THE PRIVATIZATION OF SOCIAL SECURITY WHO WINS? WHO LOSES?
By TERESA TRITCH

(MONEY Magazine) – APRIL 1996 MAY MARK THE BEGINNING OF the end of the Social Security system as Americans have known it for 60 years. Sometime this spring, the Clinton Administration's 13-member Advisory Council on Social Security will unveil proposals to ensure the long-term solvency of the program beyond 2030, the year it is now projected to go broke. The council's report will set off a national debate that is expected to last until Congress votes a rescue plan, probably during the next President's term. The issues: Should Congress merely tinker with Social Security? Or should Congress adopt a radical proposal to partially privatize the system? One idea: Require working Americans to contribute more than 80% of the Social Security taxes they now pay to personal retirement savings accounts invested in stocks and bonds.

The real issue for you, of course, is whether tinkering or privatization would give you a more comfortable retirement. To help you find out, Money asked former Social Security Administration actuary Bruce Schobel, now a vice president at New York Life, an insurance company in New York City, to calculate the monthly retirement benefit for real and hypothetical people of different ages and incomes under each reform proposal. He discovered that, in theory, every steadily employed worker, no matter what his or her age or income, could come out ahead under privatization. However, a favored few--namely, young, high-earning fast-trackers now in their twenties and early thirties--stand to gain much more than everyone else. And privatization could easily mean poverty-stricken retirements for low earners, unless they become astute investors.

The council itself is split between privatizers and defenders of the current system, which pays $336 billion a year to some 43 million beneficiaries. The payments come from the 12.4% annual Social Security payroll tax, shared equally by 141 million workers and their employers, on the first $62,700 of earnings. Trouble is, the system, which now pays a maximum $14,976 yearly retirement benefit to 65-year-olds, will begin to slide into the red in 2013, as millions of baby boomers begin to retire. Here are the council's two main rescue plans:

First, the panel's six traditionalists, led by Robert Ball, 82, Social Security's commissioner from 1962 to 1973, aim to fix the present system to ensure its solvency. They propose reducing some benefits, taxing more retirees' benefits, and hiking the payroll tax to 14% in 2045. "The changes we are proposing will leave the system that has worked for the past 60 years much the same," says Ball. The Ball contingent would depart from tradition, however, by permitting the Social Security trust fund to shoot for higher returns by investing nearly 40% of its assets in stocks and corporate bonds. Historically, stocks have returned an average of about 10% a year, vs. 4% for Treasuries.

Second, the panel's five privatizers, headed by Sylvester Schieber, 49, an economist at Watson Wyatt pension consultants in Washington, D.C., favor a revolutionary change. They would slash workers' 6.2% share of the payroll tax to 1.2% and require them to invest the remaining 5% in Personal Savings Accounts (PSAs) that would resemble Individual Retirement Accounts. (The government would continue to collect payroll taxes--1.2% from workers and 6.2% from employers--to pay disability and survivors benefits, as well as a basic safety-net benefit of $360 to $410 a month to all retirees.) As with IRAs, you would open your PSA at a financial services company, such as a bank, brokerage or mutual fund. And you could invest your after-tax contributions in any financial asset, from blue-chip stocks and Treasury bonds to penny stocks and corporate junk bonds. After age 62, you could withdraw your money, including your PSA's earnings, tax-free. "This plan would put money in the bank with your name on it--money that the politicians in Washington couldn't take away from you," says Schieber. (A third, hybrid rescue plan offered by two council members, including chairman Edward Gramlich, 56, dean of the University of Michigan's School of Public Policy, leans more toward fiddling than privatization.)

Pension experts agree that both the Ball and Schieber plans would avert Social Security's impending bankruptcy. So what Americans will soon be debating is whether the current system should be repaired to preserve the government's promise of retirement income or largely replaced with a plan that gives individuals the freedom to make their own wise (or not so wise) investment decisions with their retirement savings.

Although details of both proposals were still in flux when MONEY went to press, we don't anticipate that any last-minute changes will invalidate Schobel's analysis. Of course, ultimately any proposals, including the council's, are bound to get overhauled, if not mauled, as they move through Congress. In essence, therefore, the council's ideas serve as the debate's starting point--and should be used to calculate who might win under privatization and who might lose. Here are the assumptions Schobel made to compute benefits under the Ball and Schieber plans, starting in 1998, the earliest either man believes a rescue effort could be launched:

Salaries of the real and hypothetical people cited as examples below will grow 5% a year until they retire, which is what the Social Security Adminstration's trustees now assume when they project future benefits.

