Though you may not want to hear it, it's the truth: Social Security is in trouble. Although America's most important program is in no danger of going bankrupt, and will be making payouts to many generations of retired workers to come, its current payout schedule isn't sustainable.
According to the latest annual report from the Social Security Board of Trustees, Social Security is set to undergo a big shift this year. For the first time since the early 1980s, the program will pay out more in benefits than it collects in revenue. With the exception of 2019, this net cash outflow is only expected to grow with each passing year, culminating in the complete exhaustion of its $2.9 trillion in asset reserves by 2034.
As noted, the presence of the 12.4% payroll tax and, to a lesser extent, the taxation of benefits, ensures that money will continue to flow into Social Security, which can then be disbursed to eligible beneficiaries. Social Security will survive -- there's little doubt about that.
However, its payout schedule will need to be adjusted if its asset reserves disappear. Per the Trustees, an across-the-board cut in benefits of up to 21% may be needed by 2034 if Congress doesn't find a way to resolve Social Security's $13.2 trillion cash shortfall between 2034 and 2092.
A lingering solution: Privatize Social Security?
It's this imminent cash shortfall that's had lawmakers in Washington coming up with ways to improve Social Security for decades. Among the dozens of proposed solutions was the idea of partially or fully privatizing the program.
What does "privatization" mean, exactly? The idea is that instead of the federal government being responsible for your entire retirement payout once you decide to claim your benefit, a portion, or all, of your benefits would be set aside in a separate account that you would control. The thought process being that if you could control your own retirement benefits, you might be able to grow them at a quicker pace over the long-term than the federal government has. It would also, in theory, give retirees more reason to pay attention to their retirement benefits.
The idea of partial privatization gained a lot of steam in 2005 when George W. Bush was President. Though Bush's privatization reforms failed to be implemented, the idea of privatizing Social Security has nonetheless stuck around. With this in mind, let's take a look at some of the prominent pros and cons of partial or full privatization, and ultimately double back on why Bush's proposal was never implemented.
The pros of privatizing Social Security
The most obvious benefit that privatization would offer is the ability to invest your retirement benefits as you see fit. Right now, Social Security invests the entirety of its asset reserves in special-issue bonds and, to a lesser extent, certificates of indebtedness, which are returning an average of 2.9% annually. By comparison, the stock market has historically returned 7% annually, inclusive of dividend reinvestment and when adjusted for inflation. Assuming working-age Americans were willing to stick with their investments over an extended period of time -- the S&P 500 has never posted a loss over a rolling 20-year period -- they should be able to trump the present yield of Social Security's asset reserves. In theory, it should mean more folks on solid footing during retirement.
Secondly, privatization could turn out to be a long-term positive for the U.S. economy. Think about this for a moment: Even if only a portion of Social Security benefits were privatized, we're still talking about an estimated 175 million covered workers who'd now have capital to invest in the stock market. Such an incredible infusion of capital could be responsible for a mammoth bull run in stocks. It may also lead to a stronger economy via job creation and higher wages.
A third positive is that privatization would, theoretically, help reduce red tape. By placing Americans in control of their own full or partial accounts, the government would be able to reduce its responsibility in providing a financial foundation for retired workers. That could lead to lower government expenditures, as well as (gasp!) lawmakers being able to focus on other pressing problems. Understandably, the Social Security program is already quite efficient, relative to the revenue it brings in each year -- but with privatization it could improve even more.
The cons of Social Security privatization
On the flipside, the scariest aspect of privatization is that Americans, many of whom have little or no financial knowledge, would be given control of a private account containing some or all of their retirement benefits. Last year, Financial Engines offered an 11-question online financial literacy quiz... and just 6% of those who took the quiz passed! Americans tend not to have a good grasp on basic financial concepts, and, just as concerning, many don't understand the benefits of compounding and allowing your investments to do the heavy lifting for you over time. As a result, it's possible that folks could lose money through privatization, putting low- and middle-income individuals or families in even worse shape than they might already be in.
A second problem is that privatizing Social Security would create a big debt headache for the federal government. While a long-standing myth suggests that lawmakers have raided or stolen from Social Security, that's just not the case. Its asset reserves are earning interest in special-issue bonds, as opposed to just sitting in a vault and losing purchasing power to inflation. In turn, the federal government is using the cash it receives from the sale of special-issue bonds to fund general revenue line items. If there's less money for the federal government to borrow as a result of capital being diverted to privatization, it could cause national debt levels to accelerate at an even quicker pace than they are already rising.
Lastly, privatizing Social Security doesn't exactly resolve the underlying issues with the Social Security program. Yes, it would give Americans more control over some portion of their benefits, but it doesn't change the fact that Social Security's worker-to-beneficiary ratio is falling, or that longevity is steadily increasing. In fact, it's possible that diverting even a small portion of payroll taxes usually intended for the Trust to private accounts could expedite the time it takes for the program to exhaust its asset reserves.
Here's why privatization won't work
Now, back to where we began: Why didn't George W. Bush's privatization reform bill pass muster?
Ultimately, this last negative -- the fact that it wouldn't do anything to improve the Social Security program over the long run -- is what did it in. Don't get me wrong, turning private accounts over to millions of Americans with little or no financial knowledge is scary, too. But the bigger issue here is that Bush's proposal addressed something that could only be considered if the program were on solid footing, which it wasn't, and still isn't.
In order to fix Social Security and resolve its $13.2 trillion cash shortfall over the next 75 years, we're going to need to see bipartisan cooperation on Capitol Hill. Unfortunately, the only time that seems to happen is when the 11th hour hits. Even the Social Security reforms passed in 1983 during the Reagan administration were completed in seemingly the final hour. Lawmakers had more than a decade of warning that the program's asset reserves were insufficient, yet waited until the last moment to fix the program.
This is likely what'll happen again, to the detriment of current and future retirees.