Recently I asked a group of adult students to write a paper about Social Security reform. I asked them to tell me what has been proposed, what proponants of reform say and what opponants say. It was an interesting exercise to see the degree to which misunderstandings persist regarding the idea of private investment accounts. A significant number of students thought that private accounts were an attempt to "destroy" Social Security and that they would have less money when they retired as a result.

While this is an extremely complex topic, it seems worthwhile to address the misunderstandings that underly these beliefs. The reason that private accounts are being considered is that they will provide a larger benefit for less money than the current system. Because of demographic changes (more old people; far fewer young people than expected) if the basic structure of Social Security is not changed, it is guaranteed that benefits will be less or taxes will be higher. The use of private accounts does not solve this problem, but since the return on private accounts will be higher, it will mitigate the problem.

What are private accounts? They are investments. These investments can be in stocks, bonds, mutual funds, index funds or something similar. People think this is risky and that people run the risk of losing a lot of money. The word "investing" makes people nervous, but investing is really no different than any kind of savings. If you put your money in the bank, that money does not sit in a vault. Most of that money is invested by the bank in ways that you cannot control. All you know is that you give them money; they pay you some interest, and when you need the money you get it. Savings in banks are guaranteed by the FDIC up to $100,000 (I think that's the current amount) and the way that banks invest your savings is regulated by government. Government can regulate private accounts as well. Many people have additional retirement savings in the form of 401(k)s and IRAs. These are private investment accounts.

In addition to savings, many people work for companies that offer a pension. Guess where the money for their pensions is saved? It's invested in the stock market. The company that provides the pension sets aside a certain amount of money each year to insure that the pension fund is adequately funded. They project how much money they will need based upon what they believe the stock market will do. So anybody with a pension has their retirement savings in the stock market.

Originally published March 22, 2005.