Can People Guarantee a Secure Financial Future?

-- Posted by Neil H. Buchanan

In a recent class discussion about Social Security, I was pointing out the surprising similarities between pay-as-you-go (PAYGO) financing and "fully-funded" financing. Although there are many important differences between the two methods of financing a nation's retirement system, I noted that PAYGO (the basis for the U.S. Social Security program) is no different from a fully-funded system of accounts in an aggregate sense. (Interested readers can find an explanation of this fact in my Sept. 2, 2010 FindLaw column.) A student asked whether it was nevertheless true that fully-funded financing (which typically means individual retirement savings accounts) is fundamentally safer than PAYGO financing, because the government can cut Social Security benefits at any time -- notwithstanding their status as "entitlements" -- while private accounts are "your money," which the government cannot take away.

Regular readers of this blog might recall that I discussed some aspects of this question recently in "I Guess You Can Take That Away From Me." There, I discussed news reports (which I continue to suspect were exaggerated or distorted, but which are instructive nonetheless) of some European governments having recently "confiscated" the funds from some of their citizens' retirement accounts. One notable aspect of those reports is that some of the accounts were government-run (that is, funded accounts that were deemed to be the property of the individuals whose names were on the accounts), while other accounts had been in private financial institutions. The existence of individual accounts -- even private accounts -- did not make them "safe from the government."

My discussion in that earlier blog post was focused on some of the indirect ways that a government can make private savings more or less safe. The argument was based on one of my favorite themes, which I have taken to calling simply "the baseline problem." In this instance, the baseline problem means that the very existence of private financial markets and institutions is premised on the existence of a government that enacts and enforces the laws that enable citizens to save money and earn interest, dividends, and capital gains. The contracts on which depositors/investors rely to guarantee that they will receive their money when promised, the notion of property, and so on, are legal conventions. When one's money is deposited in a bank, it does not go into a vault. It goes out to other people, who promise to pay it back under specified legal rules.

The least obvious way that private accounts do not make one's financial future "safe," therefore, is that the government can fail to enforce the rules on which depositors/investors rely when they save their money. This can be for direct gain to the government (such as the supposed confiscations mentioned above), or due to changes in policy that favor financial institutions, such as changing the law in ways that allow financial institutions to impose fees on deposits that shrink the size of an individual's net worth. In short, there is nothing about private deposit accounts that makes them inherently less vulnerable to changes in government policies, compared to the promises made by Social Security. Changes in the law can make either type of system less favorable to retirees.

The more obvious method by which the government can change a person's future standard of living, no matter the type of retirement system that is in play, is to make changes in the tax system. The intuition behind my student's question is based on the observation that the purported deficit crisis in the U.S. has led to calls to cut future Social Security benefits. Anyone hearing those calls would naturally seek out a safer alternative. Note, however, that some of the same people calling for future benefits cuts have also floated the idea of simply taxing future Social Security benefits. (Usually, these proposals are designed as progressive taxes that exempt poorer retirees.) Both benefit cuts and tax increases have the effect of reducing the deficit, and both reduce the living standards of future retirees.

What about private retirement accounts? A government that is in a budget crisis -- and, as I have noted many times on this blog, any budget crisis in the U.S. is going to be based on uncontrolled health care costs, not retirement/pension costs -- will be under pressure to cut spending and raise revenue. Raising revenue means increasing taxes, and the new or increased taxes can be levied on retirement income as well as on any other type of income. Indeed, since our current tax rules provide myriad ways in which retirement savings can be sheltered from tax, a future budget crunch could lead to observations that retirement money has "never been taxed even once." Retirement accounts, therefore, could be an especially ripe target for taxation.

Even less direct forms of taxation can undermine the presumed security of privately-held retirement funds. For example, suppose that the orthodox economists finally get their way and convince Congress to switch from an income tax to a consumption tax. Without revenue-losing (and extremely complicated) transition relief, the result would be to shift the tax burden onto retirees. Because retirement is all about consumption (saving being for younger people), taxing only consumption (rather than all income) means that retirees -- even if the money in their private retirement accounts is never directly taken or taxed -- will end up with a lower standard of living than they otherwise would expect.

The question, therefore, is not whether one system of financing retirement is more fundamentally safe than the other. Both are ultimately creations of the legal system, and both can be made less favorable to retirees by changes in laws on which people rely. The practical question, therefore, is whether there are political reasons to believe that one type of retirement system is safer from unfavorable policy changes, compared to the other system.

In the current political environment, there are definitely reasons to think that private accounts are less vulnerable than legislated Social Security benefits. Politicians across the political spectrum are calling for cuts in future Social Security benefits, while no politician will even suggest increases in taxes. Even if private retirement accounts are not safer than Social Security as a fundamental matter of legal guarantees, therefore, they currently are less likely to be reduced by realistic policy changes.

Note, however, how quickly this can change. It is only within the last few years that one of the great truisms of American politics changed: Social Security is the Third Rail (touch it and die!) of politics. It is precisely because of concerted ideological efforts that people were led to believe that "Social Security is broke," which succeeded in undermining their belief in the safety of their promised benefits. Even so, there is still very strong opposition to cutting Social Security benefits, and any effort to do so will be met with fierce opposition.

The anti-tax culture is just as subject to change. People who believe today that there is no way that Congress will ever enact tax increases -- and certainly not tax increases aimed specifically at withdrawals from private retirement accounts -- do not understand the contingent nature of political realities. If Social Security can be attacked, after being so politically untouchable for so long, anything can be attacked. In fact, the supposed safety of private accounts is undermined by the very fact that they are private. Whereas people have reason to join together to protect "everyone's" Social Security benefits, changes in taxes are not obviously or necessarily a fundamental attack on retirement security. And just as Social Security cuts can be offered as progressive policy changes (undermining the unity of the opposition), so can tax increases be designed to affect only sub-categories of retirees.

The bottom line, therefore, is that only political action can guarantee the safety of any retirement system. We cannot know today whether a future crisis -- real or imagined -- will lead to policy changes that will undermine our plans for a comfortable retirement. Switching from Social Security to private accounts, however, will not make anyone's future living standards more secure from changing political tides.