IDEAS ON LIBERTY
Economics on Trial
MARCH 2001

Social Security Reform: Lessons from the Private Sector
by Mark Skousen

"Of all social institutions, business is the only one created for the express purpose of making and managing change. Government is a poor manager."
     —Peter F. Drucker 1

In the ongoing debate over the privatization of Social Security, one story has been over-looked: The private business sector in the United States has already faced the pension-fund problem and resolved it.

Here's what happened. After World War II, major U.S. companies added generous pension plans to their employee-benefit programs. These "defined benefit" plans largely imitated the federal government's Social Security plan. Companies matched employees' contributions; the money was pooled into a large investment trust fund managed by company officials; and a monthly retirement income was projected for all employees when they retired at 65.

Management guru Peter F. Drucker was one of the first visionaries to recognize the impact of this "unseen revolution," which he called "pension fund socialism" because this Social Security look-alike was capturing a growing share of investment capital in the United States.2 Drucker estimated that by the early 1990s, 50 percent of all stocks and bonds were controlled by pension-fund administrators.

But Drucker (who doesn't miss much) failed to foresee a new revolution in corporate pensions—the rapid shift toward individualized "denned contribution" plans, especially 401(k) plans. Corporate executives recognized serious difficulties with their traditional "defined benefit" plans, problems Social Security faces today. Corporations confronted huge unfunded liabilities as retirees lived longer and managers invested too conservatively in government bonds and blue-chip "old economy" stocks. Newer employees were also angered when they changed jobs or were laid off and didn't have the required "vested" years to receive benefits from the company pension plan. Unlike Social Security, most corporate plans were not transferable. The Employment Retirement Income Security Act (ERISA), passed in 1974, imposed regulations on the industry in an attempt to protect pension rights, but the headaches, red tape, and lawsuits grew during an era of downsizing, job mobility, and longer life expectancies.

The New Solution: Individualized 401(k) Plans

The new corporate solution was a spin-off of another legislative invention—the Individual Retirement Account (IRA). The 401(k) rapidly became the business pension of choice, and there is no turning back. These "defined contribution" plans solve all the headaches facing traditional corporate "defined benefit" plans. Under 401(k) plans, employees, not company officials, control their own investments (by choosing among a variety of no-load mutual funds). Corporations no longer face unfunded liabilities because there is no guaranteed projected benefit. And workers and executives have complete mobility; they can move their 401(k) savings to a new employer or roll them over into an IRA.

According to recent U.S. Labor Department statistics, there are about nine times more defined-contribution plans than defined-benefit plans. Almost all of the major Fortune 500 companies have switched to defined-contribution plans or hybrid "cash-balance" plans. Companies that still operate old plans include General Motors, Procter and Gamble, Delta Airlines, and the New York Times Company. IBM, a company that once guaranteed life-time employment, switched to a "cash-balance" plan two years ago, giving its 100,000 employees individual retirement accounts they can take with them in a lump-sum if they leave the company before retirement (long-service workers are still eligible for IBM's old defined-benefit plan). But virtually all "new economy" companies, such as Microsoft, AOL, and Home Depot, offer 40 l(k) plans only.

Why Social Security Needs Reform

Congress could learn a great deal studying the changes corporate America has made in pension-fund reform. In fact, Social Security is in a worse position than most corporate plans were. Since less than a fourth of all contributions go into the Social Security "trust fund," the government program is more a pay- as-you-go system than a defined-benefit plan, where most of the funds go into a corporate managed trust fund. As a result, the unfunded liability, or payroll-tax shortfall, exceeds $20 trillion over the next 75 years. To pay for so many current recipients, Congress has had to raise taxes repeatedly to a burdensome 12.4 percent of wages, and payroll taxes will need to be raised another 50 percent by the year 2015 to cover the growing shortfall.3 Few corporate plans require such high contribution levels.

Moreover, the Social Security trust fund is poorly managed, so much so that experts indicate that the annual return on Social Security is 3.5 percent for single-earner couples and only 1.8 percent for two-earner couples and single taxpayers.4

Clearly, converting Social Security into personal investment accounts would be a step in the right direction, a policy change already achieved in Chile and other nations. Unfortunately, government—unlike business—is not prone to innovation. As Drucker notes, "Government can gain greater girth and more weight, but it cannot gain strength or intelligence."

1. Peter F. Drucker, "The Sickness of Government," in The Ageof Discontinuity (New York: Harper, 1969), pp. 229, 236.
2. Peter F. Drucker, The Unseen Revolution: How Pension Fund Socialism Came to America (New York; Harper & Row, 1976). This book was reprinted with a new introduction as The Pension Fund Revolution (New Brunswick, N.J.: Transaction, 1996).
3. Andrew G. Biggs, "Social Security: Is It a Crisis that Doesn't Exist?" Cato Social Security Privatization Report 21 (www.cato.org), October 5, 2000, p. 3.
4. Ibid., p. 32.