This column by ACRU General Counsel Peter Ferrara was published August 10, 2014 on Forbes.com.
The greatest fallacy in economic policy today is the failure to see the vast, pro-growth opportunities offered by fundamental, structural entitlement reform. Today’s entitlement programs broadly discourage capital formation and investment, as well as labor force participation. Structural entitlement reforms that would reverse those effects would pump huge waves of capital and labor into the economy, creating an economic boom.
That creates the opportunity for an entirely new perspective on entitlement reform. Instead of the negative politics of cutting benefits for the poor, seniors, and the sick, the productivity and market incentives of pro-growth entitlement reform create the opportunity for positive, populist reforms that would result in better benefits and incomes for the poor and seniors, and better health care for the sick, while reducing taxes and government spending by the greatest amounts in world history.
Over the next 3 weeks, I will discuss a comprehensive entitlement reform agenda that would produce these results, in continuation of the series I have been writing about the economic policies that would restore booming American economic growth. So far, over the last 3 weeks, I have discussed tax reform, deregulation, and transformed monetary policy based on a renewed gold standard. Now we are moving on to government spending, deficits and debt, focusing in particular on entitlements.
The entitlement reforms to be discussed next altogether would reduce federal taxes and spending over a generation by at least half from what they would be otherwise. They all involve proven reforms that have already been tried and have worked spectacularly in the real world. The reforms are all positive and populist, producing far better results for the poor, seniors, and the sick. That is because they rely on modern capital and labor markets, and market incentives and competition, to achieve the social goals of the current entitlement programs, which naturally work far better than government monopoly, tax and redistribution programs. The reforms would all also contribute vastly to far greater economic growth and prosperity for all.
Indeed, as I will show in the coming weeks, the potential is to empower middle class working families to retire as millionaires, eliminate involuntary poverty entirely, assure universal health care for all, and produce decades of above par economic growth, significantly above the historic, world leading, postwar, American economic growth trendline, that made America the mightiest economic and military power in world history.
Social Security Personal Account Prosperity
It all starts with granting each worker the freedom to choose personal savings, investment and insurance accounts to provide the benefits currently paid by Social Security.
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.
Social Security’s pay-as-you-go, tax and redistribution system does not earn the investment returns that a fully funded savings and investment system would, where the payments of workers and their employers today are saved and invested to finance their own future benefits. Consequently, over the long run the current, pay-as-you-go 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.
Indeed, 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.
Because Social Security is run completely on a tax and redistribution, pay-as-you-go basis, with no savings and investment, it is 100% unfunded, as that term is used in reference to all other pension systems, such as state and local government pensions, or private, employer pensions. It does have a dedicated revenue stream, but promises to pay into the system in the future are not considered to mean that the system is funded in reference to any other pension system. The Social Security actuaries calculate the unfunded liability of Social Security to total $23.1 trillion.
Medicare is also run completely on a tax and redistribution, pay-as-you-go basis, with no savings and investment. Evaluating Medicare on the same basis as any other system for retirement benefits, the unfunded liability of Medicare totals $106.8 trillion, based on calculations of the Medicare actuaries for 2009. I use the projections for the year 2009 because after the passage of Obamacare in 2010, the Medicare projections thereafter assume that Medicare does not pay doctors and hospitals sufficiently to assure timely and adequate health care for seniors, in accordance with the provisions of Obamacare.
That makes a total unfunded liability for the two programs combined of $130 trillion, almost 10 times the entire national debt. Our entire economy is only about $17 trillion.
There is a better way, proven to work in the real world. Workers could each be empowered to choose to save and invest what they and their employers would otherwise pay into Social Security in personal savings, investment and insurance accounts. Studies show that at standard, long term, market investment returns, for an average income, two earner couple, over a career the accounts would accumulate to close to a million dollars or more. Even lower income workers could regularly accumulate half a million over their careers.
Those accumulated funds would pay all workers of all income levels much higher benefits than Social Security even promises let alone what it could pay. Retirees would each be free to choose to leave any portion of these funds to their children at death.
Another virtue of these personal accounts is that with workers financing their own benefits through their own savings and investment, they can be free to each individually choose their own retirement age. Moreover, they would have market incentives to choose on their own to delay their own retirement ages as long as possible, because the longer they wait the more they would accumulate in their accounts, and the higher benefits those accounts could pay.
As a result, millions of workers with less physically taxing jobs would choose on their own to delay their retirement well into their 70s, a result that coul
d never be imposed politically. But other workers whose jobs required heavy physical labor or who for other physical reasons could not work past their early 60s could retire then. With planning, they or their employers could make additional contributions to the accounts over the years to finance more benefits in that earlier retirement. This is a far superior solution to the question of the retirement age than politics imposing one, uniform, unworkable retirement age on all.
