Should Social Security Privatization Be Voluntary?

William Polley posts some doubts about the wisdom of allowing voluntary participation in a privatized social security scheme.

I see that the Bush administration's Social Security proposal makes the personal accounts voluntary.

The President favors voluntary personal accounts as part of a comprehensive solution to give younger workers the option to save some of these payroll taxes. Personal accounts give younger workers the opportunity to receive higher benefits than the current system can afford to pay, and provide ownership, choice, and the opportunity for workers to build a nest egg for their retirement and to pass it on to their spouse or their children.

Those who do not choose to have a personal account would continue to draw benefits as Americans have long done from the Social Security program...

Will someone please explain to me how today's young people who choose to stay in the existing pay-as-you-go system can expect to someday receive the same level of benefits that are paid today if some in the generation after them are in a fully funded system?

OK, I'll give it a shot.  I'll stick with my habit of not commenting on what a final proposal may or may not look like, but I do think there is a very good reason to favor a transition phase that makes participation in a private-account scheme voluntary.

Since William generally supports a privatization proposal of the sort floated by Jagadeesh Gokhale and I some years ago -- which I noted in at least one earlier post as well -- let me organize my comments around that exercise.  The idea is actually very simple.  Compound interest being what it is, given enough time even a very small advantage in the return to private accounts can dominate the return in an alternative pay-as-you-go plan.  What Jagadeesh and I did was perform some very simple calculations comparing the returns that workers of a specific age could expect to receive from the current pay-as-you-go setup -- assuming that contributions and benefits are adjusted to bring the system into actuarial balance -- with the returns such a person could expect from switching to a privatized system -- assuming that taxes are levied to finance the benefits for those who choose to stay in the pay-as-you-go plan.

What we were trying to find out was whether any living age group would have higher returns by making the switch, given plausible assumptions about demographics, asset returns, and the like.  We argued that the answer was "yes." 

The rub, of course, was that the results from this type of exercise depend -- sometimes critically -- on the assumptions that are made.  Modesty (or self-defense) requires me to conclude that making a definitive judgment about the true return to the typical private account, for example, is just a bit beyond the rank of your standard well-meaning policymaker.  The solution, so it seems to me still, is to make participation voluntary, and let people sort themselves into the plan that they deem best.  If our guess is right, we will see a systematic sorting of younger people into the privatized system, and the pay-as-you-go world will slowly fade away.  If they don't, well maybe the critics of privatization are right.

There will, of course, be an element of trial-and-error in all of this.  Those in the privatized system still have to help pay the freight for the existing pay-as-you-go liabilities, and it will not be immediately apparent what tax rates settings will do the trick.  That will be revealed in time, and adjustments will have to be made.  But being a good conservative commentator, I live by a simple creed.  Give the market a chance.  It will probably give you the right answer.

UPDATE: William responds.  And I couldn't agree more with this statement:

I think this is the right kind of debate to have. I am looking forward to seeing more specifics from the administration and more discussion of the finer points.