The best political argument for privatization is that the consumption sacrifice will be more palatable if workers are given ownership rights over the extra contributions they will be forced to make. Privatization plans are based on a simple idea. Instead of contributing to a collective, pay-as-you-go retirement program, workers would be required to build up retirement savings in individually owned and directed private accounts.
Workers could withdraw their funds from the accounts when they became disabled or reached the retirement age, and their heirs could inherit any funds accumulated in the account if the worker died before becoming disabled or reaching the retirement age.
Under some proposals, workers could choose to withdraw some of the funds as a lump-sum distribution when they become disabled or retire. Eberly and James H. Workers would be free to decide how their contributions were invested, at least within broad limits. In some privatization plans, contributions would be collected by a single public or semi-public agency and then invested in one or more of a limited number of investment funds. A worker might be given the option of investing in, say, five different funds — a money market fund, a stock market index fund, a real estate investment trust, a corporate bond fund, and a U.
Treasury bond fund. This strategy would permit workers unparalleled freedom to invest as they chose, but administrative costs might be high.
Privatization has attracted growing interest because many public retirement systems around the world have encountered serious financial difficulties.
In Chile, a costly and failing public system was replaced by a less costly private system that has so far been quite successful. The United Kingdom has also shifted toward much greater reliance on private pensions. Advocates of privatization in the United States have proposed several plans for moving to a partially or fully private retirement system.
Two plans were outlined in the just-published report of the Advisory Council on Social Security. A majority of Advisory Council members voted to scale back defined-benefit Social Security pensions and require workers to contribute a percentage of their pay to private defined-contribution retirement accounts.
Under one plan, workers would be required to contribute 1. The 1. Under the more ambitious privatization plan, the overall contribution would rise by 1. Privatization plans differ from Social Security in two important ways. Workers who made larger contributions would receive bigger pensions, other things equal. Workers whose investments earned high returns would enjoy more comfortable retirements than workers who invest poorly. In contrast, Social Security pensions are financed mainly by the payroll taxes of active workers see box 1.
This difference between the two kinds of system implies that the savings accumulation in a private plan would be many times larger than the reserves needed in pay-as-you-go Social Security.
Barry P. Because the connection between individual contributions, investment returns, and pension benefits is very straightforward in a defined-contribution pension program, a private retirement system offers less scope for redistribution in favor of low-wage workers. Redistribution in favor of low-wage or other kinds of workers must take place outside these accounts.
The Social Security pension formula explicitly favors low-wage workers and one-earner married couples in order to minimize poverty among elderly people who have worked for a full career.
Social Security, established in , is the most costly item in the federal budget. After the income tax, it also provides the largest source of tax revenues.
The program provides old-age, survivors, and disability insurance protection to most people who work in wage and salary jobs and to the self-employed. Workers and their employers each pay taxes equal to 6. The self-employed pay Payroll tax revenues are used to pay benefits to people who are currently collecting Social Security pensions.
This method of financing is referred to as pay-as-you-go funding. Any excess of taxes over benefit payments is invested in special U. Treasury bonds, which earn the average rate of return on publicly traded government debt.
Workers who accumulate enough earnings credits become eligible to receive a Social Security pension when they attain the early retirement age 62 or become too disabled to continue working, no matter what their age. Social Security is a defined-benefit pension program. The exact amount of the pension is determined by a formula that is enshrined in law and is updated every year to reflect changes in economy-wide wages and consumer prices. The Social Security benefit formula provides substantial redistribution in favor of workers with low career earnings, workers who face an abnormal risk of becoming totally disabled, and married couples with only a single earner.
The generous treatment of these groups is affordable because high-wage workers, unmarried and childless workers, and dual-income married couples receive less favorable treatment under the system. The United States cannot immediately scrap its public retirement system and replace it with a private system.
About 1. Even if the country adopted a private system for young workers, people who are already retired or planning to retire within the next few years would continue to receive Social Security checks for several decades. Public funds must be appropriated to pay for these pensions, regardless of the system established for workers who will retire in the distant future. The need to pay for the pensions of people who are already retired or near retirement age poses a challenge to all plans for privatizing Social Security.
Money must be found for existing pension liabilities at the same time workers will be asked to contribute to a new type of private pension account. Because active workers will be required to finance pensions for retired workers and old workers nearing retirement, they may resent the obligation to pay for their own retirement pensions through contributions to new private accounts.
