A Proposal for Social Security

President Bush’s Commission to Strengthen Social Security confirmed what thoughtful analysts have known for years: Without substantial reforms, Social Security will not be able to pay the benefits promised to U.S. citizens — at least not without a substantial increase in Social Security taxes, which, of course, would hinder the ability of U.S. businesses and industries to compete.

To close the growing funding gap created by the declining ratio of workers to retirees, the CSSS has proposed three solutions, each of which would enable participants to transfer a portion of their Social Security contributions toindividual mutual fund accounts that invest in both stocks and bonds. While, over the long run, this would produce more revenue than the current practice of investing in government bonds, in our opinion, the high costs involved in this approach would substantially reduce future benefits and would not relieve the government of the enormous cost of transitioning from a pay-as-you-go system to a funded system. This would also put pressure on businesses, especially small businesses, to expend resources directing and managing relationships with financial institutions.

Critically, the CSSS’s proposals would also abrogate Social Security’s most valuable feature — government-guaranteed retirement benefits (or “defined benefits”). Contributions would still be government-mandated, but benefits would be uncertain — dictated by the market value of one’s portfolio at the time of retirement.

We propose an alternative approach that would be a far more effective and fiscally prudent way to maintain current benefit levels and stable contribution rates. Our system, termed “risk diversification through a common portfolio,” would differ from the CSSS proposals in two fundamental ways.

First, it would replace personal accounts with one common account that would invest its assets in a highly diversified indexed portfolio of stocks and corporate bonds. It is clearly inefficient to incur the costs associated with maintaining millions of accounts — thereby transferring wealth from employees and employers to the financial services industry — when, on average, those individual accounts can do no better than the return on one common account. To counter the objection that the resources accumulated and managed by Social Security would become very large and thus create the potential for political manipulation, we propose requiring that a blue-ribbon board supervise the investment portfolio, as has been successfully done in Canada and Ireland.

Second, and more important, our plan would preserve defined benefits. To accomplish this, the U.S.