This column by ACRU General Counsel and Senior Fellow for the Carleson Center for Public Policy (CCPP) Peter Ferrara was published October 6, 2011 on Forbes.com.

Republicans are in disarray over Social Security. Mitt Romney wants to hide safely within the establishment status quo that is not working. Rick Perry understands the problem, but has yet to offer a workable solution. In path-breaking legislation introduced Sept. 12, the pioneering Rep. Thaddeus McCotter (R-Mich.) has now provided that solution, which reflects the full detail provided in my recent book, America’s Ticking Bankruptcy Bomb. McCotter is providing Republicans and the nation with rare creative leadership in proposing this insightful legislation.

Next year the baby boomers begin to retire on Medicare in earnest, and the year after that on Social Security. For decades now, the federal government’s own official reports have been showing that Social Security would not be able to pay all promised benefits to the baby boom without dramatic, unsustainable tax increases.

Last year, for the first time since President Ronald Reagan saved the program in 1983, Social Security began running a cash deficit. Under what the government’s actuaries call intermediate assumptions, those deficits will continue until the Social Security trust funds run out of funds to pay promised benefits by 2037. After that, paying all promised Social Security and Medicare benefits will require eventually almost doubling the current total payroll tax of 15.3% to nearly 30%.

Under what the government’s actuaries call pessimistic assumptions, the Social Security trust funds will run out of funds to pay promised benefits by 2029. After that, paying all promised benefits to today’s young workers would eventually require raising the total payroll tax rate to 44%, three times current levels, and ultimately more.

Social Security operates as a pure tax and redistribution system, with no real savings and investment anywhere. Even when it was running annual surpluses, close to 90% of the money coming in was paid out within the year to pay current benefits. Even the remaining annual surpluses were not saved and invested. They were lent to the federal government and spent on other government programs, from foreign aid to bridges to nowhere, with the Social Security trust funds receiving only internal federal IOUs promising to pay the money back when it is needed to pay benefits. Those federal IOUs are rightly accounted for in federal finances not as assets but as part of the Gross Federal Debt, subject to the national debt limit. That is because they do not represent savings and investment, but actually additional liabilities of federal taxpayers.

Such a pay-as-you-go tax and redistribution system does not earn the investment returns that a fully funded savings and investment system would. Consequently, over the long run the system can only pay low, inadequate, below market returns and benefits. That is why studies show that for most young workers today, even if Social Security does somehow pay all its promised benefits, those benefits would represent a real rate of return of around 1% to 1.5% or less. For many, the real effective return would be zero or even negative. A negative rate of return is like putting your money in the bank, but instead of earning interest on it, you have to pay the bank for keeping your deposit there. That is effectively what Social Security is for many people today.

Moreover, on our present course, that is what Social Security will be for everyone in the future. Whether the long term deficit is closed ultimately by raising taxes or cutting benefits, that will mean the effective rate of return from the program will be lower, ultimately falling into the negative range for everyone.

McCotter’s Solution

McCotter’s bill provides a complete solution to these problems, benefiting both future seniors and taxpayers, based on proven reforms that have already worked in the real world. The bill empowers each worker age 50 and below with the freedom to choose a contribution to a personal savings and investment account equal roughly to half of the employee share of the Social Security payroll tax. That contribution would be financed by a payment each year from general revenues, with no reduction in the payroll tax revenues flowing into Social Security. That avoids AARP’s chief criticism of personal accounts: that they would drain from the program the funds needed to pay for today’s benefits.

Each worker would be perfectly free to choose to stay with Social Security as is and forgo the personal accounts entirely. There would be no change in Social Security benefits under current law for those who make this choice. No change would be made in any way for those already retired today, or those anywhere near retirement.

The worker would invest the personal account funds by choosing from a range of privately managed investment funds, just as with the Federal Thrift Savings Plan for federal employees, or the Social Security personal account system adopted 30 years ago in Chile that has operated with such great success for the workers of that nation.

To the extent a worker chooses the personal account option over his career, the personal account would finance an equivalent percentage of the worker’s future Social Security retirement benefits. For a worker who exercises the account for his entire career, the account would finance the maximum of 50% of the worker’s retirement benefits. For those who exercise the account option for fewer years and later in their careers, the account would finance proportionally less under a statutory formula. But the personal accounts will pay more than the amount of Social Security benefits they replace, leaving the retiree with higher benefits overall on net.