Some privatization plans would fund new retirement accounts by diverting a small part of the present payroll tax into private retirement accounts. Thus, 1 percent of the This source of financing for private accounts will not last forever, however.
Even if workers under age 40 are completely excluded from collecting Social Security pensions, benefit payments will exceed Social Security taxes by around see figure 1.
Thus the strategy of diverting a small part of Social Security taxes can work only if current benefits are scaled back. In addition, workers must contribute much more than 1 percent of their wages if they hope to accumulate enough private savings to enjoy a comfortable retirement. More ambitious privatization plans would divert half or more of the present Social Security payroll tax into private retirement accounts and slash Social Security payments available to young workers for example, those under age forty-five.
These plans would require borrowing or new federal taxes to pay for existing Social Security liabilities. The diversion of payroll taxes would starve the Social Security system of revenue, forcing the program to run huge deficits.
To cover these deficits Congress would be forced to raise taxes or borrow funds. The need for extra taxes or borrowing would eventually shrink as pensioners collecting Social Security were replaced by pensioners who received benefits from the new private accounts, but this process would not be complete for several decades.
In the interim, the federal government would need to impose extra taxes temporarily replacing most of the lost Social Security taxes or sell a large amount of additional public debt. Any discussion of reform should begin by recognizing that the current retirement system is already a mixture of public and private plans.
The public plan is universal but skewed toward protecting low-wage workers. Private or employer-sponsored plans cover about half the full-time work force, but they tend to leave part-time and lower-wage workers uncovered.
Advocates of privatization see a number of advantages in increasing the size of the private system and shrinking the size of the public one.
For some proponents of privatization, ideological concerns are paramount. They are fundamentally opposed to public provision of retirement benefits. More common are people who see important economic advantages in privatizing Social Security. They believe workers will receive larger pensions and the economy will grow faster under a private rather than a public retirement system.
Finally, some advocates of privatization believe the United States is more likely to take needed steps to prepare for a rising aged population if the retirement system is reformed to include a bigger private role.
A few critics of Social Security, who are particularly distrustful of public intervention, believe it is an unwarranted intrusion on personal freedom to require workers to contribute a fixed percentage of their pay to a retirement plan. Libertarians who hold this view oppose all mandatory saving schemes for retirement, whether or not the retirement funds are placed in private accounts.
Most advocates of privatization acknowledge that it makes sense to compel workers to save for old age, disability, and early death. In the absence of mandatory saving, many workers would save too little and could become destitute and be forced to rely on public aid when they stop working.
Most privatization advocates believe that decisions about the investment of retirement saving are best left up to workers and their employers. Nearly all advocates of privatization try to appeal to these interests.
They argue that pension contributions would be more affordable or benefits more generous if the nation moved toward a private retirement system. Stated crassly, most workers could expect a better deal under a private system than they can obtain under Social Security. This argument is based on a straightforward calculation.
If workers invested Estimates are displayed for workers born in a variety of years who earn steady wages at three different earnings levels. The low-wage worker is assumed to earn roughly the minimum wage; the average-wage worker earns the average covered earnings under Social Security; and the high-wage worker earns about two-thirds of the maximum taxable wage.
The Actuary then computed the interest rate that would be required so that the discounted value of real tax payments would be exactly equal to the discounted value of real benefit payments. Two facts about Social Security stand out in figure 2. Low-wage workers get a better deal than high-wage workers, and workers born before get a much better deal than workers born later. Even more striking than the disparity between low-wage and high-wage workers is the difference in returns enjoyed by people born before and after The high return enjoyed by workers born before helps explain the current popularity of Social Security, especially among older voters.
In particular, workers born around enjoyed two pieces of good fortune. When they entered the work force in the early s, the combined employer-employee tax rate was just 2 percent. More recently, the tax rate has been raised to cover much more generous pensions to a far larger number of retirees. Workers born in , for example, faced a combined contribution rate of People born in were also fortunate in enjoying rapid wage growth throughout most of their careers. Real annual earnings climbed 2 percent a year between and , rising about percent over four decades.
Rapid growth in real wages produces a good rate of return in a pay-as-you-go pension system. Unfortunately, real wage growth slowed dramatically in the mids.