Proven to Work In the Real World
A true personal account option for Social Security was first adopted in the South American nation of Chile over 30 years ago, in 1981. Those in the work force were freed individually to choose either the new personal accounts, or to stay in the old Social Security system. Workers who chose the personal accounts paid, in place of the old Social Security taxes, 10% of wages each month into a personal account directly and personally owned by the worker.
For investment of the individual account funds, the worker chooses from among 20 or so alternative, private, investment funds approved and regulated by the government for this purpose. As a result, workers do not need to be experienced investors to participate in the personal account system. They only need to pick one of the 20 investment funds, and the investment company will choose the individual stocks, bonds and other investments for the worker.
In retirement, workers can use some or all of the funds in their accounts to purchase an annuity, which guarantees the worker a specified monthly income for life, indexed to inflation. The annuity would also pay a specified survivors benefit for the worker’s spouse or other dependents after the worker dies. Workers also contribute an additional 2.3% of wages for the purchase of private, group life and disability insurance, taking the place of the pre-age 65 survivors and disability benefits of the old system.
Within 18 months of the reform, 93% of workers chose to switch to the new personal account system, 25% in the first month. Jose Pinera, the Chilean Minister of Labor at the time who spearheaded the reform, says, “They moved faster than Germans going from East to West after the fall of the Berlin Wall.” The experience of these workers has been exactly as discussed above. They pay about half of the required taxes under the old system, yet because of the compound interest over a lifetime of savings and investment, they are retiring with major asset accumulations that pay them much higher benefits than the old system even promised them, let alone what it could pay.
Within a few years after the reform was adopted, annual economic growth soared to 7%, double the country’s historic rate, while unemployment fell to 5%. The higher savings and lower taxes resulting from the personal account reforms are recognized as major contributors to that. After 20 years under the reforms, the enormous savings in the personal accounts totaled 70% of GDP. In fact, Chile is well on its way now to becoming a fully developed, first world, economy. The unfunded liability of the old system is now virtually eliminated, and the new personal accounts involve a private, fully funded system.
But also in 1981, workers in 3 counties in and around Galveston County, Texas voted to opt out of Social Security into a new defined contribution plan under a provision of Federal law that allowed state and local government workers to make this choice. Close to 10% (9.737%) of the worker’s salary is contributed to the defined contribution account each year. The money goes to a bank, First Financial Benefits of Houston, which then lends the money long term to top rated financial institutions for a guaranteed interest rate. That rate has averaged 7.5% to 8%. Those financial institutions make their own investments with the funds and use the earnings to pay the guaranteed interest rate. The risk to workers is consequently greatly reduced. Their investment returns do not go up and down with the stock market. The workers also do not have to make investment decisions. The bank does that for them.
Just as in Chile, workers in this real savings and investment plan have enjoyed documented benefits much higher than Social Security even promises, two to three times as much, with higher survivors and disability benefits as well.
Finally, there is another example from America, the Thrift Savings Plan (TSP) for Federal employees. This TSP system has 3.5 million investors with a total of $158 billion in investments. The maximum Federal contribution to the account is 5% of salary, which would be matched by 5% from the worker, for a total of 10%. For investment, the workers choose among 6 fund options with different mixes of investments among stocks and bonds, and can choose to shift among these funds at any time. At retirement, workers can use some or all of the assets in their accounts to purchase an annuity guaranteeing a specified monthly income for the rest of the worker’s life. With 10% of the worker’s salary going into this system each year, over an entire career at standard market investment returns this system alone would end up paying much more than Social Security even promises, let alone what it can pay.
The Financial Crisis
But didn’t the financial crisis prove that such personal savings and investment for retirement is a bad idea, as President Obama claims, mocking the idea of personal accounts? I joined with William G. Shipman, former principle with State Street Global Advisors, to rebut that uninformed rhetoric. We calculated the results for a hypothetical, middle income couple entering the work force in 1965, and retiring in 2009, at the end of the financial crisis. We assumed they invested everything in a broadly diversified portfolio of stocks, using the actual market returns for each of those years.
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.
These calculations are consistent with the experience of the already existing, real world versions of personal accounts. Chile’s personal account system survived the financial crisis with no bankruptcies in the personal account investment funds. Indeed, not even a dollar had to be paid out on the guarantee backing the accounts, as the lifetime of savings and investment in the accounts still provided benefits greatly exceeding what the old system even promised.
In the Galveston plan in the U.S., returns on the accounts declined for a couple of years during the financial crisis, but no one lost their retirement funds, with all still enjoying much higher benefits than Social Security. Moreover, the returns have long since recovered. Similarly, the personal accounts enjoyed by federal workers in the federal Thrift Savings Plan (TSP) suffered declining returns for a couple of years, but the accounts have since recovered those losses, as documented on the website of the TSP.
