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Social Security: Still the Most Efficient Way to Provide Retirement Income

The program has stood the test of time well.

Social Security has stood the test of time well. (Photo: eric1513 / iStock / Getty Images Plus)

Last week marked the 82nd anniversary of Franklin Roosevelt’s signing the bill that created Social Security. The program has stood the test of time well.

It accounts for more than half of the income for 60 percent of senior households and more than 90 percent for almost one third. It has reduced poverty rates among the elderly from more than one-third to roughly the same as the rest of the adult population. In addition, it provides disability insurance, as well as life insurance for family members, for almost the entire working-age population.

This is a pretty good track record. This is the reason the program is hugely popular and efforts at privatization, like President George W. Bush’s 2005 effort, have all gone down in defeat. It’s hard to beat Social Security.

A big part of the benefit of Social Security is that it is very efficient. The administrative costs of the retirement portion of the program are just 0.4 percent of what is paid out in benefits each year. By comparison, the costs of even relatively well-run privatized systems, like those in Chile or the United Kingdom, are 10-15 percent of benefits. That difference would amount to $80 billion a year (close to $1 trillion over a 10-year budget horizon) being paid out to the financial industry instead of to retirees.

This was a huge hurdle for President Bush to overcome with his privatization plan. His main route was to invent stories about the much higher returns that workers would be able to earn with the privatized accounts he promised them.

But this story of better returns turned out to be based on phony numbers. Essentially, his crew was extrapolating stock returns from a period when the economy was growing fast and price-to-earnings ratios in the stock market were much lower. Their claims about future returns could not be reconciled with the Social Security trustees growth projections that provided the basis for the debate.

To make this point, we invented the “No Economist Left Behind” test where we challenged supporters of privatization to write down numbers for capital gains and dividend yields that added to the stock returns assumed by the Bush administration. This amounted to writing down two numbers that added to 7 percent (the annual real return they assumed for stocks), a task which should not be too difficult for someone with a Ph.D. in economics.

It turned out the privatizers were not up to the challenge. If they picked a high number for real stock returns (say 5 percent), they would soon have price-to-earnings ratios well over a hundred to one. No economist wanted to be associated with this prediction.

The alternative was to assume a high dividend yield. This quickly had companies paying out more than all of their profits in dividends or share buybacks. This meant they wouldn’t even be able to invest enough to maintain their capital stock, also an unlikely scenario.

The moral of the story is that there is no free lunch in financial markets. That was true back in 2005 and is probably even truer today. Price- to-earnings ratios are even higher than in 2005, and profits are an unusually large share of national income, meaning that they are likely to grow at a slower pace than the economy as a whole in future years. With real estate also at unusually high prices, it is virtually guaranteed that returns to all forms of financial capital will be considerably lower in future years than in the past.

In this story, the best way to generate wealth for future retirees is to minimize the money that is wasted in fees for the financial industry. This is the route being followed by the states of Illinois, California and Oregon, all of which have passed legislation that allows workers in the private sector to invest with their public employee retirement funds. Several other states are close behind in this process.

While these plans keep a strict separation of the funds, they allow workers throughout the state to invest their money by taking advantage of the structure already in place for public employees. The savings on administrative expenses compared to existing IRAs or 401(k)s can easily be on the order of 1-2 percentage points annually. This difference could translate into almost $30,000 in additional savings for someone putting aside $2,000 a year for 30 years, a difference of close to 30 percent.

In short, insofar as we want to supplement the income provided by Social Security, we should look to the program as a model. Keep it simple and keep the costs low. If people want to speculate in financial markets they are welcome to do so, but retirement policy means simple and cheap, and if that reduces profits for the financial industry, that’s good too.

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