Our subjects would begin to collect reduced Social Security benefits at age 62, as do 59% of today's retirees. (At present, they get 80% of the full benefit they'd be entitled to receive if they worked until 65. Under Ball's plan, workers born in 1949 or later couldn't qualify for full benefits until age 67. The age at which you could collect full benefits would continue to rise under Schieber's plan, for example, reaching age 68 in 2023 for workers born in 1955.)

PSAs would earn 8% a year, a rate of return that actuaries think is reasonable for retirement portfolios.

The government's flat monthly safety-net benefit under Schieber's plan would start at $413 in 1998 and increase by annual wage growth, presumably 5% a year. Workers ages 25 to 54 in 1998 would receive a smaller safety-net benefit based on their number of years in the new system.

Schieber's plan would pay transition benefits to workers 25 to 54 years old as the nation gradually shifts to a privatized system. The monthly benefits would depend on how much a retiree earned while employed and how many years he or she paid current Social Security taxes.

Our subjects wouldn't squander their PSA money, say on round-the-world cruises. Moreover, the PSAs would continue to earn 8% a year, and each month our subjects would withdraw an amount equal to 1% of their account balances on the day they retire.

Here's a closer look at who stands to win and lose under Social Security privatization:

Current retirees' benefits would remain unchanged. But more retirees would pay income taxes on their payouts under both the Ball and Schieber plans than at present. Currently, married couples with joint incomes of $32,000 or less and singles with incomes of $25,000 or less pay no tax on their benefits. Up to half of benefits are subject to tax for married couples who earn $32,000 to $44,000 and for singles with incomes of $25,000 to $34,000. Recipients with incomes above those limits pay tax on as much as 85% of their benefits. In an early draft of their report, which Ball and Schieber now say is being revised, they both proposed phasing out those income limits starting in 1998, so that by 2007 all retirees with taxable incomes would pay tax on the portion of their Social Security benefit that exceeds their own contributions to the system. At press time, only one thing seemed likely: More retirees would end up paying tax on their benefits.

Both rescue plans also presume that retirees will get smaller Social Security cost-of-living increases starting in 1998. That's because Ball and Schieber figure that the Bureau of Labor Statistics will trim the consumer price index (CPI), which drives Social Security cost-of-living increases, by 3/10 of 1%.

Young fast-trackers will be the biggest winners. There are two keys to coming out ahead under the privatization plan: You need youth and affluence. A fat salary would let you stash lots of cash in your PSA, and your long work life would give that money plenty of time to grow. As an example, consider Philip Hodge, 25, pictured on page 120, who plans to become a neurosurgeon after graduating from Johns Hopkins Medical School in Baltimore in May. Since neurosurgeons earn a median $279,000 a year, Hodge would certainly be able to contribute the maximum allowable to his PSA, currently 5% of his first $62,700 in earnings. His 5% annual PSA contribution would be worth a cool $1,011,000 when he retires at age 62 in 2032. If Hodge drew down his account as Schobel assumes, he'd collect an ample monthly income of $10,110 from his PSA plus a guaranteed safety net of $1,345 from Uncle Sam, for a grand total of $11,455. Under Ball's modest plan, by contrast, Hodge would get only $5,441 a month--fully 53% less than under privatization. Says Hodge of the privatization plan: "All that sounds good, but with or without Social Security, I plan on being a saver."

Young workers sidetracked from the fast track wouldn't do nearly as well, but they'd still come out ahead under privatization. Consider a hypothetical 25-year-old high school dropout who toils until retirement in 2032 in what the Social Security Administration's trustees define as low-wage jobs--ones paying no more than $11,600 a year in today's dollars. He would get $2,067 a month under Ball's plan. Under privatization, he would receive 57% more, or $3,235 a month--$1,345 from the government plus $1,890 from his $189,000 PSA. This calculation assumes that the sidetracker would earn 8% a year on his PSA investments. Only if he did far worse than that, say, earning just 2%, would he do better under Ball's plan.

Of course, it's conceivable that high earners like Hodge could also invest poorly and blow their chances of amassing a million-dollar nest egg. But high earners have an edge. If they don't learn how to invest astutely, they can simply hire professionals to do it for them; low earners usually can't afford to do that.

Middle-aged, middle-income workers will gain little from privatization and pay dearly while switching to the new system. By definition, these people are in the middle. They're neither rich, nor young; therefore, they may suffer financially under privatization. Take, for example, attorney Ronald Sutherland, 42, and his wife, Martha Holland, 41, of Newfields, N.H., pictured on the facing page. Sutherland would accumulate $122,000 in a PSA by retirement in 2015 and would withdraw $1,220 a month as Schobel assumes. He would receive another $1,405 a month from Uncle Sam--a $305 guaranteed benefit plus a $1,100 transition credit. And his wife, who works seasonally as a tax preparer, would collect $650 a month in spousal benefits. Grand total: $3,275, or 9% more than the $2,992 the couple would collect under Ball's plan.