President Obama’s rhetoric implies that lifetime savings and investment to support retirement benefits is not a good idea, because such investment entails market risk. Yet, despite the financial crisis, every state and local government pension fund, every corporate pension plan, the federal employee retirement plans, and the successful Social Security reform in Chile, copied now by other countries around the world, continues to be based precisely on capital investmen
t to finance the expected retirement benefits.
But didn’t the experience of President Bush prove the unpopularity of the persona account idea? Quite to the contrary. Bush ran on promises of personal accounts in 2000 and 2004, winning both times while carrying the senior vote, with a boost to the Republican youth vote. But Bush never proposed any personal account plan while in office. Instead, he proposed progressive price indexing in a nationally televised address, so forgettable a blunder that no one even remembers it any more. That was the result of bad staff work.
Democrats tried to make personal accounts the central issue in the 2002 midterms. But everyone supporting personal accounts won; everyone opposing them lost.
Instead, it was Paul Ryan who proposed a personal account option for Social Security, with my close advice, which mirrored quite closely the Chilean plan, in 2004 and 2005. The score of the bill by the Chief Actuary of Social Security, still available on the official website of the Social Security Administration at www.ssa.gov, documented all of the above claims for the reform.
The Chief Actuary found that the personal accounts in the Ryan Sununu bill would achieve full solvency for Social Security, completely eliminating Social Security deficits over time without any benefit cuts or tax increases. That results because so much of Social Security’s benefit obligations are ultimately shifted to the private sector accounts, while the employer share of the tax remains in place.
Indeed, over several decades, virtually 100% of Social Security retirement benefits would be shifted to the private sector personal accounts, as the Chief Actuary concluded that the accounts proposed in the bill would be so beneficial for workers that all workers would eventually choose the accounts (which is validated by the experience in Chile). That would be the largest reduction in government spending in world history. No benefit cut reform would achieve anywhere near that result.
In fact, as discussed above, at standard, long term market investment returns, the accounts would produce substantially more in benefits for working people across the board than Social Security now promises, let alone what it can pay. So seniors would retire with higher benefits, at a retirement age they chose, rather than the government.
Ryan’s bill would also ultimately eliminate the unfunded liability of Social Security entirely. That would result because over time, pay-as-you-go, non-invested, purely redistributive Social Security would be transformed into the fully funded, savings and investment based, personal accounts.
Workers would also directly own and control the funds in the personal accounts, which they could choose to leave to their children or other heirs. After just the first 15 years under Ryan’s personal accounts, workers would have accumulated $7.8 trillion in today’s dollars, after inflation, according to the Chief Actuary’s score. After 25 years, that would be $16 trillion. This is the only economically plausible means for addressing the issue of inequality.
The personal accounts funnel new rivers of savings and investment into the economy. Higher savings and capital investment translate into higher productivity and increased wages for working people. It creates new jobs and new opportunities. The bottom line is increased economic growth. Such increased capital would finance the practical implementation of our rapidly advancing science, leapfrogging our economy further generations ahead of the world.
Financing the Transition
Any plan for personal accounts for Social Security involves a transition financing issue. That arises because Social Security operates on a pay-as-you-go basis, with almost all of the money coming in immediately going out to pay current benefits. If part of the money coming in goes for savings and investment in personal accounts instead, additional funds will have to come from somewhere else to continue paying all promised benefits to today’s retirees.
The transition financing money is effectively financing the savings going into the personal accounts of working people across America. That accumulated savings and investment is not a cost to the economy, it is a mighty, productive contributor to the economy. The working people seeing that money growing in their own personal accounts would certainly recognize that it is not a cost, but, in fact, an asset. The personal accounts are actually just a politically sophisticated means of shifting from the current, completely non-invested, tax and redistribution, Social Security system, to a fully funded system based on savings and investment, which should be readily recognized as the complete, responsible, desirable solution to the issue of Social Security.
But this transition financing would all be more than covered by the reduced government spending resulting from the other entitlement reforms discussed in this series, and by the increased royalty revenues from an aggressive policy of leasing federal lands and offshore for oil and gas exploration and development (which would be further massively pro-growth) . With the transition financed entirely by such reduced spending and new revenues, the personal accounts would produce entirely a massive contribution to national savings and investment.
A Vision for Reform
The personal accounts should eventually be expanded to provide a private alternative for the entire employee share of the payroll tax, privately financing all of the benefits now financed by the payroll tax. That should include the Medicare payroll tax as well, with the saved funds financing monthly annuity benefits used to purchase private health insurance in retirement.
With the accounts then paying for all of the benefits currently financed by the payroll tax, that tax would eventually be phased out altogether, which would be the largest reduction in taxes in world history. Workers would instead be paying into the family wealth engine of their own personal savings, investment and insurance accounts. In the process, government spending equivalent to about 10% of GDP would be transferred to the private sector, the largest reduction in government spending in world history.