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Partially Privatizing Social Security Sounds Great, but Offers 2 Big Drawbacks

By Sean Williams – Nov 24, 2018 at 6:06AM

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There's a price to be paid for the possibility of more impressive returns.

Few social programs bear as much importance to the financial well-being of older Americans as Social Security. Despite the average retired worker payout being only $1,417.22 a month in September 2018, the program is responsible for keeping 15.3 million retirees out of poverty. Furthermore, more than three out of five of today's aged beneficiaries lean on Social Security for at least half of their monthly income. No other social program is relied upon by seniors as much as Social Security.

That's what makes this next fact so concerning: Social Security is in deep trouble.

A Social Security card standing up diagonally on a countertop, with the name and number blurred out.

Image source: Getty Images.

Social Security is facing its biggest challenge since inception

According to the latest Social Security Board of Trustees report released in early June, 2018 represents a long-awaited, but much-feared, inflection point. Beginning this year, the program will expend more than it collects in revenue for the first time since 1982. With the exception of 2019, the net cash outflow from Social Security is expected to grow with each passing year. By the time 2034 rolls around, all $2.89 trillion of the program's asset reserves are projected to be exhausted.

The positive news, if any could be culled from this forecast, is that Social Security is in no danger of insolvency. Its two recurring sources of revenue -- the 12.4% payroll tax on earned income, and the taxation of Social Security benefits for people or couples earning over certain thresholds -- ensure that there will always be money flowing into the program for disbursement to eligible beneficiaries.

What the net cash outflow does imply, however, is that the current payout schedule isn't sustainable over the long term. The report suggests that an across-the-board cut to then-existing and future retirees of 21% may be needed by 2034 to protect payouts through 2092, without the need for any further cuts.

It's a grim forecast, and it rightly has a lot of people worried and calling for solutions.

A senior man reading the money section of a newspaper.

Image source: Getty Images.

The partial privatization of Social Security appears to make sense on paper...

One resolution that's been put on the table, and was exceptionally popular in the early to-mid 2000s, is the idea of partially privatizing Social Security. By "partially privatizing," I mean taking a portion of a worker's earnings and setting that income aside into a separate retirement account that would be overseen by that worker. Such an idea was proposed by George W. Bush in 2005, although it failed to garner enough support in Congress to find its way into law.

Why consider a partial privatization of Social Security? For starters it would presumably reduce some of the responsibility the federal government has in terms of overseeing the financial well-being of the nation's current and retired workforce. In other words, it would require workers to take an active role in preparing for their eventual retirement.

More importantly, partial privatization was viewed as a path to more impressive returns. As required by law, any net cash surplus (i.e., excess money collected annually relative to program expenditures) is to be invested in special-issue bonds and certificates of indebtedness by the Social Security Administration. As of September, this nearly $2.9 trillion in cash was earning an average of 2.9% in annual interest income. Comparatively, workers could choose to invest in a stock market index fund and potentially earn the historic average annual return rate of 7%, inclusive of dividend reinvestment and when adjusted for inflation. The opportunity for more robust returns was believed to put retirees on better financial footing over the long run.

What's more, should workers choose to invest their retirement account funds into the stock market, this steady influx of new capital could have a positive impact on the overall market, pushing it higher.

On paper, and without digging below the surface, partially privatizing Social Security sounds like a viable plan.

A young woman shrugging her hands and shoulders.

Most workers struggle with investing basics. Image source: Getty Images.

... but it falls short in two key respects

Unfortunately, partial privatization doesn't pass the sniff test if we really dig into some of the intangibles surrounding the proposal.

One of the biggest concerns with privatization is that it would require workers to actively take a role in their retirement. That may sound great, but the truth of the matter is that financial literacy in the U.S. is often lacking. An 11-question financial literacy quiz offered by Financial Engines last year saw 94% of Americans fail. Ninety-four percent! Considering that more than three out five retirees are counting on Social Security as their primary income source, if they were to lose money on their separate retirement account, it could place these folks in quite the financial pickle during their golden years. 

To boot, it may cause workers with lower lifetime incomes to become unduly aggressive with their investment strategy in an attempt to make up the ground they lost to middle-income workers. This could expose their separate retirement account to excess risk and losses, putting them in even worse financial shape.

The second major problem, and the real reason privatizing Social Security in any manner is pretty much off the table, is that it does nothing to resolve Social Security's long-term (75-year) cash shortfall.

You see, a majority of the revenue (more than 87% in 2017) collected by Social Security is derived from its 12.4% payroll tax on earned income. If some percentage of earnings were exempted from the payroll tax and placed into a separate retirement account for existing workers, it would create an even more prominent cash shortfall for the more than 62 million people currently receiving a Social Security benefit. These current beneficiaries depend on payroll tax levels increasing over time, not decreasing.

Per the Trustees report, Social Security is facing a $13.2 trillion cash shortfall between 2034 and 2092. It's possible that this shortfall would grow with the privatization of Social Security. That makes it an intriguing idea on paper but a poor real-world solution.

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