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Social Security Primer

By: Frank Armstrong

By: By: Frank Armstrong, CFP, AIF

This is the first in a three part series on Social Security, prompted by the current efforts at reform being launched by the Bush Administration. We hope investors will educate themselves on this important issue.

It’s the 1930s. Let’s start a Social Security System. We have lots of young people working, and only a few old folks to support. In fact, we have 42 workers for each retiree.

We set the age high enough so that not many people will live long enough to qualify. Those who do won’t live very long anyway. So, we will give them a benefit. The fact that they never contributed a penny doesn’t matter. We will tax the workers to pay those benefits and still have lots left over. Early retirees get a real bonanza.

Some of our workers will die or get sick before they retire. So, let’s give them or their survivors a benefit too. No problem. We will take a little out of each contribution to pay “insurance” benefits. There will still be lots left over.

To pay for all this, let’s tax the workers 5% and their employers 5%. If it costs 2% for retirees, and 2% for insurance benefits we still have 6% left over. (These are not the actual rates, and the tax rates changed over time.)

Note that this tax does not come from general revenues. It comes exclusively from payroll. And there is a cap on covered compensation. That makes it a regressive tax that falls more heavily on the poor or middle class.

Social Security is not just a forced savings/investment program for retirement. In addition to being a retirement system and an insurance system, Social Security is a wealth transfer and/or welfare system, an important part of the “safety net” and the backbone of our social contract.

If Social Security were a private pension plan, we would invest that 6% that wasn’t presently needed to provide benefits for our current workers when they retire. Over time these savings could grow to a huge capital account to keep the plan solvent.

But, Social Security is a government program and doesn’t have to play by the rules it sets down for everybody else. So, the government just steals the money (the Social Security surplus) that’s left over. Let’s be crystal clear: There is not one red cent in the famed “lock box.” All the past surplus Social Security taxes have been spent for something else.

The government has put an IOU into the lock box. When the day comes that current receipts don’t cover payments, the government will have to fork over funds from the general revenue into Social Security to redeem the IOUs. Initially, that will feel like a soft landing. However, as time passes, the increasing account deficits will multiply, putting a substantial crimp in the government’s ability to fund other worthwhile enterprises. An IOU is not the same thing as investing for future needs.

Many economists point out that the IOU has the full faith and credit of the US Government to back it up. That’s true. But, the IOU is not a guarantee of any particular benefit level. It promises whatever benefit level the government decides to pay when it comes due. The administration is currently proposing that future benefits be based on CPI inflation rather than on the far more generous current wage inflation assumption. The effect on future retirees will not be trivia and may be Draconian. Further cuts in benefit levels are possible and indeed probable. The government can make them at any time they like, subject only to the howling of the Grey Panthers. In reality, future benefit levels are entirely a political question to be decided at the time of payment rather than a formula set today that you can count on tomorrow.

Another way to think of the IOUs is that they are a promise to pay something as yet undefined from general revenues beginning the moment current Social Security taxes fall short of benefit payments.

In a “pay as you go” program, current taxes pay current benefits, and in this case today’s and yesterday’s surpluses have been diverted to fund the general government spending. The politicians get away with this because most people zone out when the subject is government accounting. By keeping multiple sets of books and robbing from one program to pay for another, the government can obscure some pretty distasteful fiscal truths.

By diverting surplus funds to the general account today, the government doesn’t have to raise income taxes. Ah, but income taxes are progressive. So, by diverting funds to the general account, the rich are getting a tax break, subsidized by funds stolen from the middle class and poor who pay a regressive social security tax. The political logic is faultless, the ethics questionable.

Now let’s flash forward to 2005 to see how the system is fairing. The population has aged dramatically. More people are retired, and those retirees are living much longer. So, now we only have three workers for each beneficiary. In 2030 there will be only two! The annual Social Security surplus has shrunk and will soon disappear entirely. Very soon after that “pay as you go Social Security” as we know it is going to crash. That day happens when we all have to admit that there really is nothing in the Social Security Trust Fund, and we have to begin to subsidize the payments from general revenues. Then the really painful choices will have to be made. Any politician that tells you differently is either terminally stupid and/or deliberately misleading his constituents. There is no third choice.

We can tinker around the edges to push that day off a little further into the future. The band aid fixes are well known:

  • Reduce Benefits
  • Delay Retirement Dates
  • Means Test Benefits
  • Tax Benefits

Everybody in Washington knows that even if we do all these things, doing so won’t fix the problem. The shortfall will have to come from general revenues or progressively higher payroll taxes. Eventually the accumulated burden will suck the federal budget dry. America will become less and less competitive, our kids will hate us for the higher taxes, and other needed programs will be starved out.

In an alternative universe where the surpluses as generated were invested in capital goods rather than hollow IOUs, the account would be fiscally sound and we wouldn’t be having this debate. Of course, income taxes would have been higher because the government wouldn’t be able to steal from the Social Security Trust Fund. And of course, a government that had to account properly for its spending might have been forced to be more responsible.

We are faced with an enormous actuarial funding shortfall that is not going to go away by pretending that it doesn’t exist. By failing to fund the program properly, we dig ourselves a little deeper into the hole with every day that goes by. The system can be fixed but the longer we wait the more difficult it gets. We have to start by admitting that we have been stealing from the trust account for generations and that restoring the plundered amounts will require some type of make up tax or funding.

Diverting a portion of the current Social Security Tax paid by younger workers to private accounts or other real investment programs will shorten the period until the system runs a deficit. The various trillion dollar bond proposals we have been hearing about as a potential fix pass that funding requirement down another generation.

From the politicians’ point of view, none of this will happen on their watch. They will all be out to pasture or dead and buried before the chickens come home to roost. So, it’s easy to pander to the voters by denying that there is any problem at all. Courage, intelligence, imagination, integrity and leadership are in woeful short supply in Washington, but the Social Security issue brings out the very worst qualities the town is known for.

Voters share these attributes with their elected representatives. In their hearts they have to know that something is wrong. But, so far their position has been: “Lie to me, Baby”. Their heads are buried deeply in the sand where they prefer to keep them. So, a large number of politicians are happy to oblige by telling the world that Social Security is just fine without any changes at all.

So far, the debate, if you could call it that, has hardly been serious. The Chairman of the Federal Reserve made some thoughtful and pointed disconcerting comments last year, but they were drowned out by election year rhetoric. Now the Bush Administration has pushed for a “privatized” account along the lines of the Chilean system. The volume is going to be turned up, ideally more substance than pure political noise.

 

Next:

You are going to be hearing a lot about Chile’s pension system. It’s either a miracle or disaster depending on to whom you listen. Can it be both? Can it be neither? Tune in for the whole story