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Saving Social Security: A Better Approach

The disappearance of the defined-benefit (DB) pension plan is one of the greatest financial tragedies to befall the U.S. citizen. As demographics have changed and as defined-contribution (DC) plans have become the primary vehicles for retirement savings, retirement planning has become fraught with uncertainty. This article argues that DB plans, such as the U.S. Social Security system, are fundamentally superior to DC plans and that the Social Security crisis is largely a crisis of demographics and funding. Social Security’s assets should be invested in a single portfolio that holds both stocks and bonds, and its risky return should be swapped for a fixed return to enable the provision of a DB. This proposal inexpensively affords insurance against a market decline and allows pensions of any kind to be made portable. In recent years, a number of proposals have been made to transform U.S. Social Security from a defined-benefit (DB) pension into a thinly veiled defined-contribution (DC) plan. We contend that a fully or partially funded DB plan is fundamentally superior to a DC plan for Social Security, and in this article, we describe how the DB feature can be preserved in the face of declining population growth, increased life expectancy, potentially lower economic growth, and diminished investment returns. To keep Social Security in some semblance of balance, any proposed restructuring must address four questions. First, should the Social Security system be structured as a pay-as-you-go or PAYGO system (in which the payments of the young are used to pay benefits to the elderly) or as a funded system in which each generation saves, in whole or in part, for its own retirement? Second, how should its assets be invested? Third, what rate of contribution is needed to ensure that citizens receive at least the same level of benefits as they would under the present system? And finally, what additional contribution is required to make the transition from a PAYGO system to a partially funded system? In this article, we argue that Social Security ought to maintain its defined-benefit structure, that it ought to invest in such risky assets as stocks and corporate bonds, and that a small (1.2 percentage points) additional contribution is all that is needed to keep it in balance. We address the many issues that arise when reforming Social Security and examine some examples of privatizations and the reasons for their failure. Social Security contributions have risen over time to 12.4 percent of the first US$102,000 of wage income in 2008 and will increase inexorably to 18 percent of all wage income by 2050 as a result of an increase in life expectancies and a steady decline in the number of workers per retired person. Demographic change is the root of Social Security’s problem; the required level of contribution for all PAYGO systems is inherently unstable. But a viable solution to the problem exists, and the Parable of the Talents from the Bible provides a useful analogy and points to the right solution: Before setting out on a journey, a wealthy landowner gave each of three servants talents (units of money) in proportion to their abilities. The first servant invested his 5 talents wisely and returned 10 talents to his master upon his return. The second, who had two talents, also invested his talents wisely and returned four talents to his master upon his return. The master, delighted by the industriousness of both servants, rewarded them richly. The third servant, however, for fear of losing his one talent, buried it under a tree and returned it unused to his master, who excoriated him for his sloth and had him cast out of his house. The key to our proposal, and to every other sensible proposal to save Social Security, is to follow the example of the first two servants and wisely invest the assets of the Social Security Trust Fund. We propose converting Social Security from a largely PAYGO system into a partially funded system and increasing the contribution rate by 1.2 percentage points. We envision investing Trust Fund assets in stocks and bonds, and we recommend smoothing fluctuations in return by using an innovative swap. These enhancements would eliminate the high costs associated with individual accounts while allowing for both a guaranteed level of benefits and the portability of pensions. The proposed changes would also make transparent the cost of political interference in the management of Social Security’s assets.