Bold reform is needed to address the financial imbalances threatening the long-term viability of Social Security. That view, admittedly, has not always been widely shared. Nor has it been an easy sell in political terms — which explains in part why mainstream reformers have only offered half-measures in varying shades of beige. But, as Social Security continues its decades-long march toward a day of reckoning, more Americans (especially millennials) are asking a very big question: is Social Security’s current structure, dating from the 1930s, actually worth keeping?

Given the program’s low implicit rates of return when viewed as an individual investment and its long-term vulnerability to the vicissitudes of demography, fundamental changes are, at the very least, worth exploring. Ideally, reform should not only restore the system’s sustainability but also create a platform that gives individual households more control over how they amass assets to support retirement.

Who’s FICA? Why’s He Getting All My Money?

Social Security is a pay-as-you-go system, using current revenues to cover obligations incurred in the past. Put another way: today’s workers do not fund their own retirement; instead, they fund the benefits of current retirees and disabled individuals with the expectation that the next generation will do the same for them. Under the Federal Insurance Contributions Act (FICA), employees and their employers contribute equal shares of a 12.4 percent payroll tax, up to $142,800 per worker. That adds up to real money: FICA contributions exceed federal taxes for two-thirds of all households.

When FICA revenue exceeds current outlays, the balance goes into the Old Age, Survivors and Disability Insurance (OASDI) trust fund. The fund invests only in Treasury bonds. Aside from payroll contributions, Social Security’s only other sources of revenue are interest paid on these bonds and limited income taxes on pensioners’ benefits.

So, What’s the Problem?

Start with the big one: demographics. Due to increasing life expectancy, declining birth rates, and lower labor force participation, the ratio of workers-to-beneficiaries plummeted from 8.6-to-1 in 1955 to 2.8-to-1 in 2013. That ratio will surely continue to fall over the next decade as increasing numbers of baby boomers enter retirement.

As a result, the CBO estimates that the trust fund will formally run out of money in 2031. Nobody expects Congress to turn its back at that point — but the fiscal medicine needed to heal the patient becomes much harsher the longer we wait. We can’t be certain who would lose the most as part of an emergency repair, but the smart money is on those currently in the workforce. Faced with this slow train wreck, policymakers have been strikingly uncreative. The prevailing consensus is that financial balance should be salvaged through increasing payroll taxes and/or gradually raising the retirement age for future generations of retirees — as was done the last time this happened in 1983.

In that year, Congress did some belt tightening to avoid technical insolvency, including accelerating scheduled increases in the payroll tax rate and gradually increasing the retirement age. These reforms were supposed to keep the trust fund in the black for at least 75 years. We are only halfway through that period, and, once again, the trust fund is in trouble. The cracks in this system can only be papered over for so long.

But wait; there’s more! In addition to the demographic realities, Social Security doesn’t give Americans the best bang for their buck. The trust fund’s reliance on Treasury bonds excludes investment in more fruitful (though more volatile) assets. This year so far, the trust fund has earned returns below the rate of inflation. Furthermore, when viewed as an individual investment, Social Security provides most retirees a paltry real rate of return on contributions, which will get even worse under another regime of belt tightening. A medium male earner (earning a career average salary of $51,977) who entered the workforce in 2004 can only expect implicit real annual returns of 1.85 percent.

There Is a Better Way

I believe the United States should follow the example of 30-plus countries ranging from Singapore to Poland that incorporate mandatory individual retirement accounts (MIRAs) into their public pension programs. This would be pretty simple in concept: the government would divert FICA contributions into MIRAs for each contributor. The accounts would be invested in private mutual funds pre-approved by a federal agency.

This approach would address both of the fundamental issues facing Social Security. MIRAs would be immune from the direct consequences of demographic shifts because, rather than relying on the wages of future generations to cover their pensions, contributors would accumulate funds for their own retirement. Furthermore, MIRAs would stand a very good chance at earning higher rates of return than the paltry return on Social Security that most retirees now get. After all, investors in the S&P 500 received a 6.8 percent after-inflation annual return on stocks from 1971 through 2020.

