In the past week or so, I’ve heard from dozens of fearful readers asking about Donald Trump’s plans to privatize Social Security. I’m going to suggest that people relax. President-elect Trump and his cohorts may have plans to privatize the Social Security system, but I highly doubt those plans will ever see the light of day.
Actually, every Republican president since Ronald Reagan has vowed to privatize Social Security. And each one of those presidents rather quietly dropped the idea shortly after taking office. Why? Because the plan simply doesn’t work. Or to be more precise, it would be prohibitively expensive to switch from our current Social Security system to a privatized one. I will explain.
Almost every privatization plan I’ve ever seen backed by a leading Republican legislator or president is what is commonly known as a “carve-out plan.” It is called that because it gets its funding by carving out a chunk of the current Social Security system. For example, currently 6.2 percent of a worker’s salary is deducted for Social Security taxes. A carve-out plan might specify that 4.2 percent continue to be used to fund Social Security, while 2 percent would be turned back over to taxpayers for them to invest on their own.
On paper, it may sound great. You get to keep a chunk of your payroll tax to do with what you want. And, of course, it is hoped you will invest that money, and not buy a new car or boat! (A better version of these plans mandates that the payroll tax portion you keep must be invested in one or more of several managed IRA-type accounts.)
But the often unexplained downside to these plans is that huge reductions would be necessary in future Social Security benefits. It’s just simple math. If you are going to carve out about one-third of the Social Security payroll tax to fund a worker’s private IRA account, then, obviously, future Social Security benefits for that same worker are going to have to be cut by at least one-third.
And here is the bigger problem with carve-out plans. It’s not just future benefits for current workers that would have to be cut. But also benefits to current retirees would have to be radically reduced. Remember: Our Social Security program, like every major social insurance system in the world, is funded on a pay-as-you-go basis. This means the money deducted from today’s workers’ paychecks is used to fund benefits to current retirees. So if you cut the amount of money going into the system by a third, then the money coming out of the system must also be reduced by the same amount. In other words, you must eventually cut benefits to all current retirees by about 30 percent.
Of course, that is politically (and morally) unacceptable. Many past carve-out privatization plans promised not to reduce benefits to current retirees. But the only way to accomplish that is to take money out of the general funds of the Treasury to make up the Social Security payroll tax deficit in order to pay all promised future Social Security benefits. And we are not talking millions, or even billions, of dollars. We are talking many trillions of dollars.
In other words, the transition costs of privatizing Social Security are simply too high. Either the political and moral costs are too high to cut future Social Security benefits, or the economic costs are too high to dramatically increase the deficit to avoid future benefit reductions. And I am betting that Donald Trump and the privatization schemers on his transition team will eventually realize those steep costs and drop their plans -- at least their carve-out plans.
But there is an alternative to the carve-out privatization plan. It is usually referred to as an “add-on plan.”
This type of plan would require workers to contribute an extra amount to fund any private account investments they set up. So, 6.2 percent of a worker’s salary would still be deducted to finance Social Security benefits. But in addition, that worker would be required to chip in an extra percentage point or two of salary to fund a managed investment account. In other words, instead of carving anything out of the current Social Security system, this type of plan gets its funding by adding to the system.
Of course, the downside to an add-on plan is that more out-of-paycheck spending would be required from workers to fund their retirement portfolio. But the advantage to the plan is it has greater rewards. Most add-on proposals I’ve seen are modeled on the highly successful Thrift Savings Plan, an add-on IRA that has been available to federal government workers for years and has given many of them the kind of financial security in retirement not usually associated with middle-class civil servants.
An add-on privatization plan is not usually favored by Republicans because it reeks of a tax increase, even though the increase would be funneled into private investment accounts. But if president-elect Trump is the political maverick he is touted to be, and if he is committed to privatizing the Social Security system, an add-on plan might be the way to go.
Finally, there is one other tactic that I would be remiss not to mention. It does not involve individual worker’s investments, but rather the investment policies of the Social Security trust funds. As has been explained countless times in this column, those funds have always been invested in U.S. Treasury bonds. One way to “privatize” Social Security would be to diversify the system’s portfolio — to invest some or all of Social Security funds in the private markets.
Such a practice could generate much higher returns, albeit it with greater risk, than Treasury bond yields. But here is the downside to such a scheme. Once again, we are not talking millions or billions of dollars, but rather many trillions of federal dollars that would be flooding the markets. No one really knows what impact that would have on Wall Street. And would we really want the Social Security system, meaning the federal government, to be a major stockholder in the likes of Philip Morris and its tobacco products or Apple and its computers and phones?