The couple look like winners too at first glance. But there's a huge hidden catch: The projected benefit leaves out their share of the trillions of dollars in extra taxes the government would have to collect to finance the 72-year transition to privatization. In effect, the huge middle-class would have to contribute most of the money the government would transfer to three groups of Americans--current retirees, everyone 25 to 54 years of age in 1998 and workers 55 and older.

Where will the transition trillions come from? The Schieber group recommends that Congress impose a 1% national sales tax to raise at least $50 billion a year from 1998 to 2070 in addition to borrowing $1.2 trillion from 1998 to 2043. So all Americans would end up giving with one hand and taking with the other. For example, Sutherland and Holland would have to fork over an estimated $5,000 in sales taxes before they retired and collected their first transition benefits. And low-income families would be hit far harder by the sales tax, since they tend to spend much more of their income than more affluent households do.

Workers age 55 and older might gain--but just a little. Ironically, this is true only because Schieber's privatization plan allows them to keep the Social Security benefits they're due under current law. Take Beverly Antaramian, 56, of Phoenix, pictured on page 121. Under Social Security today, Beverly, a $90,000-a-year sales manager for a cosmetics firm, is in line to get $1,325 a month starting in 2002. By contrast, under Ball's tinkering, her monthly benefit would shrink 9% to $1,209--because she will have worked only 32 years by age 62. To cut the government's costs, the benefits calculation under Ball's plan is based on a 38-year work life, rather than the 35 years under current law. And the more years you fall short of Ball's magic number, the bigger the reduction in your benefit.

Low-wage workers who make poor investments would be the biggest losers. Since low earners would have less to invest in PSAs than the wealthy, they could be devastated by bad investment decisions. Consider, for example, Cynthia Thurmond, 34, of Chicago, pictured at right. The single mother of three earns $20,710 a year as a patient accounts representative at a substance-abuse treatment center. If her PSA returned 8% a year, her monthly income at retirement in 2024 would total $2,665--a $635 government-guaranteed benefit, a $600 transition payment and $1,430 from her $143,000 nest egg. Under Ball's plan, by contrast, she would get only $1,935--some 27% less. But all of that $1,935 would be guaranteed by the government, while more than half of the $2,665 she would collect under privatization would depend on her ability to make prudent and skillful investment decisions. Says Thurmond, who has never invested: "If my personal investment account didn't pan out, I don't think I'd have enough money to live on."

The privatization of Social Security raises three additional concerns that affect all workers:

Administrative costs would take a bite out of every PSA's returns. During the advisory council's deliberations, Ball criticized Schieber for assuming that investment expenses in a PSA would amount to only 0.3% a year. Schieber told Money he now agrees with Ball. What might you actually pay? Certainly much more; after all, the average growth-stock mutual fund charges shareholders 1.4% a year for expenses.

Congress may let workers raid their PSAs. It's quite possible that voters will pressure lawmakers to give them the same right to tap their PSAs without paying a 10% early-withdrawal penalty, say, for large medical bills, as they already have with their 401(k) plans. Asks Bruce Schobel: "How can Congress say no to someone who needs their retirement money to pay for their kid's kidney transplant?" Of course, if Congress gives in to popular demand, many people who raid their accounts early may never be able to accumulate the sums necessary to ensure a comfortable retirement.

You might outlive your nest egg and have to survive on your meager government-guaranteed benefit. Schieber's privatization plan lets you do whatever you wish with the lump sum you've accumulated in your PSA when you retire. For example, you could invest the entire amount in low-risk, growth and income mutual funds or use it to acquire an insurance company annuity, which would guarantee you income for life. But you'd also be free to spend the money in your PSA as quickly as you wish, and you could conceivably outlive your money. Those most at risk are women, who live almost seven years longer than men on average and are almost three times less likely to have private pensions. Says Peter Diamond, an economist at the Massachusetts Institute of Technology: "Elderly widows already make up the largest pocket of poverty among the aged, and a privatized Social Security system could exacerbate that problem."

Given the political uncertainties surrounding Social Security reform, only one thing seems sure right now: If privatization stands a chance of becoming law, it needs a champion with the political skill of the four-term President who pushed through the original wildly radical Social Security system in the first place back in 1935.