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Executive Summary
O
ne of the more common concerns abouttransforming Social Security’s pay-as-you-go financing into a market-based structure is thetransition cost. Critics claim that people wouldbe unduly burdened because they would have topay twice—once for their own retirement andonce for those already retired. This doubleexpense would be so prohibitive, it is argued, asto warrant rejecting privatization even if it weremeritorious on other grounds.Such arguments ignore the enormousunfunded liabilities of the current SocialSecurity system. Any valid discussion of thecosts of moving to a market-based SocialSecurity system must compare those costs withthe costs of maintaining the current system,including the costs of meeting those unfundedliabilities.The mechanisms for paying those costsremain the same whether one attempts to propup the existing system or shift to a new,market-based system—debt, additional revenue,reductions in spending within the program, orreductions in spending elsewhere in the govern-ment. Regardless of the mechanism used to paythose costs, moving to a market-based systemwill always be less costly than attempting to pre-serve the current system.Therefore, redesigning Social Security as amarket-based system of personally ownedretirement accounts does not actually entail anynew costs. Indeed, moving to a market-basedsystem can ultimately result in substantialsavings.1
William Shipman is a principal with State Street Global Advisors and co-author of 
Promises toKeep: Saving Social Security’s Dream.
 He is co-chairman of the Cato Institute’s Project on SocialSecurity Privatization.
October13, 1998SSPNo. 13
 Facts and Fantasies aboutTransition Costs
 by William Shipman
 
Introduction
One of the more common concerns abouttransforming Social Security’s pay-as-you-gofinancing into a market-based structure is thetransition cost. Critics claim that people wouldbe unduly burdened because they would have topay twice—once for their own retirement andonce for those already retired. This doubleexpense would be so prohibitive, it is argued, asto warrant rejecting the idea of privatizationeven if it were meritorious on other grounds.However, the transition cost need not be pro-hibitive or even greater than the benefits fromthe new system. Theoretically, a net saving rela-tive to what the future holds under today’s lawcould be realized. An illustration is the tradeoff in refinancing a home mortgage. Costs, such aspoints, title insurance, title search, attorneys’fees, credit report and the like, are associatedwith achieving a lower interest rate. The deci-sion to refinance includes not only the lowerinterest rate, but these transaction costs as well.If the present value of the costs and the lowerinterest expense is significantly less than thepresent value of the existing mortgage interestexpense, then there is a net benefit from refi-nancing even though costs were incurred toachieve it.The home mortgage paradigm is useful in theSocial Security reform debate. The cost of thepresent system is the forgone consumption,either by individuals or the government, neces-sary to pay future promised benefits. The cost of getting to a market-based structure is the for-gone consumption required to invest in marketsand pay some payroll tax.
1
If the latter is lessthan the former, then there is a net saving duringthe transition, even though costs were incurredto achieve it.If the forgone consumption were in the formof a reduction in government spending, thenthere would be an added benefit, which is theefficiency gain from this choice. Although inde-terminate, this gain may be significant.
2
Whichever path the country ultimately takes, thetiming of the decrease in consumption can bemanaged through deficit finance, but it cannotbe avoided.One significant advantage of a privatized sys-tem is the greater retirement income earnedfrom investing in markets. If this income, takinginto account the cost of achieving it, is greaterthan Social Security’s retirement income adjust-ed for the cost of maintaining it, then the goal of privatization seems worthwhile. If not, then theargument for reform is less persuasive. Thestarting point to determine which system issuperior is Social Security’s financial futureunder present law, which is detailed in the 1998Trustees Report.
3
The term
 privatization
should be used withcaution. The term is now so liberally employedthat quantifying the price of getting there is amatter of much interpretation. Different privati-zation plans can produce entirely differentresults. This paper, therefore, presents a frame of reference that is useful in estimating the costs of making the transition to specific market-basedstructures. The analysis will show that movingtoward market-based financing does not neces-sarily incur a cost over and above present law,and may produce a saving.
Social Security Today:Deep in Debt
Social Security comprises two differentprograms: Old-Age and Survivors Insurance(OASI) and Disability Insurance (DI). Com-bined, they are called OASDI. This paper con-siders OASI only but not the taxes paid to or thebenefits received from the Disability Insuranceprogram.In the OASI program one pays a payroll taxduring working years and receives a monthlybenefit check during retirement years. It is a sys-tem of money in and money out and can becompared with other money-in, money-outsystems.Actuaries estimate OASI’s long-term finan-cial health over a 75-year period.
4
They projectannual revenues and expenses and adjust eachfor expected inflation. The difference, expressedin today’s dollars, is how much the system isfunded or unfunded. Projections assume threedifferent economic and demographic scenarios:optimistic, pessimistic, and middle of the road.This paper compares privatization with the mid-dle-of-the-road scenario, formally referred to asthe Intermediate Assumption.
