. Then it is applied to a formula that assigns a bigger replacement rate (the ratio of pension to income) to lower tiers of income (called “bend points”). It is hard to figure out what’s going on—few Americans know what a “bend point” is.
Limiting lawmakers’ flexibility to cut benefits with little resistance is perhaps the best argument against private accounts. If the goal is to ensure that benefit reductions must be made out in the open, private accounts may be the best way to go.