Seidman, Laurence S. - University of Delaware

Laurence S. Seidman [1]

FUNDING SOCIAL SECURITY: A STRATEGIC ALTERNATIVE

My article and book present the case for funding social security. Funding social security is not a new proposal; its basic components have been recommended by other advocates of social security reform.
There are two middle positions between our current pay-as-you-go (PAYGO) defined-benefit social security, and privatized defined-contribution social security. One is PAYGO social security with supplemental individual defined-contribution accounts. The other is funded social security.
Funded social security is a defined-benefit plan. Funded social security is achieved by preserving the current U.S. social security defined-benefit formula, and gradually shifting the financing from payroll taxes to a mix of portfolio investment income and payroll taxes.
Funding social security has two distinct essential elements: fund accumulation, and portfolio diversification.
Fund accumulation requires gradually adjusting tax rates, ceilings, and benefit rates to achieve substantial annual surpluses. Protection from the payroll tax increase is given to low-income workers by expanding the earned income tax credit. A large permanent capital fund would then accumulate gradually over the next century, and the fund's annual investment income would eventually enable a permanently lower payroll tax rate.
Portfolio diversification is achieved by having the social security administration contract with private investment firms (under competitive bidding) to invest this capital fund in a conservative diversified portfolio of government bonds, and corporate stocks and bonds.
With funded social security, all investment risk is pooled: there are no individual accounts. Private investment firms manage social security's portfolio the way they manage the portfolio of conservative risk-averse private clients. Funded social security avoids excessive reliance on either government bonds (because the yield is lower) or corporate stocks (because the risk is higher). The investment firm handles stock voting as it does for private clients.
Funding social security will eventually double the return that workers obtain on their saving-- from 2% to 4%. In a mature PAYGO system, the return equals the growth rate of real output---roughly 2%. With funded social security, the return will be roughly 4% (the average of a 6% return from corporate stocks, and a 2% return from government bonds). This doubling of the return makes a tremendous difference over a person's lifetime. For example, consider a worker age 45 saving $5,000 that year. Compounded at 2% per year it grows to $7,430 at age 65; compounded at 4% per year it grows to $10,956.
Funded social security rests on a cautious and realistic view of the stock market. It is important to emphasize two points. First, funded social security uses payroll taxes as well as portfolio investment income to finance benefits. Second, the portfolio is conservative: government bonds constitute an important share of the social security portfolio.
Like the current U.S. social security system, funded social security is a defined-benefit plan where each retiree's benefit is linked to the retiree's own wage history by a legislative formula; the benefit does not directly depend on the performance of the portfolio. If portfolio earnings fall, then a fraction of the portfolio must be sold to finance legislated benefits. However, if the portfolio performs poorly for several years, then either the legislative formula must be adjusted or payroll taxes increased. Thus, indirectly, benefits are eventually affected by portfolio performance: funded social security does not eliminate stock market risk. But it minimizes the risk for the individual retiree by pooling the risk over all retirees, utilizing a conservative diversified portfolio invested in government and corporate bonds as well as corporate stocks, spreading the risk over time by selling fund assets as a first resort while adjusting the legislated benefits formula only as a last resort, and using payroll taxes as well as portfolio investment income.
It is crucial to recognize that fund accumulation and portfolio diversification are separate components. It would be possible to have fund accumulation without portfolio diversification: social security could accumulate a large fund, but invest it solely in special non-marketable low-yield government securities (as it does currently under the U.S. Social Security system). Conversely, it would be possible to have portfolio diversification without fund accumulation: social security could maintain only a small fund, but invest that fund in a mixed portfolio. The term funded social security implies both components: a large capital fund invested in a diversified portfolio.
Fund accumulation is the key to raising the capital accumulation of the economy, while portfolio diversification is the key to capturing a larger share of the economy's capital income for the social security system.
Funded social security would be completely separated from the Federal budget. Congress would be expected to balance the budget without counting social security. One purpose of converting social security from PAYGO to funding is to raise the national saving rate. This purpose would be defeated if an increase in the social security surplus by $100 billion permitted Congress to increase the deficit in the rest of the budget by $100 billion.
There is no way to escape a transition cost if the objective is to raise the national saving rate through the funding of social security. Raising the saving rate entails a short run cost in order to achieve a long run gain. The cost is borne as a combination of a transitional tax increase and a temporary slowdown in benefit growth.
To protect the capital fund from a raid, each worker would be sent an annual statement that provides an estimate of his retirement benefit. The key to deterring a raid on the capital fund is to make sure that current workers realize that it is their future benefits that are being raided. If the fund is drawn down, then its investment income will be lower in future years, and so will social security benefits. If the Social Security Administration sends each worker an annual estimate of his expected retirement benefit, based on current tax rates, benefit rules, and the size of the fund and its investment income, then a raid on the fund this year would reduce each worker's expected benefit in next year's annual statement. With annual individual benefit estimates, members of Congress would be deterred from voting for a raid.

1 Professor of Economics at the University of Delaware, author of the article, "Funding Social Security," Tax Notes October 12, 1998, ~241-49 (available on request: phone, 302-831-1917; e-mail address, SeidmanL@college.be.udel.edu), and the book, Funding Social Security: A Strategic Alternative, Cambridge University Press, New York, 1999, l-800-22l-4512).