Consider, too, that the rate of return of MIRA investments would not be dependent upon longevity. Since Social Security is an annuity, if you die young, you collect less — a reality that disproportionately affects African-Americans who, on average (in the pre-Covid-19 world) live 3.6 years fewer than whites. By contrast, the funds in individual accounts could be inherited by one’s descendants if the contributor dies prematurely, enabling more families to accumulate wealth.

MIRAs resemble the voluntary 401(k)s and IRAs already available to most Americans in households with earned income. But low- to middle-income individuals do most of their effective savings through Social Security because they can’t afford to set aside funds beyond their FICA contributions. Indeed, 42 percent of non-retired Americans have no individual retirement account.

Even those with retirement accounts have not saved enough; a recent study found that, on average, Americans have saved just 39 percent of what is necessary (beyond Social Security) for a stable retirement. Those Americans could have saved much more by investing FICA funds in assets that generated income at the pace of the stock market over the past half-century.

MIRAs would also yield significant benefits outside of the retirement sphere, establishing a stronger connection between Main Street and Wall Street. Even as U.S. stock indexes reached record heights in 2019, the number of Americans investing directly in the stock and bond markets reached a 20-year low. Most Americans do not think that the stock market has any effect on their finances — and, as a result, view it as a plaything for the wealthy. Racial minorities, younger individuals and lower-income families are all significantly less likely to invest.

MIRAs would help reverse America’s current crisis of confidence in capitalism, making every working-age American an investor with a direct stake in the performance of our capital markets. More efficient capital markets would pay off in social as well as individual terms. Economists Vittorio Corbo and Klaus Schmidt-Hebbel found that Chile’s transition to a system of MIRAs increased GDP by 5 percent between 1981 and 2001.

Risk vs. Reward?

I know you’re thinking about the elephant in the room: Would substituting private accounts for Social Security annuities invite too much risk? There’s no denying that stocks can be highly volatile in the short to medium term. However, Social Security contributors would be investing over the course of many decades, and it is hard to find a 20- or 30-year period since World War II in which stocks haven’t performed well.

Real rates of return from the Swedish premium pension — Sweden’s system of individual retirement accounts — exceeded those from Social Security over a 20-year period that included two global recessions. Even assuming a worst-case scenario in which an individual retired at the depths of the 2008 financial crisis, “private investment [over a working lifetime] would have outperformed Social Security” according to Michael Tanner of the Cato Institute. In fact, it is not even close. An average-earning married couple retiring in 2009 after 45 years of contributions would have received 75 percent more from private investment.

We Do Not Need to Reinvent the Wheel

Not all MIRAs are created equal. Much depends on who will administer the accounts and what assets they will be permitted to hold. Fortunately, in designing its features, the United States can learn from the other countries that have adopted private individual accounts. Their accounts generally fall into one of two camps: the Latin American (or Chilean) model or the Swedish model.

Under the Latin American model, individuals place the entirety of their contributions in an account administered by private fund managers who make all investment decisions. The Swedish model, on the other hand, is a multi-pillar system, combining a traditional defined benefit component (an annuity like today’s Social Security) with a “premium pension” composed of individual accounts. These “premium pensions” are administered by the government, but individual contributors choose the funds in which they invest.

Because MIRAs completely replace the “paygo” framework (as in, pay as you go) in the Latin American model, countries adopting this approach tend to impose stricter limits on what assets can be in the accounts. Although individuals can move freely among funds, they can only invest in one at a time. Under the Swedish model, individuals can invest contributions in multiple funds, from a list that offers hundreds of options. If they choose not to choose their own funds, the cash is invested in a default fund managed by the government.

