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Executive Summary
T
he debate over whether Social Securityneeds to be reformed is largely over. Thequestion now is what type of reform. Manyexperts suggest moving toward a saving andinvestment structure wherein some portion of the Social Security tax is invested in markets.Opponents of privatizing Social Security,however, warn of numerous and formidablerisks associated with markets. Among otherissues, they raise questions of market risk,retirement bene
fi
ts of low-income workers in aprivatized structure, potential difficulties forunsophisticated investors in a market-basedsystem, and the plight of survivors of deceasedworkers.None of these objections survives a carefulexamination of the evidence. In fact, most rep-resent a misunderstanding of 
fi
nancial marketsand Social Security and how a privatized SocialSecurity system would work. For example:
•Critics claim that private markets are dan-gerously risky and that only knowledgeableand experienced investors can successfullyhandle such risks. In reality, however, long-term investment in private capital markets isless risky than the current Social Securitysystem and can be handled by even inexpe-rienced investors.•Because Social Security has a progressivebene
fi
t formula, some assert privatizationwould hurt low-wage workers. Moreover,others claim that a privatized system wouldappeal only to the wealthy and most savvyinvestors. However, because of its muchhigher returns, a privatized Social Securitysystem would actually bene
fi
t low-wageworkers and would appeal across all individ-ual income and education levels.•One of the most common criticisms of pri-vatization is that private
fi
nancial institutionswould charge excessive fees, thereby reduc-ing retirees’returns to unacceptable levels.However, actual fees and administrativecosts for existing investments are generallywell below 100 basis points (one percent).Assuming fees of this magnitude, yieldswould still be much higher than bene
fi
ts cur-rently provided by Social Security.•Finally, critics claim that a privatized systemcould not provide survivors’bene
fi
ts. In real-ity, a market-based retirement system wouldprovide better survivors’bene
fi
ts than thecurrent system.
1
 Melissa Hieger is a vice president and William Shipman is a principal with State Street Global Advisors. Mr. Shipman is co-author of 
Promises to Keep: Saving Social Security’s Dream
and co-chairman of theCato Project on Social Security Privatization.
July 22, 1997SSPNo. 10
Common Objections to a Market-BasedSocial Security System: A Response
by Melissa Hieger and William Shipman
 
Introduction
It is generally accepted that under presentlaw Social Security taxes will not be adequateto meet promised Social Security bene
fi
ts. This
fi
nancial dilemma re
fl
ects a demographic reali-ty: the available number of workers to be taxedwill be insufficient to pay bene
fi
ts at currentlevels to an ever-increasing number of retireeswho are living longer. As our political, academ-ic and business leaders wrestle with this prob-lem, more and more often they suggest movingtoward a saving and investment structurewherein some portion of the Social Security taxis invested in markets. Advocates of this viewargue that because market returns are greaterthan those from the present pay-as-you-go sys-tem, tax increases or bene
fi
t cuts will be lessonerous.Opponents, however, warn of numerous andformidable risks associated with markets.Among other issues, they raise questions of market risk, retirement bene
fi
ts of low-incomeworkers in a privatized structure, potential diffi-culties for unsophisticated investors in a market-based system, and the plight of survivors of deceased workers.This paper examines such common objec-tions to privatization as:
1.Low-income workers will suffer becauseSocial Security’s progressive bene
fi
t for-mula will no longer apply.2.Financial security in old age should notdepend upon the participant being a knowl-edgeable investor.3.Social Security is virtually risk-freebecause it is backed by the full faith andcredit of the government. Amarket-basedsystem, on the other hand, is inherentlyvolatile. Moving toward a privatized sys-tem, therefore, subjects workers to riskwhich is unnecessary.4.Although the stock market rises over thelong term, it could collapse at the end of one’s working career, leaving little or noth-ing for retirement.5.Markets cannot handle the volume of investment capital that a privatized systemwould create. This inability could cause anear-term “speculative bubble” during theyears baby boomers are paying into the sys-tem and then a market collapse as theywithdraw funds in their retirement years.6.Only the wealthy or the
fi
nancially astutewould choose the market-based system,leaving the
fi
nancially less-well-off to fendfor themselves in a system ultimately des-tined to unravel.7.Amarket-based system would necessitatehigh administrative costs, reducing returnsto unacceptable levels.8.In many cases, Social Security pays bene-
fi
ts to survivors of deceased workers. In aprivatized system, workers who die at anearly age would not have amassed enoughwealth to care for their family members,leaving them
fi
nancially vulnerable.
None of these objections survives a carefulexamination of the evidence. In fact, most rep-resent a misunderstanding of 
fi
nancial markets,Social Security, and how a privatized systemwould work. Compared with the current SocialSecurity system, a market-based retirement sys-tem would incur less risk and offer more bene-
fi
ts to low-income workers.
Objection #1: Low-incomeworkers will suffer becauseSocial Security’s progressivebenefit formula willno longer apply.
Opponents of Social Security privatizationworry that the level of bene
fi
ts to low-incomeworkers from a market-based system would beless than from present-day Social Securitybecause Social Security redistributes wealthfrom high-income to low-income workersthrough a progressive bene
fi
t formula. It is truethat the current bene
fi
t formula is progressive;that is, lower-income workers receive more foreach dollar earned than do higher-incomeworkers. However, whether the formula intend-ed to achieve this actually results in a systemthat is progressive is subject to some disagree-ment.
