September 2, 2004

September 2, 2004 | WebMemo on Social Security

A Poor Critique: Personal Retirement Accounts and Transition Costs

Kudos to the President for announcing his desire to fix Social Security by allowing individuals to take ownership of their own retirement benefits through personal accounts. Even before the President announced his vision for an ownership society, debate about the pros and cons of such a system had already heated up. Critics are already saying that it will cost too much to adopt personal retirement accounts. The truth is that a system of personal retirement accounts will involve up-front transition costs, but it will actually save money in the long run. How much depends on the size and structure of the accounts, but across proposed plans, savings average 66 percent of the current system's future costs.

 

Social Security is built on the promise the federal government has made to retirees that it will pay them a certain level of retirement benefits and the promise made to workers that they too will receive these same benefits when they retire in the future. Workers and their employers pay into Social Security with every paycheck through the Social Security payroll taxes. But this money is used to pay out current benefits. As individuals continue to work, they accumulate bigger and bigger promises from the government for their future retirement benefits. But the total cost of Social Security's promises far exceeds the value of future payroll taxes, leaving the government-and tomorrow's taxpayers-with a massive obligation, an obligation that is unfunded.

 

The most recent report of the Social Security Trustees puts that obligation at $27 trillion. In other words, the system will cost $27 trillion more than payroll taxes will raise to pay benefits over the near and long term. Looked at another way, Congress would need to collect and invest an additional $5 trillion today in order to pay off this obligation in the future. Yet critics cite transition costs as a reason to dismiss personal accounts without addressing the massive obligation the Social Security program faces today.

 

Think of transition costs for converting to a system of personal accounts as the amount of general revenue needed to make the system whole. Rep. Jim DeMint (R-SC), Sen. Lindsay Graham (R-SC), Rep. Nick Smith (R-MI), Reps. Jim Kolbe (R-AZ) and Charlie Stenholm (D-TX), Rep. Paul Ryan (R-WI), and Rep. Sam Johnson (R-TX) have introduced plans to create personal accounts as described by the President. Transition costs for these plans, as estimated by the Social Security Administration, average from $7 to $8 trillion. Doing nothing-continuing with Social Security as it exists today-will cost $27 trillion.

 

Ignoring the costs of the current system is nothing if not disingenuous. Should a family forsake refinancing a mortgage because there would be costs involved, even though the family could save tens of thousands of dollars by refinancing and taking advantage of lower interest rates? Rejecting Social Security reform and private retirement accounts on the basis of transition costs is the same flawed argument.

 

One reason that Social Security is in the mess that it is today is because it is financed on a pay-as-you-go basis. Social Security operates without any recognition of the obligations that the program is accumulating. Today Social Security generates a surplus in terms of cash flow. But the program has huge unfunded promises-promises that total $27 trillion-lurking in the future. Congress ignores the cost of these promises because it budgets the same way-considering only one year's tax revenues and one year's expenses. Congress does not consider Social Security's promises and its future liabilities past an arbitrary five or ten year window. This must changed for Congress to address the federal government's finances in a transparent way.

 

Lawmakers should not think that they have the luxury of time on their side. Whoever is elected President in November will preside over the retirement of the first of the baby boom generation on January 1, 2008. Social Security's surplus will stop growing in 2009, beginning the fast decline into a sea of red ink. The longer Congress waits to fix Social Security, the more expensive it will be. Kudos to President Bush for recognizing the urgency of reform.

 

Alison Acosta Fraser is Director of the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Alison Acosta Fraser Senior Fellow and Director of Government Finance Programs
Domestic and Economic Policy