In recent years, the Chilean pension system has been generating negative headlines. Indeed, the mass protests that rocked Chile in 2019 were motivated, in part, by frustration over inadequate pension benefits. But this frustration is more the result of the organization of the Chilean labor market than the structure of the retirement system. Almost one-third of Chile’s population work in off-the-books “informal” employment and thus contribute little or nothing to MIRAs. On average, those who did contribute earned an annual real return of 8 percent over the past 40 years.

I am more drawn to the Swedish model. Ideally, the Social Security Administration should manage the accounts, reducing administrative costs that are usually passed on to the contributor. In 2019, administrative costs for the Swedish premium pension amounted to 0.23 percent of total capital invested — significantly lower than comparable rates in Chile. Administrative costs for Social Security in 2019 were 0.6 percent of the system’s outlays.

Furthermore, I think it would make sense to allow for greater investor choice, similar to the Swedish model (or the American model for IRA accounts). Rather than placing all retirement savings with single fund managers, contributors should be able to spread their investments across a variety of funds. Of course, there should be limits, and the SSA should play a role in setting boundaries.

The barriers to entry for managed funds are quite low in Sweden’s premium pension system. Contributors can select funds that are entirely composed of stock from a specific industry or region, which are much more prone to market fluctuation. One would hope that the SSA would make rules limiting fund fees and requiring that individual investor portfolios are reasonably diversified.

A Phased-in Approach

MIRAs would exist in two phases: a transition phase resembling the multi-pillar Swedish model combining defined benefit annuities with private accounts, and a final phase where the accounts dominate retirement savings. One frequent criticism of individual accounts relates to this transition. Diverting the contributions of current workers into individual accounts would impair Social Security’s ability to pay benefits to current retirees. Or to put it another way, Social Security would have to do double duty as the source of income for current retirees and the savings of future retirees. But this argument should not be a deal breaker unless one accepts Social Security as a proverbial Hotel California: “You can check out any time you like, but you can never leave.”

In fact, a gradual transition should alleviate those concerns. Transition costs would be levied across generations, predominantly on those who will reap the benefits of higher expected returns.

There are a variety of mechanisms by which the additional revenue needed for the transition could be collected. Since wealthy individuals with large existing investments would likely benefit incidentally, I’d include an increase in the payroll tax cap, a temporary increase in the capital gains tax rate and a reduction in the maximum benefit for wealthy retirees. While these revenue-generating proposals mirror some measures suggested to patch the current system, the difference is that the additional revenue would go to changing the structure of Social Security rather than to propping up the paygo model.

Once the program managed a surplus, Social Security would first pay out defined benefits (monthly annuity checks) to current retirees and disabled workers and then return the remaining portion of FICA contributions to workers via MIRAs. As workers retire who have accumulated larger and larger amounts in their MIRAs, the maximum defined benefits for Social Security would be phased down until MIRAs largely replace the paygo structure.

By the final phase, the maximum benefit for OAS (old age and survivors’ insurance) would have fallen to guarantee a very basic minimum pension, with MIRAs covering the bulk of retirement benefits. Disability benefits would remain unchanged since this part of Social Security resembles true insurance. Upon retirement, individuals would have the option to purchase an annuity with their MIRA assets. Or they could withdraw funds gradually under a formula keyed to the life expectancy of the beneficiary — much the way required minimum distributions work with IRAs.

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Social Security has saved tens of millions of elderly Americans from poverty. But its pay-as-you-go structure, initially designed to minimize political opposition by kicking the financial can down the road, has not been changed since 1935. And it has metastasized into an unwieldy money machine that opaquely transfers wealth from generation to generation. To save Social Security, we must reform its fundamentals.

I am not naïve about the prospects for reform. President George W. Bush proposed a partial privatization of Social Security that sank like a stone. But political winds can change direction at any time, and opinions have become more fluid as the ballooning cost of OASDI weighs ever more heavily on millennials and Gen Zers. In my view, the case for bold reform is compelling: a system of individual accounts would eventually make the system’s effect transparent — and far more efficient in transforming savings into consumption when people really need it.