1
But whatever the conclusion, a morefundamental question remains: is the objectiveof progressivity to level retirement bene
fi
tsacross income classes, or is it to lift the lot of low-wage earners? If it is the former, it is ques-tionable whether Social Security is effective. If it is the latter, there is no question that SocialSecurity is ineffective.To calculate bene
fi
ts the Social SecurityAdministration adjusts the worker’s wages (andself-employment income) earned prior to theyear in which the worker turned 60 by in
fl
ationadjusting them using what is called the AverageWage Index.
2
Then the highest 35 years of earn-ings are added and divided by 420 (the number
Comparedwith thecurrent SocialSecuritysystem, amarket-basedretirementsystem wouldincur less riskand offermore benefitsto low-incomeworkers.
2
 
of months in 35 years) to calculate the AverageIndexed Monthly Earnings (AIME). ThePrimary Insurance Amount (PIA), which inmost cases is one’s initial monthly bene
fi
t if retiring at the normal retirement age, is then cal-culated using bend points, the primary determi-nant of the system’s progressivity. As an exam-ple, a worker who turned 62 in 1996 would usethe following formula to determine his initialmonthly bene
fi
t:
•90 percent of the
fi
rst $437 of AIME, plus•32 percent of AIME in excess of $437 butnot in excess of $2,635, plus•15 percent of AIME in excess of $2,635.
As is clear from the formula, bene
fi
ts as a per-centage of earnings fall as wages rise, yieldinghigher returns for lower-income workers. Table1 shows this for low- and maximum-incomeworkers born in 1930, 1950, and 1970.Despite this, the system may not be as pro-gressive as it appears. Some experts have point-ed out that low-income workers start theircareers at an earlier age than do high-incomeworkers, and have a shorter life expectancy.Therefore, low-wage workers receive backfewer bene
fi
ts over their lifetime compared towhat they pay in than do wealthier workers.
5
The RAND Corporation found that while SocialSecurity bene
fi
ts retain some degree of progres-sivity, taking into account such factors as mari-tal status and life expectancy shows that “theOASI system is not as progressive” as generallybelieved.
6
Indeed, the study found that forunmarried men, the rate-of-return among high-wage earners was actually higher than amonglow-wage earners, making Social Securityregressive for that category of recipients.
7
The RAND study also concluded that the cur-rent bene
fi
t structure disadvantages African-Americans, who have lower life expectanciesand marriage rates. According to the study,whites consistently earn higher rates of returnthan blacks.
8
In fact, on a life-time basis, theincome transfer from blacks to whites is asmuch as $10,000.
9
Others counter by noting that the systemretains its progressivity because lower-wage-earning workers tend to have more menial andphysically stressful jobs, leading to higher ratesof disability and, therefore, bene
fi
ts. Also, theirfamilies often have just one wage earner, yield-ing higher spousal bene
fi
ts. In addition, bene
fi
tsare taxed using progressive income tax rates,leaving them with higher after-tax bene
fi
tsbecause of their low, or even zero, marginal taxrate. Finally, given that bene
fi
ts are based on 35years of work history, low-income workers, whohave more periods of unemployment, receivethe same bene
fi
ts as other workers with thesame income but many more years of work.Whether these differing views of progressivitycancel each other out or not is subject to debate,but there is no question that the bene
fi
t formulaitself is progressive. Because it is assumed thatwithout redistribution lower-income workerswould be worse off, the preference for redistri-bution is one of the arguments against market-based
fi
nancing.One test of this hypothesis is to compareSocial Security bene
fi
ts to simulated marketbene
fi
ts for the same low-income workers asabove. We will assume that each individualstarts working at age 21, retires at the normalretirement age (NRA), and lives to the averageexpected life span of the population aged 65.
10
Low-income is de
fi
ned as annual earnings equalto half the national average wage, about $13,366in 1997. For each worker only the combinedemployer and employee OASI tax stipulated bylaw is invested. These taxes are shown inAppendix A.Market-based bene
fi
ts assume the OASItaxes are invested exclusively in stocks orbonds. The stock portfolio contains 90 percentlarge capitalization stocks and 10 percent smallcapitalization stocks, comparable to the mar-ket’s capitalization presently. The bond portfo-lio is an equal weighting of government andcorporate bonds. Actual annual returns through1996 were used. The average annual nominal
The RANDCorporationfound thatSocialSecurity is notas progressiveas generallybelieved.
3
Table 1Progressivity of Social Security Benefits
Annual Initial Monthly Benefit as aYear of Earnings Social PercentageYear ofRetire-Prior to Year ofSecurity Benefit of Last Year’sBirthmentRetirement(NRA)Labor Income
Low Maximum Low MaximumLowMaximumWageWageWageWageWageWage
19301995$12,539$63,979$581$1,26656%24%19502016$14,897$72,280$668$1,66154%28%19702037$17,867$86,598$799$1,99454%28%
Note: It is assumed that each worker starts work at age 21 and retires at the normal retirement age(NRA) as stipulated by law (for the 1930, 1950, and 1970 birth years the NRAs are 65, 66, and 67,respectively).
3
Low wage is defined as 50 percent of the national average wage and maximum wage isthe maximum earnings subject to the OASI tax. All figures have been converted to real 1997 dollarsusing actual and projected levels of the Consumer Price Index.
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