Big, Small Issues Loom in Social Security Debate

January 31, 2001 (PLANSPONSOR.COM)-A senior economist at the Federal Reserve Board of Dallas is calling for privatizing social security, but the former CEO of the Federal Retirement Thrift Investment Board told PLANSPONSOR.COM that such a system is "unworkable."

The economist advocating privatization, Thomas F. Siems, said in a paper released January 23, that social security must transform itself from a “pay-as-you-go” system, which transfers wealth inter-generationally, into one based on creating private accounts invested in the capital markets.

However, Francis X. Cavanaugh, who has 30 year?s experience at the US Treasury, said current privatization plans fail to account for some basic realities.

In the paper, Siems calls the current system flawed since it produces a declining rate of return. If payroll taxes were invested in the open markets, they could produce returns four to 10 times greater. The paper, “Reengineering Social Security in the New Economy,” was released by the conservative Cato Institute, a Washington, D.C. public policy foundation.

Privatization “Unworkable”

Cavanaugh, who was the first executive director and CEO of the Federal Retirement Thrift Investment Board, told that privatizing social security “would not work” due to its inability to meet fiduciary concerns combined with high administrative costs.

Cavanaugh, who also wrote “The Trust about the National Debt” (Harvard Business School Press, 1996), said privatization?s basic flaw is due to “bigness” and “smallness” problems.

“Bigness” in that Social Security covers 50 million participants with a wide range of needs that cannot be covered by the small businesses which must administer any privatized 401K plans.

The “smallness” problem is twofold: Employers would face large administrative expenses which would be high enough to consume any interest earned by employees to make it worthwhile.

When many privatization plans are floated, they too often just consider large corporations which have benefits staffs in place, Cavanaugh said.

“But there are many more small businesses which are not sophisticated when it comes to 401k plans, and many of their employees are not even literate in the language of business. There is no 401k plan around that is not heavily dependent on the employer?s administrative expertise and that would just not be there is mass privatization would happen.”

High Administrative Expenses

Another problem with privatizing Social Security is that national salaries are not that high to cover expenses. The average income for Social Security participants is around $20,000, which includes part time workers. Most Republican plans call for putting 2% of salary into a private account that would be about a $400 per year contribution

The second problem is expenses. Assume a small business has 10 employees. When a large provider sets up a 401k plan, they generally charge $5,000 per company, a $1,500 annual fee, $50 per person and a 5% management fee. This amounts to about $3,000 per year in administrative expenses, or $300 per year per employee, he said.

If the employee annual contribution is $400 charged against a $300 administrative fee, it leaves $100, plus some return, “so you would clearly be better if you put the money is a mattress,” Cavanaugh said.