The Hidden Costs of Private Accounts

Ellen Frank

This article is from the November/December 2001 issue of Dollars and Sense: The Magazine of Economic Justice available at

issue 238 cover

This article is from the November/December 2001 issue of Dollars & Sense magazine.

As Bush's handpicked commission on Social Security grapples with the details of diverting Social Security revenue into private accounts, it will almost certainly confront a knotty little logistical problem—an issue that so stumped privatization boosters in the past that most either finessed the problem or threw up their hands entirely. The problem is how to actually manage the 150 million plus personal accounts even a partially privatized system would require.

When privatization was initially floated several years back, advocates had in mind something along the lines of the current employer-sponsored 401k programs. In a 401k plan, employers contract with a fund manager to invest employee contributions. To minimize paperwork and oversight costs, they limit the number of available investment options, generally to around 10 funds, though sometimes to as few as three or four, so that workers are not wholly free to actively manage their own portfolios.

Even so, tracking this money is neither easy or cost-free. Employers need to set up accounting and compliance systems, select investment options, and monitor fund performance. The U.S. Department of Labor estimates that administrative costs run somewhere between $100 and $200 per year for each person enrolled in a plan. On top of that, fund managers rake off fees—usually 1 to 2% of the balance—to cover costs and leave some profit. And the system doesn't work seamlessly. Contributions get lost, delayed, misdirected; sometimes willfully, sometimes by accident.

Consider, then, how a national 401k-type program, funded out of payroll taxes and covering every single worker in the United States, would operate. Each and every employer in the country would need to set up a monitoring system and contract with financial firms to manage the accounts of even part-time, transient workers. The plan Bush put forth during his presidential campaign would divert two percentage points of the 12.4% payroll tax to personal investment accounts. Presumably, the law would require employers to offer some minimum array of investing options. Let's say they would have to offer five options, and let's imagine further that the typical employee would choose to allocate her savings equally among the five funds.

Consider, as an example, the local donut franchise with several part-time employees, typically working 20 hours each week at $7.50 an hour. Currently, the business owner sends $18.60 per worker to the Social Security Administration (SSA)—the combined employee and employer share of payroll taxes. Now, though, the donut shop will need to send out two checks—$15.60 to the government, and $3 to the financial contractor managing the employee's investment accounts. That's 60 cents in each of the five funds. The cost to the donut shop owner of setting up and monitoring these accounts could add up to thousands of dollars each year.

Now, imagine that our representative fast food worker quits after 10 weeks and takes a job with the pizza shop down the road. Does she shift her $30 in accumulated savings to the pizza maker's plan? Must the pizza shop owner offer the same five investment options as the donut franchiser? If not, who will arrange for the transfer of her funds from one financial contractor to another?

Or can the worker simply leave her miniscule balances—$6 in each of five funds—where they are, opening new funds with new financial firms as she shifts from part-time job to part-time job in the low-wage sector of the economy? If so, who will pay the administrative costs of maintaining all these accounts? The donut shop? The pizza store? The worker herself? Will the typical U.S. teenager complete high school with perhaps 20 different accounts, each containing a few dollars apiece, and those few dollars destined to be eaten away by annual management fees and administrative costs? And what happens if funds are lost, or deliberately withheld, or sent to the wrong fund manager? Would the federal government oversee this? Would the grocer, the baker, and the pizza maker pay for independent oversight? Would the mutual fund industry want this headache? Would anyone?

Chewing over this logistical nightmare, earlier advocates of privatization proposed to streamline the process. To ease the burden on small businesses, employers would instead send all payroll tax money to the SSA, as they do now, and the SSA would place two percentage points in privately managed accounts, nominally owned by the covered workers. Acting like a centralized human resources office for the entire U.S. labor force, the SSA could offer a wider array of investment choices and set up a system, similar to those offered today by a number of large employers, that would allow workers to actively manage their savings.

This is undoubtedly much simpler. But it is not cheap. The SSA would now be responsible for two major administrative functions—managing the flow of funds to current pensioners, and handling the mutual fund monitoring and record-keeping for 150 million private accounts. Economists estimate that this would at least double the administrative costs of running Social Security, raising the annual cost of administration from nearly 1% to just under 2% of payroll taxes. Will these costs be paid by workers? If so, nearly half of the projected returns from private accounts will be lost to administrative costs—and this is before we even talk about fees charged by the finance industry.

Or will Social Security's extra costs be paid by the Treasury out of general tax revenues? In this case, the government could save itself the trouble. If general revenues amounting to an additional 1% of payroll taxes were shifted to the SSA, that would go a long way towards solving Social Security's long-range financing problems, adding a number of years to the life of the trust fund.

Then there's another question. If all the money targeted for private accounts must, in any case, flow through the SSA, why bother with private accounts in the first place? Why not let the SSA invest the same share of its own revenues in private assets, manage its own portfolio, and use the presumably higher returns to fund higher benefits, or close future operating deficits?

"Absolutely not!" say privatization boosters. Allowing a federal agency to manage billions in private assets in its own name on behalf of 150 million taxpayers is socialism. Allowing the same agency to contract with financial firms to manage those same stocks in the name of said taxpayers is free-market capitalism. So does ideology trump common sense in the Social Security debate.

Last year, the conservative Federalist Society invited me to debate Charles Rounds, Suffolk University law professor and supporter of private accounts. The audience questioned Rounds closely on how the accounts would operate. Would workers actually own their own savings? If so, could they withdraw funds and spend them as they chose? Or invest them in anything at all—say, Florida real estate or an internet start-up? And what would happen if their investments went sour or they spent down their savings before retiring?

These are the sorts of questions privatization boosters prefer not to address. A libertarian and Cato Institute researcher, Rounds criticized Social Security as a big-government welfare scheme which, disguised as a pension plan, coerces American workers to support retirees. Yet he conceded that a privatized system would itself necessitate quite a lot of federal coercion—workers would be required to save, to place their savings in a few pre-selected stock funds, and to keep them there until retirement. He also acknowledged that Congress might need to saddle the SSA with yet another task—administering a supplementary welfare program for those who outlived their savings.

That is the dirty little secret of privatization. A system of private accounts would be so expensive to set up and monitor, and would expose workers to so much risk and so many fees, that the federal government would almost certainly have to manage the whole mess, from choosing investment options and monitoring accounts, to establishing a parallel welfare system for those whose investments prove unprofitable.

So the push for privatization is not about freedom and individual choice after all. It's about diverting the money now going to SSA into the coffers of Wall Street.

Ellen Frank teaches economics at Emmanuel College and is a member of the D&S collective.