Editor’s Note: Our guest author, William G. Shipman is Chairman of Carriage Oaks Partners LLC a Massachusetts-based consulting firm specializing in retirement finance. An advocate of Social Security reform in the United States, Mr. Shipman has testified before the House Ways and Means Sub-Committee on Social Security and co-authored Promises to Keep: Saving Social Security’s Dream. He is Co-Chairman of the Cato Project on Social Security Choice. He has also served as a delegate to the White House Conference on Social Security. He can be reached at: WGS@CarriageOaks.org.

The argument to postpone Social Security reform because of the current budget deficit is entertaining theater in which Washington’s thespians of all ideological persuasions can play their assigned roles. But it has very little to do with the substance of Social Security’s financial challenges.

Demographic Realities
The main reason that Social Security is in trouble is demographic: people are living longer and families are having fewer children. The combination of these two realities shrinks the number of workers relative to retirees eligible for Social Security benefits. In 1950 there were 16 workers paying taxes for each retiree. Today there are 3.4 workers and in 2030 there will be only two.

Given Social Security’s pay-as-you-go financing, it is axiomatic that promised benefits can be delivered only if taxes are continuously raised. Indeed, as the relative number of workers declined over the last five decades, the maximum payroll tax increased about 1200 percent even after adjusting for inflation. Without reform, the future holds the same.

Alternative Solutions
There is a point at which increasing taxes further is not a politically acceptable option. At this stage one of the often-proffered suggestions is reducing benefits. Reducing benefits, if applied in isolation, is the flip side of raising taxes. It approaches the financial challenge in strictly cash flow terms. From this perspective raising taxes or reducing benefits makes obvious sense. But neither appropriately addresses broader long-run societal concerns. And neither changes belowreplacement birth rates or increasing life expectancy. Reducing benefits, much like raising taxes, is a financial patch.

At this stage politicians look for alternative solutions. Invariably, they move to where their constituents already are. In our case, as has been true in so many other countries, they begin to consider saving and investing in professionally managed diversified portfolios of stocks and bonds. However, this fundamental restructuring of pay-asyou-go systems to market-based financing is not a panacea. Market-based systems can be poorly designed and it is important that they not be.

Such reform takes time to complete. In fact, it takes decades. And it may, depending on its design, require resources beyond the payroll tax. But if thoughtfully constructed, the system will be funded and sound at the end of reform. Continuing to pay Social Security’s promised benefits solely through ever increasing payroll taxes requires even greater resources, and the system is never stable.

Structuring for Reform
Beyond the policy of pension reform, there are many structural issues that must be considered. The transition cost, or bridge financing to which it is sometimes referred, should be addressed. From a cash flow point of view moving to market-based financing, in whole or part, will cause greater strains in the early years than staying with pay-as-you-go financing. This is often characterized as some will have to pay twice, once for their own retirement and once for those retired. From a broader perspective, however, the all-in cost of market-based financing will under all reasonable assumptions be less than the all-in cost of staying with pay-as-you-go financing. Cash flow should not be the only metric of concern. Unfortunately, political pressures are often focused more on cash flow realities than long-run accruals. Much work is needed to explain clearly the differences and why it is politically advantageous to think further out than a single year’s budget.

Success in market-based systems will hinge on the assets that are allowed for investment. A portfolio of only domestic government bonds is a portfolio of contingent tax liabilities. Such a socalled market-based system is roughly equivalent to the pay-as-you-go system it purports to replace. Success requires the investing in wealth-producing assets. Not only that, such investments should be diversified across asset classes, national borders and time. Should it be determined that the sole purpose of the accumulated assets is to provide for retirement security, then well established portfolio practices and risk management should play a central role. Otherwise, it is possible —perhaps even probable—that the accumulated wealth will be used for other needs, political or otherwise.

Workers through their individual accounts should have personal property rights over their accumulated wealth. When there is a direct relationship between one’s saving and one’s wealth there is a buy-in on the part of individuals. Noncompliance, a common problem in many pay-asyou-go systems, is much less of a concern when individuals have property rights.

Having said this, if the system incorporates personal property rights and modern portfolio practices but is highly taxed, as is the case in some countries, compliance is compromised. People save and invest for after-tax, not pre-tax income.

Administrative costs must be reasonable. Unnecessarily high administrative costs act like a tax for they reduce one’s after-cost wealth. Few countries presently have the administrative infrastructure in place to support a defined contribution national saving and investment system. To build one is a significant undertaking but quite feasible. In all likelihood no single system will work for all countries. But basic design features are applicable to most.

Other issues such as portability, distribution choices at retirement, spousal equity, redistribution, labor market mobility and investment choice—to name but just a few—should also be considered in any funded system. The details are not endless, but nearly so.

The Window of Opportunity
If reform is put off, as opponents suggest it should be, the demographic time clock still ticks. The window of opportunity slowly shuts. The ultimate costs rise. From this perspective, whether the current budget is currently in surplus or deficit matters little. The cost of not reforming the system will not go away.

In just seven years the conventional wisdom on how to deal with Social Security’s future has changed dramatically. Most students of the issue, proponents and opponents of reform alike, realize that time is working against us. They understand the Trustees’ admonition of "the sooner the better." But it will take considerable political leadership to bring all parties to the table to keep Social Security’s promises. And as has been the case in other countries, the leadership must come from the top.

The time has come to face the reality of population aging and unsustainable tax-based retirement systems. The challenges are daunting, but the opportunities are unprecedented. As more and more countries move from tax-based to marketbased systems we will be entering a global financial renaissance wherein taxes will be less, wealth will be greater and people finally will be secure during their retirement years. DSG

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