Commentary | Budget Taxes and Public Investment

A Deal Privitization Can’t Beat

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Opinion pieces and speeches by EPI staff and associates.

THIS PIECE ORIGINALLY APPEARED IN THE WASHINGTON POST ON DECEMBER 23, 1998.

A Deal Privatization Can’t Beat

by Dean Baker

The most common argument for privatizing Social Security is that workers would enjoy a higher rate of return on their money if they could invest it in the stock market. Privatizers argue that Social Security gives workers a low, or even negative, rate of return. They assert that the stock market, on the other hand, would give workers a 7 percent annual rate of return even after adjusting for the effect of inflation. These claims fundamentally misrepresent the facts by exaggeration privatization’s return and discounting the return Americans receive from Social Security.

Privatizes, understate Social Security’s return because they base their calculations exclusively on the retirement benefits that individual workers receive. They ignore the other aspects of the program, such as disability benefits and survivors’ benefits for dependent children and spouses. Social Security is more than an investment vehicle. It is an insurance policy against disability, premature death and an impoverished old age after a lifetime of low earnings. Any insurance company that charged its customers, on average, a dollar for each dollar in benefits it paid out would quickly go out of business. In the real world, insurers actually charge customers approximately $1.18 for each dollar in benefits they pay out. Any fair comparison of Social Security to the private sector must include this premium in its calculations.

But Social Security is an insurance policy against something else: inflation. Its retirement payments take the form of a real valued annuity: a payment that continues as long as the worker (and/or spouse) lives, and is adjusted for inflation. It is difficult if not prohibitively expensive to buy in the private market an annuity that is protected against inflation, and workers typically pay premiums of 15 percent to 20 percent to purchase an annuity that is not indexed to the cost of living.

When you factor in these four insurance features of Social Security – its protection against disability, premature death, an impoverished old age and inflation – its return increases significantly. No private substitute can offer nearly as good a financial deal.

While the conventional calculations understate the returns from Social Security, they inflate those of private accounts. The most important source of exaggeration is the projected returns in the stock market. Although those returns have averaged 7 percent over the past 75 years, they are unlikely to continue to be that high. The Social Security Trustees’ projections of slowed economic growth suggest that stock market return will range from 3.5 percent to 4 percent during the next 75 years. It is also important to note that most people will not keep all their money in stocks all the time. The conventional assumption is that over a worker’s life he or she will invest 50 percent of savings in stocks and 50 percent in lower-yielding bonds or money-market funds.

Next, it is necessary to count the administrative costs. In privatized retirement systems in Chile and Great Britain, these costs have run between one percent and 2 percent annually. Finally, one has to include the taxes needed to finance the transition to a privatized system. These taxes could be as high as 1.6 percentage points of a worker’s wage. Zero return is paid on transition taxes.

When the returns on private accounts are accurately tallied, they fall below 2 percent and may even dip below one percent. That’s far worse than most workers fare with Social Security. A two-earner” couple, for example, for example, in which the husband’s annual wage averages $27,500 and the wife’s wage averages $13,200 will reap a return of 3.2 percent when all the benefits of the Social Security program are assessed on the basis of their insurance value

Social Security’s benefit structure is progressive, so that poorer families receive a better return than higher-income families. A couple in which both spouses earn annual wages averaging $13,200 will get a return of 3.5 percent, when all the benefits of the Social Security program are taken into account, while a couple in which one member averages $44,000 and the other averages $27,500 will get a return of 2.4 percent. Still, an honest and thorough appraisal raises Social Security’s rate of return a full percentage point or more above what any privatization plan can deliver to most Americans.

Social Security will not make anyone rich, but it’s been a good deal for 60 years, and there’s no reason it can’t be a good deal for another 60.

[ POSTED TO VIEWPOINTS ON MARCH 30 ]

Dean Baker is a research associate for EPI and The Preamble Center. He specializes in macroeconomics.

See more work by Dean Baker