The economy-wide average wage did not grow at all in the twenty years from to Slow wage growth will be reflected in slow growth in pensions and a lower rate of return on Social Security contributions for future generations of retirees.
In fact, because taxes will have to be hiked or benefits cut to keep Social Security solvent, workers born after will probably receive lower returns than those shown in figure 2. Many advocates of privatization believe that full or partial privatization will boost U. The low rate of capital accumulation contributes to the slow growth of national income and wages.
If saving could be increased, income growth would accelerate, making it easier for the nation to afford the extra burden of supporting a large retired population in the next century. Unlike the present Social Security system, which is largely financed on a pay-as-you-go basis, a private retirement system would involve huge accumulations of assets in individual retirement accounts. Because workers would be setting aside a percentage of their pay in private accounts for their own retirement instead of sending in contributions that are immediately spent on pension payments, the introduction of a privatized system could lead to a jump in saving.
In theory, national saving can be raised within the existing Social Security system, even if there is no move toward privatization. This could occur if Congress raised the present contribution rate or reduced benefits, increasing the annual surplus of the program.
The Social Security trust funds would accumulate larger reserves than are anticipated under current law. Instead of accumulating assets in tens of millions of individual retirement accounts, as in a private system, the saving would take place in a single public fund. Advocates of privatization doubt, however, that the funds accumulated within a public fund would actually be saved. They fear Congress would use the funds to finance growing deficits in other government accounts, such as Medicare.
In the absence of larger Social Security surpluses, the Congress would be forced to deal with the deficit in other programs, either by curtailing spending or by increasing taxes. A larger surplus in Social Security makes it easier for Congress to avoid this unpleasant choice.
Privatization advocates therefore think it is safer for the accumulation to take place in tens of millions of privately owned accounts, outside the reach of a revenue-hungry Congress. Privatization also offers a politically acceptable method of managing the accumulation of huge reserves and corporate stocks. In a system where the accumulation takes place in a single public system, legislators and public officials would be responsible for allocating the funds among investment alternatives and across individual companies.
Their investment decisions might be guided by political rather than economic considerations, reducing the yield of the investments, diverting investments into unproductive uses, or intruding on the business decisions of company managers. In a private system of individual accounts, decisionmaking authority over the accumulation would rest on the shoulders of millions of workers. Through their choices among investment alternatives and specific investment funds, workers and private fund managers rather than public officials would exercise ultimate authority over the allocation of investments.
A private retirement system, with its broad dispersion of asset ownership, also has an advantage over a public retirement fund when it comes to accumulating corporate stocks. The U. If retirement asset accumulation took place within a single public fund and if the public fund owned shares in thousands of companies, Congress or public trustees would have to decide how these shares should be voted.
Voting decisions might be determined by political rather than economic criteria, possibly reducing the efficiency and profitability of American business. Some advocates of privatization also maintain that voters would be more willing to accept an increase in their combined contribution to the retirement system if percent or more than percent of their extra contribution took the form of deposits into individually owned and managed investment accounts.
While voters would reject a hike in the payroll tax, they will tolerate — and may actually welcome — compulsory saving in individually owned accounts. This argument for privatization is essentially pragmatic. Because the work force is growing older, it is important to raise national saving. Voters and Congress are more likely to take the steps needed to increase saving if workers have direct ownership of their extra contributions to the retirement system. This fear is exaggerated but not completely unfounded.
In order to pay promised Social Security benefits, the future contribution rate must be increased. Future voters might balk at paying higher taxes, and benefits would then have to be cut. The expected revenues of Social Security will fall short of expected benefit payouts by 14 percent over the next seventy-five years, a shortfall that is equivalent to 2.
By benefit payments would need to be cut nearly one-quarter to keep the program solvent under the present payroll tax. This does not mean Social Security pensions must eventually be eliminated, as some young workers fear, but it does mean their taxes must be increased or their benefits cut if the system is to be preserved.
The two main economic arguments in favor of privatization are that it would increase real returns on pension contributions and boost national saving. Both arguments are valid, for some forms of privatization, assuming the public system to be dismantled is financed on a pay-as-you-go basis. There is no reason, however, that public retirement benefits must be supported with pay-as-you-go financing. The important distinction is between advance funding and pay-as-you-go financing, not between public and private management of investment funds.
