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Gingrich's Social Security Plan: Privatize Gains, Socialize Losses

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Last week, former House Speaker Newt Gingrich unveiled details of his plan to partially privatize Social Security. His plan would allow younger workers to contribute a portion of their payroll tax obligation to a private investment account. Roughly speaking, Gingrich is signing on to the legislation from 2004 sponsored by Representative Paul Ryan (R-WI) and former Senator John Sununu (R-NH).

Like any plan to introduce private accounts, Gingrich must first explain how he will fund benefits for current retirees. Presently, existing benefits are paid for by the payroll tax contribution from current workers -- with private accounts, those payroll taxes would be diverted to private accounts. But I've talked about that issue before in relation to the plans of Herman Cain and Rick Perry, so I won't repeat it here. (If you are interested in how the funding issue applies to Gingrich's plan in particular, read this piece by Eric Black.)

Instead I want to focus on a separate aspect of Gingrich's plan: the protection from downside risk. Under Gingrich's plan (see page 17), if an individual's investments sour, then (see page 17) "[T]he Treasury will send them a check to make up the difference" between their investments and their promised benefits. This guarantee is also part of the Ryan-Sununu plan.

But, as Pat Garofalo at ThinkProgress noted,

[P]romising to make investors whole again sets up a huge moral hazard problem. If investors know full well that the government is going to provide them with a minimum benefit, no matter what they do, then the incentive is to make risky investments and hope for a big payoff. After all, why not take the risk if the government has guaranteed that you can't lose money? Investors have every incentive to bet big in the hopes of a large payout, because if they go bust, the government will bail them out.

Gingrich counters that private account holders could invest only in a select few funds -- each of which would be regulated by the government to meet basic diversification requirements. From his plan (again see page 17):

Because the government authorizes and regulates all investment funds, it is able to manage the risk of the personal accounts. This provides a key check on excessively high-risk investing, and all but ensures that the returns accrued in the personal accounts are more than adequate for retirement.

Gingrich is correct that his plan would not allow an individual to invest purely in, say, the latest social networking IPO. But under the Ryan-Sununu plan that Gingrich emulates, investors could still choose a fund that has higher risk and reward -- such as a fund invested only in international stocks, or small-cap stocks.

Furthermore, Gingrich's plan explicitly allows individuals to (see page 16) quickly switch between funds -- meaning that investors could increase their risk and return by attempting to time the market. These investors would know that if they happened to guess incorrectly -- or if their risky exposure to international stocks soured -- the Treasury's guarantee would protect them from losses.

The protection from downside risk is would be more palatable if investment choice is further restricted to, for instance, balanced or target-date funds. And the plan would have to restrict reallocation within the same account, so that workers could not increase their risk by attempting to guess market trends. However, even with these further restrictions, any federal guarantee of losses from equity investments is a bad idea -- the government is taking the downside risk, but the individual gets any upside gain.

In short, you can't have it both ways: you cannot allow individuals to take on more risk while retaining the absolute safety net of Social Security. If Gingrich believes that privatization is the way to go, his plan needs to force individual workers -- rather than taxpayers as a whole -- to bear the risk of poor investment returns.

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