Cash Flows:
OASI derives revenues primarilyfrom a payroll tax. The payroll tax started in1937 at 2 percent up to $3,000 of wage earningsand is now 10.7 percent up to $68,400.
5
Themaximum tax, therefore, has gone from just $60to $7,319 in 61 years, about a 950 percentincrease in real terms. (Economists agree that
The transitioncost need notbe prohibitiveor evengreater thanthe benefitsfrom the newsystem.
2
 
workers effectively pay both the employee’s andemployer’s shares of the payroll tax.) The max-imum wage subject to tax automatically rises onthe basis of the increase in average wages. In just 10 years the OASI tax will apply to about$100,000 of wage income.
6
Starting in 2000 thetax rate falls to 10.6 percent. For 1997 the OASIpayroll tax revenue was $349.9 billion.
7
The Social Security system receives revenuefrom a tax on part of the Social Security bene-fits, but the revenue is proportionally small andnot significantly variable over time. It is notincluded in this analysis. If it were, conclusionswould not be materially different. The OASITrust Fund is also credited interest income. Thisfund will be discussed in the next section.OASI costs are benefit payments and rela-tively minor administrative expenses. Last yearcosts totaled $318.4 billion.
8
For 1997, there-fore, OASI payroll tax revenues exceeded costsby $31.5 billion. In 2015 the tax revenue excessis expected to end, and cash flows will be nega-tive for every year thereafter.
9
Figure 1 showsthe trends of revenues, costs, and the resultingdeficits for the next 75 years as projected bySocial Security’s actuaries.
The OASI Trust Fund:
The Social Securitysystem did not always have a comfortable cashflow surplus. During the early 1980s the sys-tem had a deficit and had to borrow moneyfrom other government programs. In anticipa-tion of this problem, in 1981 President RonaldReagan established the National Commissionon Social Security Reform, informally calledthe Greenspan Commission for its chairman,Alan Greenspan. The Commission was toreview the condition of the Trust Fund, analyzepotential solutions to ensure its financialintegrity, and provide appropriate recommen-dations.
10
On April 20, 1983, the presidentsigned into law the 1983 Social SecurityAmendments that resulted from the Commis-sion’s work. Some of the important amend-ments included the following:
11
•New federal employees were required to becovered by Social Security.•State and local governments could no longeropt out of Social Security.•Up to half of the Social Security benefitswould be taxed for higher-income elderly.•The cost of living adjustments would bedelayed for six months.•The timing of the increase in the payroll taxrate would be accelerated.•The age at which full benefits could bereceived would be raised from 65 to 67.•Early retirement age benefits were reduced.
The new law was to make Social Securityactuarially sound for the next 75 years; that is,all future benefits could be paid until 2058 with-out any further tax increases.During the system’s early period, the lawworked according to plan. For the first 15 yearstaxes exceeded benefits. But as in previous peri-ods when the system enjoyed a positive cashflow, the difference was not saved and investedfor future retirees; it was spent by the federalgovernment on goods and services not related toSocial Security. Because of these expenditures,the government issued nonmarketable bonds tothe OASI Trust Fund. The bonds, which areinterest bearing, are backed by the full faith andcredit of the United States government. If atsome date OASI taxes are no longer sufficient topay benefits, then Social Security will presentthe bonds to the government for payment. Thegovernment, which has no assets set aside forthis contingency, would have to raise additionaltaxes, reduce other spending, or issue more debtto redeem the bonds. The bonds, therefore, are apotential tax liability facing American workersas well as an asset of the OASI Trust Fund. Thebonds are not a store of wealth, but rather a gov-ernment accounting convention. The year 2015is when OASI is expected not to have enoughtax income to pay benefits and, therefore, to3
Figure 1Projected Social Security Cash Flow, 1998–2072
Note: The annual data are estimated from the
1998 Trustees Report.
   ––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––
   $   T  r   i   l   l   i  o  n  s
1815129630 –3 –6 –9
       1       9       9       8       2       0       0       1       2       0       0       4       2       0       0       7       2       0       1       0       2       0       1       3       2       0       1       6       2       0       1       9       2       0       2       2       2       0       2       5       2       0       2       8       2       0       3       1       2       0       3       4       2       0       3       7       2       0       4       0       2       0       4       3       2       0       4       6       2       0       4       9       2       0       5       2       2       0       5       5       2       0       5       8       2       0       6       1       2       0       6       4       2       0       6       7       2       0       7       0
 –  –  –  –  –  –  –  –  –  – 
Year
BenefitsPayroll TaxesNet cash Flow
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