Millions of employees of state and local governments have advance-funded pensions, and their pension funds are publicly managed. Advance funding, combined with a more aggressive investment strategy, can offer a higher return to current and future contributors. The larger accumulation in pension funds, whether they are publicly or privately managed, can boost national saving.
If the reserve were invested in the same mix of assets that would be selected by workers, it would earn an identical rate of return. The net return would actually be somewhat higher, because the expense of maintaining a single public fund is considerably smaller than the cost of administering tens of millions of private accounts, many of which would be extremely small.
For Social Security to accumulate the same kinds of assets that workers would place in private retirement accounts, a change in Social Security investment strategy is needed. By law, Trust Fund reserves are invested in U. Treasury debt where they earn the rate of return on publicly held U. Workers seeking a high return on their retirement savings invest in other types of assets in addition to government securities. Based on the experiences of workers who invest in k pension plans, the Advisory Council estimates that 55 percent of the retirement savings of workers under age forty would be invested in equities.
One of the three plans outlined by the Advisory Council proposed investing up to 40 percent of Trust Fund reserves in corporate stock, increasing the expected rate of return on reserves by about 1.
The Social Security Actuary has calculated the rate of return that workers can anticipate under the current system and under alternative systems proposed by the Advisory Council. These calculations are helpful in understanding the potential gains from privatization and how they are achieved. Figure 3 shows the expected rate of return of an average-wage worker under two alternatives. One alternative assumes workers will continue to receive Social Security benefits under the present benefit formula but that taxes will eventually be raised starting in to ensure that the OASDI Trust Funds are never depleted.
This strategy keeps Social Security solvent, but it reduces the rate of return received by younger workers, because they must make larger contributions to obtain the same amount of benefits. Figure 3 shows that the rate of return under this policy will decline continuously for workers born in successive generations. However, if the marriage lasted for fewer than 10 years, then they are not eligible to claim any spousal benefits.
Exceptions may be available in all of these countries except Cuba and North Korea. Immigrants who do not have enough U. These benefits are based on their work credits earned abroad combined with their U. Workers who have not earned at least six U. Federal government employees hired before are included in the Civil Service Retirement System CSRS , which provides retirement, disability, and survivor benefits. These workers did not have Social Security taxes deducted from their paychecks and thus are not eligible to receive Social Security benefits.
They may still qualify if they have earned benefits through another job or a spouse. Most state and local employees have Social Security protection under a federal Section agreement. However, some of these workers—including those who work for a public school system, college, or university—will not receive Social Security benefits if they do not pay Social Security taxes.
They generally receive pension benefits from their employers. Some railroad employees are not covered by Social Security. Workers with at least 10 years of service in the railroad industry or at least five years after have their retirement benefits covered through the Railroad Retirement Board RRB. The RRB is an independent federal agency that administers various employment benefits for railroad industry employees and their families. Workers with fewer than 10 years of service in the railroad industry or fewer than five years after do not receive retirement benefits through the RRB.
Instead, their accounts are transferred into Social Security and they become eligible for Social Security benefits after meeting Social Security benefit requirements. The most that someone reaching full retirement age in can get in Social Security benefits per month. The tax is calculated and paid each year when self-employed workers file their federal tax returns. Those who do not file tax returns do not pay Social Security taxes, unlike employees whose employers withhold and remit their Social Security taxes from each paycheck.
If you have no record of paying into the system, you will not receive payouts. If you have not reported income and evaded taxes for a lifetime, then you have no right to Social Security benefits. Retired people who immigrate to the United States will not have the 40 U. One way to rectify this problem is to earn six work credits in the United States and receive prorated U. Older immigrants who do not qualify for U. However, those who have spent little time in the U. Some could qualify for spousal benefits if their spouse qualifies for payments.
Some government workers are also not eligible. Fortunately, some people who do not currently qualify can still find a way to do so. Social Security Administration. Department of Labor. Accessed Oct. International Social Security Agreements. Social Security. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.
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How Social Security Is Organized. Getting Benefits. Benefits and Your Income. Benefits for Spouses. Benefits for Dependents, Survivors, After Divoce. Immigrants, Non-Citizens, Americans Abroad. Smart Benefits Strategies. Retirement Planning Social Security. Table of Contents Expand. Workers With Few Credits. Workers Who Die Before Certain Divorced Spouses. Some Workers Retiring Abroad.
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