Fixing Social Security
By Phillip Longman

(FORTUNE Magazine) – SOCIAL SECURITY IS A MESS. WITH THE OLDEST babyboomers now four years away from qualifying for benefits, the program faces a shortfall of $12.7 trillion. To close the deficit, the program would need to cut benefits by 27% by the time today's 25-year-olds retire. And yet in this silly season, neither presidential candidate is offering a viable solution: Kerry says he won't touch Social Security; Bush promises an expensive privatization plan that would leave individuals with huge market risks. But there's another way. FORTUNE has learned that a new reform idea is percolating within the Social Security Administration. Nothing's official, but the idea is so good that we're previewing it here to get some public discussion going.

The idea starts with the creation of Early Retirement Accounts. Individuals could put one-sixth of the money they and their employers currently pay to Social Security into 401(k)-like accounts, which they could use to finance retirement beginning at age 62. How would Social Security make up for the loss of revenue? Monthly Social Security benefits would remain what they are today, but the age at which future retirees qualified for them would be delayed. Today you can qualify for early, reduced benefits at age 62; that age would gradually increase to 68. The retirement age for full benefits would be pushed back from 65 to 72. Preliminary analysis by the SSA indicates that the rollback in retirement ages would not only save enough money to fund the Early Retirement Accounts, but also return the system to solvency.

Most privatization plans stipulate that individuals take a 33% cut in their regular benefits and use personal accounts to make up (or exceed) the difference. That provision raises two big objections: What happens if the market tanks as you retire? And what happens if you live to be 115? Either way, you may end up eating dog food. (By contrast, today's system insures individuals not only against market losses but also against the risk of outliving their savings.) Some plans try to overcome market risk by promising a minimal return on personal accounts. But if there is a prolonged bear market, bailing out a whole generation of disappointed savers could easily become more expensive than the current system.

As for people living longer than their savings, privatizers suggest that retirees convert their personal accounts into annuities that will guarantee fixed payments for life. But annuities tend to be inefficient financial vehicles. Insurers have to set premiums high because they know that people who expect a long life will snap annuities up as a hedge against outliving their savings, while people who expect to die soon won't. Compelling everyone to buy annuities at retirement would eliminate that problem, but it would also impose a great burden on terminally ill people who might want to spend down their nest eggs quickly.

The new plan neatly solves these problems. It preserves full benefits for those who need them, the "old old." It leaves individuals exposed to some financial risk, but they bear that risk while they are still relatively young and able to recover. If your Early Retirement Account doesn't perform well enough for you to be able to retire in your early or middle 60s, then you can just work until 68 to qualify for Social Security's early retirement benefit, or until 72 to receive the standard benefit. In that case, you might miss out on some "golden years" of active retirement, but you wouldn't be stranded.

In the event that you're physically unable to work, you could still collect Social Security's Disability Insurance benefits, which would not have to be cut, as they would under most privatization plans. Also, there would be no need to bother with annuities. People would be using their personal accounts to finance only a fixed number of years before they reached eligibility for Social Security benefits.

There are other advantages. For example, the early retirement account might actually persuade people to work longer. Research shows that people with 401(k)s tend to delay retirement. Why? Because the money's theirs. If they don't spend it, they can live higher on the hog later. Also, under this plan, people who continue to work until age 65 wouldn't be sacrificing Social Security benefits as they often do today; instead they would be building up credits for bigger benefits in the future.

Because of Social Security's long-term insolvency, taxes will be raised and benefits cut, one way or another. This plan preserves a valuable government-issued insurance policy against advanced old age--the program's original purpose. But it also allows people who want to retire early a good chance (though not a guarantee) of being able to do so. Given polls showing that more young people believe in UFOs than believe they will ever collect Social Security, that's not a bad political bargain.

PHILLIP LONGMAN, a senior fellow at the New America Foundation, writes frequently about demographic issues. His most recent book is The Empty Cradle: How Falling Birthrates Threaten Global Prosperity.