You just raise benefits to make up for the extra income. That is what historically has happened. It is a bit harder to do with changing demographics, but with semi-stable ones, it has always happened.

Looking forward Social Security can't afford it's current benefits (only 66% - 75%), how will a benefit increase be able to be financed?

In either a pay-as-you-go system or a fully-funded system, you have to send a check to the retirees. In both systems, the only sources for cash (to make sure those checks don't bounce) are corporations and people earning money. (Can you find another one?) If Social Security is going to take 18% of every payroll dollar to fund its benefits to avoid that problem with the bounced checks, then the fully-funded system must also take 18% of every payroll dollar.

Wrong. This has the data from a CRS study that shows that 3% of payroll growing at SP500 growth rates could finance more than 100% of SS benefits.

http://www.socialsecurity.org/sstw/sstw06-23-00.pdf

This is because there is an additional step in a private system.

SS: Payroll tax -> benefits paid
Private: Payroll tax -> growth -> benefit paid

Pay-as-you-go system: not a large enough tax basis to cover benefits. Result: money runs out
Fully-funded system: too many people trying to cash out their investments to too few buyers. Result: prices are depressed and money runs out

Some people think that if some investment leads to productivity growth, then more investment leads to even more productivity growth. It can also lead to speculative bubbles and Savings & Loan crises. In fact, Japan's high savings rate is being blamed for 10 years of horrible economic growth. It is hard to have growth if no one spends money.

The high savings rate in Japan is what made the bubble and its burst possible, but the real problem in Japan was the regulatory and economic system. Because the gov't forced large banks to back the debt of poor investments gone bad, thus there was little downside to making extremely risk investments and a great upside if it works. So the high savings level allowed this idiotic system to survive much longer than it should have (thus making the burst worse). In other words the problem was not the savings, but the regulatory environment in which the money was used.

By the way, how does the CATO Institute plan to pay for the transition? I always felt they were a little vague on that.

http://www.socialsecurity.org/pubs/ssps/ssp13es.html

Deals with transition costs, but many of the publications speak to the costs.