High on President Bush’s list of priorities for his second term is the privatization of some portion of Social Security. The opinions on whether or not this is a good idea are even more varied and passionate than the various proposals about the issue. Some members of each side of the debate have emphasized black and white proposals. Like most complex issues, the truth lies more in a gray area.

Our Social Security System has roots back in the 1870s when public policy began to accept the fact that Americans were moving from the farm to the industrialized city. With this change came the realization that workers’ welfare should be protected. Both states and federal governments began to adopt laws such as a workers’ compensation to protect workers injured on the job.

Early in the 1900s retirement plans were beginning to sprout up for city and state employees. The Great Depression brought shrinking personal savings and lack of employment to the nation. Concerned that workers would be without resources at retirement, the Roosevelt Administration acted to put in place a retirement income supplement plan, followed in 1940 with a survivor assistance plan.

The result is now the largest public assistance program in the world, funded by a combination of worker and employer contributions. While we would like to believe that the money we contribute is set aside in individual accounts, nothing could be further from the truth, as the program has become a “pay as you go” plan.

Policy makers are struggling with the thought that as the work force declines…as it will because of the age wave of baby boomers retiring… there will be fewer workers working and contributing to the system.

Advocates for a form of privatization point to the fact that the current Social Security System does not provide enough incentive for people to save. Steven Landsbury in his book, The Armchair Economist, stated “most of economics can be summarized in four words: People respond to incentives.”

There is a fascinating article from the Cato Journal entitled “Empowering Workers: The Privatization of Social Security in Chile”. Author Jose Pinera describes the successes Chile has had with privatization of their national retirement system.

In its first 15-years of operation, pensions in the new private system already are 50 to 100 percent higher than in the old “pay as you go” system. The resources of the private fund accounts are equivalent to almost 40% of GNP as of 1995. Because of the stimulus from additional savings and investment, the Chilean economy has grown at a rate of 6.5% annually as compared to 3%.

Under Chile’s Pension Savings Account (PSA) a worker’s pension level is determined by the amount of money he accumulates during his working years. Neither the worker nor his employer pays a tax into the system. Instead, the worker has a mandatory 10% withheld from his paycheck up to a pay base of $22,000. He may also save an addition tax-deductible amount of 10%.

The worker chooses a Pension Fund Administration company, similar to a mutual fund. Workers may change companies, which provide incentives for the private companies to achieve higher returns. The return within the account is tax-free, but when withdrawn the worker pays income tax on the amount.

For workers who have not contributed enough by retirement, the government has a standard for a minimal subsidy. At retirement the worker may chose to purchase an annuity from a private insurance company or take his money out over time with a series of withdrawals. Should he die before his funds are exhausted, the balance becomes part of his estate…a quite different plan from our Social Security System. A system like this one has clear benefits as well as disadvantages.

Personally I believe that some changes are needed with the current plan. The solution may not be as easy as privatization since this carries drawbacks with it as well. It will be interesting to observe how this unfolds. In any event, investors who keep abreast of this important issue and plan for any eventuality will be better off than those who do not.