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Insecurities About Social Security

Privatization of Social Security accounts could be good news for investment firms


January 13, 2005
Copyright © 2005 CARIBBEAN BUSINESS. All Rights Reserved.

Social Security will be in the spotlight and center stage in 2005. Few disagree the program needs a huge overhaul to prepare for the upcoming retirement of the baby-boomer generation. By the year 2035, the U.S. population over the age of 65 is expected to double. Not only that, but some experts warn Social Security is underestimating future life expectancy. They point out new medical advances will add years to this average, which means beneficiaries will collect benefits for longer. As it is right now, 47 million people receive Social Security checks every month, and that number will continue to rise. In fiscal year 2004, nationwide outlays were up 4.4% or $22.3 billion from the year before. At the end of 2003, in Puerto Rico alone, there were 702,798 Social Security beneficiaries. Total benefits paid out on the island in fiscal year 2003 were $4.64 billion.

According to the Social Security Board of Trustees, as early as 2018, the program will start paying out more benefits than it receives through payroll taxes. Without reform by 2042, the Trust Fund would be broke. However, the Congressional Budget Office predicts the program will go bust a bit later, in 2052, warning the more immediate problem will be in relation to Medicare, which is funded by a similar system, and could be insolvent by 2019.

Although Social Security reform is warranted on many fronts, many disagree on the kind of reform that should take place. President George Bush is arguing for privatization of Social Security accounts, and the proposal is on the top of his agenda for the new term. One of his advisers went so far as to say it was the centerpiece of his second term. Part of the debate surrounding the topic stems from the fact that privatization potentially could benefit investment firms that would be handling tens of millions of new accounts.

The way the proposal would work is similar to the thrift savings plan, the government’s version of the 401(k). Young workers would have the option of accumulating approximately 4% of their Social Security payroll taxes through investment in various types of private accounts that theoretically would make up for the reduction of future benefits. Critics argue individuals will make poor investment decisions even with restricted choices and could leave the federal government on the hook to make up shortfalls caused by losses in the markets. Proponents argue workers could earn more money for their retirement over the long term, even if they have short-term losses.

Investment firms would handle tens of millions of the new private Social Security accounts if the privatization proposal were approved. Many Wall Street executives were among the largest contributors to President Bush’s campaign. In total, finance and investment executives raised $14.5 million for Bush’s re-election. Morgan Stanley and Merrill Lynch were among the top corporate supporters of the president’s re-election campaign, raising over $1 million combined, according to the Center for Responsive Politics, a nonpartisan group that tracks political contributions and campaign spending.

The Securities Industry Association recently issued a research report in which it calculated firms would collect at least $39 billion in fees from managing such accounts over the next 75 years. However, arguing the plan doesn’t represent an unjust bonanza for the securities industry, they pointed out the sum is only 1.2% of the estimated $3.3 trillion in revenue the industry is projected to earn in core securities business during the same period of time. The research report also presented a more sophisticated model, where workers can choose to invest in a wider range of actively managed funds. In that model, the revenue for the securities industry would be $279 billion during the next 75 years.

However, other analysts aren’t so conservative. Austan Goolsbee of the University of Chicago’s Graduate School of Business argues the individual accounts will generate $940 billion in fees for private investment management firms representing one-quarter of the revenue of the entire financial sector over the next 75 years. This study assumes 100% participation in the individual account system, which will be optional for employees if passed. Goolsbee says that for a worker at the average income level, the fees in privately managed accounts are likely to reduce the ultimate retirement value of their individual accounts by 20%.

Careful not to appear to be acting in self-interest as many have accused them of doing, most investment firms have opted not to offer any public opinions on the topic, and yet others downplay the potential advantages of privatization for the industry, pointing out the issue is much bigger than this particular debate.

Industry sources point out the issue isn’t how much the industry stands to make, but how private accounts can improve a vital service to society. They point to the federal thrift savings plan as a reference that proves the potential efficiency of the reform, since both would function basically in the same way. Rafael Colón Ascar, senior vice president & resident manager of Smith Barney, added that apart from control over their earned income, consumers would stand to gain in terms of the financial education they would receive through the assessment of their account manager. In terms of gains for the industry, Colon believed, as with all services, competitive forces and strict regulations would come into play with the management of private accounts thus limiting the fees that could be gained. To put it in perspective, he explained that on regular accounts, managers win 3% of the value of the account. With the Social Security private accounts, they would be making considerably less since they would function as index funds.

Some specialists on Wall Street also expressed worry about the administrative costs of tens of millions of small accounts, costs they argue would swallow up most of the profits and scare away many investment firms.

In fiscal year 2003, Puerto Rico workers and employers contributed close to $2.4 billion to the Social Security fund. If the proposal had been passed in Congress that year, allowing a 4% deduction of current payroll taxes to be routed to private accounts, that would equal almost $97 million that wouldn’t have been available for distribution to beneficiaries.

The decrease in available funds to pay out in benefits would force the government into borrowing as much as $2 trillion to provide benefits for retirees, disabled people, and their families. The concern is that adding to the budget deficit by such a large amount over the next decades may push interest rates up, in turn, hurting the market. On the other hand, proponents argue the debt would pay for itself in the long run because the accounts would reduce or eliminate the future obligations of the Social Security system.

In reference to the risks of increasing the deficit, The Economist believes in theory the government merely would be reducing its implicit future liabilities and increasing its explicit current liabilities. If financial markets are efficient, they should spot this and ought not to demand higher interest payments on government bonds. They believe that although the government would be borrowing more to make up for the money diverted into individual accounts, private saving would rise by exactly the same amount. However, the publication also warns that in practice the macroeconomic consequences may be less benign. Even if the deficit effect were downplayed, this point likely would spark fiery debates in Congress.

The Democrats, who up to now have expressed opposition to privatization, have found a strong ally in the American Association of Retired Persons (AARP), an influential lobby for older Americans, which is also against the drastic reform. In a $5 million nationwide ad campaign launched Jan. 4, they are very explicit about the fact they view privatization as a gamble they aren’t willing to take. In their view, modest changes could ensure the solvency of the program.

Despite all the debates surrounding the issue, Resident Commissioner Luis Fortuño believes President Bush’s plan is the right way to go. "We are empowering people in the sense that they will have greater control as to how their money is used and invested, and that’s the bottom line here. I believe we have to do this."

The head of the Federal Reserve, Alan Greenspan, hasn’t taken a firm stance on a specific proposal, yet he firmly believes change must come fast. "If we have promised more than our economy has the ability to deliver, as I fear we may have, we must recalibrate our public programs so pending retirees have time to adjust through other channels," Greenspan said during a conference in late August 2004. "If we delay, the adjustments could be abrupt and painful."

Apart from the fact that trillions of dollars are at stake, the costliest concern is the future security of millions of Americans who have paid their dues and deserve to get their fair share. Despite uncertainty about the fact the securities sector could be a big winner with privatization, the fact is all Americans stand to be big losers if the program isn’t reformed. The retirement of retirement could be at risk.

This Caribbean Business article appears courtesy of Casiano Communications.
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