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Public Pension Plans

The most important public pension plan is Social Security (Old Age and Survivors' Insurance Fund), which covers virtually all individuals employed in the private sector. Funds are obtained from workers through Federal Insurance Contribution Act (FICA) deductions from their paychecks and from employers through payroll taxes. Social Security benefits include retirement income, Medicare payments, and aid to the disabled.

When Social Security was established in 1935, the federal government intended to operate it like a private pension fund. However, unlike a private pension plan, benefits

FYI. Should Social Security Be Privatized?

In recent years, public confidence in the Social Security system has reached a new low. Some surveys suggest that young people have more confidence in the existence of flying saucers than they do in the government's promise to pay them their Social Security benefits. Without some overhaul of the system, Social Security will not be able to meet its future obligations. The inability of the Social Security system to meet its future obligations is a problem that is not restricted to the United States, however. Indeed, European countries and Japan face an even greater problem because their populations are aging sooner than the U.S. population. What to do about social security has become a hotly debated political issue in recent years.

Currently, the assets of the U.S. Social Security system, which reside in a trust fund, are all invested in U.S. Treasury securities. Because stocks and corporate bonds have higher returns than Treasury securities, many proposals to save the Social Security system suggest investing part of the trust fund in corporate securities and thus partially privatizing the system.

Suggestions for privatization take three basic forms:

1. Government investment of trust fund assets in corporate securities. This plan has the advantage of possibly improving the trust fund's overall return, while minimizing transactions costs because it exploits the economies of scale of the trust fund. Critics warn that government ownership of private assets could lead to increased government intervention in the private sector.

2. Shift of trust fund assets to individual accounts that can be invested in private assets. This option, advocated by the Bush administration, has the advantage of possibly increasing the return on investments and does not involve the government in the ownership of private assets. However, critics warn that it might expose individuals to greater risk and to transaction costs on individual accounts that might be very high because of the small size of many of these accounts.

3. Individual accounts in addition to those in the trust fund. This option has advantages and disadvantages similar to those of option 2 and may provide more funds to individuals at retirement. However, some increase in taxes would be required to fund these accounts.

Whether some privatization of the Social Security system occurs is an open question. In the short term, Social Security reform is likely to involve an increase in taxes, a reduction in benefits, or both. For example, the age at which benefits begin is already scheduled to increase from 65 to 67, and might be increased further to 70. It is also likely that the cap on wages subject to the Social Security tax will be raised further, thereby increasing taxes paid into the system.

are typically paid out from current contributions, not tied closely to a participant's past contributions. This "pay as you go" system at one point led to a massive underfunding, estimated at more than $1 trillion.

The problems of the Social Security system could become worse in the future because of the growth in the number of retired people relative to the working population. Congress has been grappling with the problems of the Social Security system for years, but the prospect of a huge bulge in new retirees when the 77 million baby boomers born between 1946 and 1964 start to retire in 2011 has resulted in calls for radical surgery on Social Security (see the FYI box, "Should Social Security Be Privatized?").

State and local governments and the federal government, like private employers, have also set up pension plans for their employees. These plans are almost identical in operation to private pension plans and hold similar assets. Underfunding of the plans is also prevalent, and some investors in municipal bonds worry that it may lead to future difficulties in the ability of state and local governments to meet their debt obligations.

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