(FORTUNE Magazine) – Just Moments after President Clinton presented his Social Security reform plan during his State of the Union address, Republican Congresswoman Jennifer Dunn of Washington went on camera to deliver her party's counterproposal. What she promised was wondrous indeed: Her party could shore up Social Security's finances without touching a dime in future benefits, raising a nickel in taxes, or diverting a penny of the money flowing to current retirees. The mechanism behind this marvel, any casual listener would have concluded, was a system of what Dunn called personal retirement accounts. Under this arrangement, a percentage of all workers' Social Security taxes would be funneled into their own mini-IRAs; the accounts would yield a higher return than Social Security now earns; and then--this part was unclear, but presumably had to do with the miracle of compound interest--everything would be fine.

We wish. After 64 years of living under the "contract between generations," we're itching to renegotiate. And who can blame us? The leading edge of the baby boom is just ten years from retirement, and the system is $3 trillion short. Privatizing Social Security--the buzz phrase that encompasses all plans in which income from self-directed retirement accounts replaces some Social Security benefits--sounds like just the thing we've been looking for. Such accounts have the ring of new thinking. They fit nicely with our mistrust of big government and our faith in America's remarkable capital markets. Indeed, after a 16-year bull run on Wall Street, what could be clearer than that we'll all be better off letting our FICA taxes compound at the S&P 500's rate of return? It sure seems obvious to our elected officials: Of the 30-odd Social Security reform plans now knocking around Congress, all the leading contenders involve some degree of privatization. As a nation we seem to have decided that what works for municipal garbage pickup and Eastern-bloc republics (well, some of them) will work for the national pension too.

Before we commit ourselves, though, we really ought to think this through. Private retirement accounts, intellectually appealing as they may be, are not a free lunch. Privatization won't reduce the number of retirees demanding goods and services. It won't help us make good on the promises we've made to current retirees and older workers. It won't even necessarily give Americans a better return on their tax dollars. As you can see in the chart later in the story, many people would be worse off under a typical privatized system than under a system reformed along more traditional lines. What privatization would do for sure, however, is violate the first principle of insurance. It would effectively junk the current system's ability to spread economic risk over an entire population and replace it with an unprecedented, nightmarishly complicated network of 147 million tiny investment accounts. If our goal is to provide a safe foundation of retirement income for an entire work force, that's not the way to do it.

By now most of us know the tale of Social Security's future, the sort of scary bedtime story actuaries might tell their kids. The system is designed to run on a pay-as-you-go basis, meaning that benefits to current retirees are paid by taxes on current workers. As an apparently unintended consequence of the last rescue package, in 1983, the system now runs a surplus, taking in an expected $54 billion more in taxes this year than it will pay in benefits. The extra cash collects in Social Security's trust fund, where it's invested in special-issue Treasury bonds. With the retirement of the baby-boomers, however, the surplus swings into deficit in the year 2013, at which point the trust fund begins to draw on those Treasuries to pay the bills. By 2032 the bonds are all gone, and the tax dollars flowing into Social Security will pay only 75% of the benefits now being promised.

Clearly something has to be done before 2032, but in the hands of privatization advocates the situation can sound downright apocalyptic. To put the system in balance over the standard actuarial measuring period of 75 years, they'll tell you, we'd need to raise $4 trillion--right now. If we were to shut down the system tomorrow, we'd be on the hook for an estimated $9 trillion. (If these numbers don't get to you, privatizers can raise the question of whether the Social Security trust fund even exists. See the box below.)

Luckily, we don't have to pay for the next 75 years' worth of benefits right now. And who said anything about shutting down the system tomorrow? A more useful question is, What would it cost to make up the shortfall within the time we have to do so? According to Henry Aaron, senior fellow at the Brookings Institution and a veteran of Social Security battles since the 1960s, the system would snap back into actuarial balance if Congress were simply to raise FICA taxes this year by 2.2 percentage points, or 1.1 points each on the employer and employee. This is not an endorsement of tax hikes--talk about a political nonstarter--but simply an indication that the program's condition is not desperate. Says Aaron: "I can't go along with the statement that this is a crisis, because it's so demonstrably false."

Besides, it's not as if private accounts eliminate the need for sacrifice. Every serious privatization proposal comes with a formula of benefit cuts or tax hikes that aren't all that different from those sought in more traditional reforms. (See the table above.) That's true even of the plan devised by Harvard University professor Martin Feldstein, which Senators Phil Gramm (R-Texas) and Pete Domenici (R-New Mexico) are promoting in slightly modified form as the ultimate patent medicine for what ails Social Security. The plan would actually raise benefits--certainly a novel solution to a long-term funding problem--and cover the shortfall out of corporate taxes and the budget surplus. A Social Security Administration analysis of Feldstein's original proposal found that it would poke a $163 billion hole in the federal budget in the year 2008 alone. Even so, the plan would keep Social Security solvent only until 2036--just four years past the current system's breaking point.