Workers who choose the personal accounts are backed by a federal guarantee that they will receive at least as much as promised by Social Security under current law, maintaining the social safety net of the current program. That is similar to the guarantee backing the personal accounts in Chile. This is workable because standard, long term, market investment returns are so much higher than what completely non-invested, purely redistributive Social Security promises. After that, it’s extremely unlikely after a lifetime of investment that the personal accounts will not be able to pay at least that much.

The bill was officially scored by the Chief Actuary of Social Security, and his calculations are available on the Social Security Administration website. The Chief Actuary scores the bill as eliminating all future deficits of Social Security, with no benefit cuts or tax increases, assuring that all Social Security benefits will be paid. That is because the personal accounts finance so much of the future benefits of Social Security that future deficits between continuing payroll tax revenues and continuing benefit obligations of the program are eliminated entirely.

As a result, McCotter’s bill involves no change in the Social Security retirement age, cuts in the Social Security COLA, or other benefit cuts promoted by other proposals. Workers with personal accounts choose their own retirement age, with the incentive to delay retirement as is feasible to allow further account accumulations. Some workers as a result with mostly intellectual jobs may delay retirement well into their 70s, which could never be imposed politically otherwise. Other workers with more physically demanding jobs would still be perfectly free to retire in their early 60s.

Because long term market investment returns are so much higher than what Social Security even promises, let alone what it can pay, future retirees will actually enjoy higher benefits with the personal accounts. Wit
h those returns accumulating over a lifetime, the personal accounts will finance higher benefits than the Social Security benefits they replace under McCotter’s bill.

The bill involves the greatest reduction in government spending in world history, as the personal accounts take over the responsibility for financing through private personal savings and investment $8.555 trillion in future Social Security benefits, as scored by the Chief Actuary of Social Security. As a result, the Chief Actuary’s score indicates that the bill eliminates entirely the unfunded liability of Social Security.

Moreover, the general revenue contributions to the accounts are financed by further reductions in government spending. The bill provides that the accounts are to be financed only out of a Spending Reduction Account reflecting spending reductions already enacted.

Further legislation now being drafted specifies the spending cuts necessary to finance the accounts, as indicated by the Chief Actuary’s score. That will primarily involve block granting dozens of federal means tested welfare programs back to the states, modeled on the enormously successful 1996 reforms of the old AFDC program. That will add up to a minimum of another $3.75 trillion in spending reductions based on the Chief Actuary’s score, and probably more, bringing the total reduced spending under the bill at a minimum to over $12 trillion.

With the transition to the accounts funded entirely by reduced government spending, there would be no transition debt at all. That means all of the savings and investment in the accounts would flow directly into the economy in full, boosting jobs, wages and economic growth today.

But didn’t the financial crisis prove that such personal savings and investment for retirement is a bad idea, as the highly ideological President Obama claims. To counter that criticism, I conducted a study with William G. Shipman, former principle with State Street Global Advisors, perhaps the largest private pension investment management firm in the world. Our results were published in the Wall Street Journal in October, 2010.

We examined the case of a hypothetical senior retiring at the end of 2009 at age 66, who had the freedom to choose personal accounts when he entered the work force back in 1965 at the age of 21. Paying what he and his employer would otherwise pay into Social Security into the personal account instead, suppose he was fool enough to invest his entire portfolio in the stock market for his 45-year working career. How would he have fared in the financial crisis, as compared to Social Security?

Let’s call our hypothetical worker Joe the Plumber. While working, he earned the average income each year for full time male workers. His wife Mary, the same age, also earned the average income each year for full time females. She invested in the same personal account with Joe, an indexed portfolio of 90% large-cap stocks and 10% small-cap stocks, earning the exact returns reported each year since 1965.

This average income couple would have reached retirement at the end of 2009 with accumulated account funds, after administrative costs, of $855,175, almost millionaires. Indeed, they were millionaires, but the financial crisis lost them 37 percent of their account funds the year before they retired. This can be considered effectively a worst case scenario, as the couple retired just one year after the worst 10 year stock market performance in American history, from 1999 to 2008.

Yet, their account would still be sufficient to pay them about 75% more than Social Security promises them, increased annually for inflation just like Social Security. This assumes that in retirement the couple switches to a lower-risk, conservative portfolio of government and high grade corporate bonds earning on average a real return of just 3%.

In my book, I argue that by modernizing our old fashioned, tax and redistribution entitlement programs to rely on 21st century capital, labor and insurance markets instead, we can achieve all of the social goals of these entitlement programs far more effectively, serving seniors and the poor far better, at just a fraction of the current cost of those programs. Rep. McCotter’s bill is a demonstration of that.