Michael Tanner--director of the Cato Institute's Project on Social Security Privatization, the libertarian epicenter of the movement--argues that you don't need to believe the current system is collapsing to favor privatization. "It isn't really a question of solvency," he says. "It's a question of fairness."

Tanner has a point, and he and his colleagues have turned the fairness issue into a powerful lever. Simply stated: Compared with the past, workers today can expect stingy benefits in return for their FICA taxes, and the rates of return shrink with each succeeding generation. For workers born in 1929, for example, benefits worked out to a return on taxes of about 4.2% after inflation. For those born in 1975, it would be more like 1.8%.

Blame this fact on past Congresses, which let Social Security run on a pay-as-you-go format and continually boosted benefits. Put uncharitably, they allowed Social Security to become the world's largest tax-funded Ponzi scheme. Like any such operation, it's a zero-sum game: Because our forebears did well, we and our children mathematically have to do worse. "Basically, every cohort born before 1937 got a subsidy from Social Security," says Olivia Mitchell, a Wharton School economist and Social Security specialist. "Every cohort born since is paying for it."

Future generations may not like this situation, but the question is, Would privatizing Social Security make it go away? Mitchell and many others who studied the question say it wouldn't--because it can't. Adding private accounts to Social Security doesn't absolve us of the promises still outstanding to seniors and older workers; those costs are baked into the system, and however drastically we alter the way we pay beneficiaries in the future, we first have to pay off the promises we owe now. Keeping our word in that regard would be just as much a cost of a privatized Social Security as it is of the current system.

Look at what really happens if we privatize. Say the program puts 2% of your 12.4% FICA tax into a private savings account. The rest continues to pay current beneficiaries, except now there's 16% less revenue to cover the same bill. The money has to come from somewhere, so taxes have to get raised, money borrowed, or benefits cut.

These transition costs, as they're called, would basically soak up whatever advantage taxpayers could get from investing their private accounts in the financial markets. A privatization plan sponsored by Sylvester Schieber of Watson Wyatt Worldwide and Carolyn Weaver of the American Enterprise Institute calls for $2 trillion in new borrowing and a "temporary" additional FICA tax of 1.52% that would last for 70 years. "If that tax is temporary," observes New York Life actuary and Social Security expert Bruce Schobel, "so are we all."

What do transition costs do to the payback on your Social Security taxes? Look at the chart on the next page of this story, which shows how a generic privatization plan developed by the Employee Benefit Research Institute, a nonpartisan pension think tank, might work for two groups, one born in 1976 and one born in 2026. In EBRI's model the people born in 1976--who would face transition costs during their whole career--would get a smaller payback from the privatized plan than from a system that merely cut benefits and hiked taxes to come back in balance.

Privatization pays off better for the group born in 2026 (which retires after 2090). William Shipman, a principal at State Street Global Advisors and a privatization advocate, argues that this is what really makes his case. "I use the analogy of refinancing a mortgage," he says. "You have to pay up-front costs like points, title insurance, and so on, but eventually you'll be better off."

That's not really an argument for privatization, though. The class of 2026 was better off because it joined the work force after its elders had absorbed all the transition costs. The 1976ers bore the double burden of paying benefits to their parents and of partially funding their own retirement ahead of time through their private accounts. (As a result the 2026ers didn't have to pay the class of 1976 as much as they would in a pay-as-you-go system.) The private accounts amounted to forced saving, but the fact that they were private isn't what mattered; what mattered was the saving. The 2026ers overall would get the same benefit if the system had never privatized and the 1976ers had instead built up identical assets in the Social Security trust fund. (In pension-speak, this is called advance funding.)

This assumes that the Social Security trust fund and any system of private accounts could hold identical investments. Right now that's not the case. The trust fund can own only Treasuries, whereas private accounts would presumably be allowed to own stocks as well. But President Clinton called for the trust fund to be diversified into stocks; we'll consider below why that's not as impossible as everyone seems to believe. But let me repeat the crucial point: The Social Security system as a whole would be equally well off whether the same assets accumulated in one big pot, like the trust fund, or in 147 million little ones, like private accounts. "Much of the discussion isn't really about private accounts vs. Social Security," says MIT economist Peter Diamond. "It's about advance funding vs. pay-as-you-go."

Advance funding--just another term for forced saving--is an idea that Republicans and Democrats seem to agree on. Every private-account proposal assumes advance funding. The President's proposal--which would pump new Treasuries as well as stocks into Social Security--is an example of advance funding through the trust fund. Prefunding does, all in all, make the system sounder in the long run for the simple reason that in a prefunded system you have investments and they earn interest; in pay-as-you-go there are no investments. Like prefunding in private accounts, though, prefunding in the trust fund is no free lunch. As one generation saves, it also continues paying for promises made under the old pay-as-you-go system. That means that for returns to improve for workers in the distant future, they have to get worse for those in the present and near future. That's a tradeoff, but it's one we ought to make.

While most economists agree on prefunding in theory, they sharply disagree on one practical matter: Can you trust the government to invest in private securities? It's not a trivial concern by any means, but it overlooks one fact: The government already does.

The 12-year-old federal employees' Thrift Savings Plan (TSP) now holds about $48 billion in stock and corporate-bond index funds. By limiting investment to index funds, the government takes itself out of the investment decision. All the stock trading and all the shareholder voting is done by a private asset manager hired by the TSP's board. Congress (which knows itself only too well) designed the board to resist political meddling. Among other safeguards, it is not hostage to the congressional appropriations process; the funds themselves pick up the board's expenses. In addition, each member is a named fiduciary, meaning he can go to jail if he fails to act solely in the interests of the fund's participants.

So far, politicians have yet to interfere in a single decision--and not because they've suddenly become virtuous. "I heard from plenty of Congressmen and Senators," says Francis X. Cavanaugh, the board's CEO from 1986 to 1994. "I read them back my duties under the law they themselves had written, and that ended that."

To be sure, many reasonable people are not convinced that a TSP-like board could protect a huge trust fund. Most prominent among them is Federal Reserve Chairman Alan Greenspan, who testified before the Senate Budget Committee: "Even with Herculean efforts, I doubt if it would be feasible to insulate, over the long run, the trust funds from political pressure." Before we let Greenspan's opposition kill the idea, however, we should ask whether it's any easier to insulate private accounts. How long could Congress resist proposals to allow people to withdraw money for a sick child, or to make the down payment on a house, or to send a kid to college? After all, in recent years Congress has done nothing but liberalize access to IRAs and 401(k)s. The politician's instinct to make crowd-pleasing gestures with other people's money remains under either system. The only difference is that with private accounts there would be no fiduciary board or public watchdogs to keep Congress from letting people spend their retirement savings. In fact, the pressure would be just the opposite. After all, aren't private accounts "your money"?

Another fundamental difference between private accounts and a prefunded Social Security trust fund is in how the two plans distribute economic risk. The trust fund is the ultimate risk pool: Outcomes good and bad can be spread over hundreds of millions of people, including those not yet born. In private accounts, the rugged individual bears all the risk and gets all the return.

Certainly, in a free-enterprise system, individuals should bear the consequences and reap the rewards of the risks they take. But Social Security is not meant to recreate the free market. In fact, it's supposed to smooth some of the Darwinian edges off capitalism by securing a stable foundation for everyone's retirement. Privatization undermines that goal. Whatever the return on the average private account turns out to be, it's an absolute certainty that millions of account holders will earn less. A person in EBRI's hypothetical privatized Social Security plan who invested in bonds only, for example, would retire with about 25% less income than a wiser or luckier contemporary. How will that person feel? Will we have reformed Social Security only to create a new class of aggrieved citizens?

Private accounts' ultimate Achilles' heel is likely to be their sheer impracticability. "The biggest hurdle to privatization is how administratively they could even do it," says Michael Johnson, a partner at Hewitt Associates, the big benefits consulting firm. "It is a huge, huge problem." Nothing the government or the financial services industry does now even begins to approach the complexity of administering private accounts for U.S. workers in all their job-hopping, part-timing, Cantonese-speaking, mom-and-pop-shop-owning diversity. Not the 401(k) industry, which covers no more than a quarter of the work force--and by far the highest-paid, most stably employed quarter at that (see First). Not the current Social Security system, whose common-fund structure lets it get by without down-to-the-dollar accounting. For example, Social Security has a margin of error of $700 per employer per year. That's one of the ways it copes with 28 million employer filings annually that fail to match with IRS and other records.

Even if they're feasible, private accounts will inevitably be more expensive to administer than the Social Security trust fund, because 147 million individual accounts lack the economies of scale that a single common trust fund would have. So not only would we be asking the owners of those accounts to bear all the risk; we'd be guaranteeing them a lower income, after costs, than an identically invested trust fund would deliver.

Here's the bottom line on privatizing Social Security. If you think it is a pain-free way to make the system solvent, you're being fooled. If you think it automatically provides a better return on your Social Security tax dollar, you're overlooking transition and administrative costs. If you think Social Security should be funded in advance but don't trust Congress to keep its hands off, you're entitled to your opinion. But are private accounts--if they're even feasible--really the solution? The current system ensures that individuals don't have to bear by themselves the risks of low wages, of flat investment markets, and of outliving their nest eggs. Is it really better policy to herd 147 million taxpayers into high-cost accounts--and then leave them to their fate?

REPORTER ASSOCIATE Natasha Tarpley