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Social Security Reform – A Few Modest Suggestions

By: Frank Armstrong

By: By: Frank Armstrong, CFP, AIF

There really is a problem

Social Security is not “just fine” today! Pretending so is morally, economically and politically indefensible. The pay as you go (PAYGO), or more correctly steal as you go (SAYGO), financing cannot continue in the face of a demographic landslide. With proportionally fewer working Americans supporting many more retirees, who are expected to live much longer than previous generations, something has got to give.

The Social Security crisis is one of funding. There isn’t any money in the so called Social Security Trust Fund to provide future benefits. The IOUs in the “Lock Box” simply represent a vague promise from the government to figure out later where to find the money. The past surpluses have been systematically diverted (stolen) to fund other government programs. Currently the lock box is a $1.7 trillion black hole.

The diversion of Social Security funds to the general account masks a dirty little secret: Payroll taxes are regressive. They fall most heavily on lower income citizens, and use of the surplus in the general account subsidizes income tax cuts for the rich. When we consider that payroll taxes are the largest tax that most Americans pay, the regressive nature of the combined payroll and income tax systems constitutes a major inequality.

On or about 2018, benefit payments will exceed receipts, after which the shortfall must come from general revenue. At that point, the alternatives begin to get pretty ugly: The government must choose between benefit cuts, delayed retirement, means testing, increased payroll tax, cuts in other government programs, or attempt some combination of those alternatives.

We must address the funding issue

For generations both Democratic and Republican administrations have failed to fund benefits when they had the chance. Now we find that we have benefits we can’t afford to pay. The simple truth is that it cannot be accomplished without additional cost. We must recognize that there already exists a huge unfunded liability. We must build up a trust fund to correct the unfunded liability and continue to pay current benefits. Every potential cure for the system entails additional costs (taxes) to address the unfunded liability. However, failing to address the problem will guarantee the highest total costs to the society. Just saying no is not a solution, and not a responsible political position.

The Administration’s proposal will require substantial tax increases while making only a tiny dent in the problem and wasting huge sums on overhead and profits for Wall Street. It has already moved to significantly cut future benefits by changing the inflation adjustment from wage to price inflation.

The question is not whether or not taxes must increase, but, whether or not we get efficient use of the public’s funds, put Social Security on a firm financial footing, and retain the features of Social Security that Americans consider sacred. The current proposals put forth by the Bush Administration fail all those tests.

A compelling case can be made that Privatized Social Security Accounts may be the worst of all the possible solutions. Long a pet issue for the Libertarians and Conservatives, this proposal has been adopted by the Bush Administration without a moment’s consideration of potentially superior options. Wall Street, sensing huge profit potential, has jumped on board.

The Chilean system is often cited as an overwhelming success. It is at best a mixed success. On the good side, it has provided an immense pool of capital for the growing Chilean economy while creating private wealth for working Chilean citizens.

But, while Chile’s privatized accounts are certainly far better than no funding at all, in practice the Chilean system has severe flaws. Cumulatively, these flaws disqualify the model as a replacement for our current system.

  • Administrative and investment costs are so high that they suck out much of the returns generated by the accounts. Perhaps as much as 25-30% of the entire returns have been consumed by overhead. These costs have been masked by local market high total returns, but these above average returns will not continue forever. Many costs are not fully disclosed and the system lacks transparency.
  • In Chile a dozen very similar providers compete for existing accounts. This generates little in the way of additional benefits, but reliably creates costs, commissions and fees.
  • A moral risk exists—in cases where investors switch providers to their detriment, the welfare system may have to bail them out.
  • An investor who makes unwise choices will have substantially different benefits than his more fortunate, informed or lucky neighbors. This result is only appropriate if you believe the benefits should resemble a crap shoot.
  • Like any defined contribution pension system, benefits are tied exclusively to market returns which certainly will be negative for extended time periods at some point in the future. The system has never been tested during an extended bear market, and constantly diminishing retirement payments over an extended period for a large segment of society are not likely to be politically tolerable.
  • Finally, while the Chilean system provides for death and disability insurance, no transfer payments are generated. This outcome is unlikely to be popular in our society which depends on Social Security to provide a safety net for the elderly poor.

It should be noted that Chile financed their transition costs in large part by sale of state assets as part of a comprehensive privatization scheme. Such options are not available here, unless we want to sell the entire national park system to developers, loggers, miners, and drillers. Perhaps we can sell the space station.

Your worst nightmare

The Chilean system is not the worst possible outcome. It goes downhill from there. As currently discussed, the Administration’s Privatized Account proposals have the potential to morph into a nightmare system of “Super IRAs” attended by an army of commission-crazed variable annuity salesmen, serving no interest beyond those of Wall Street.

Positive Alternatives

Still, just saying no is not enough. A viable alternative must be found and presented to the American public. How might funding reform be accomplished without gutting the system? There are a number of approaches that are far superior. Let’s look at just two:

  • We might fund the current system without creating private accounts.
  • We might create private accounts without providing for investment control.

These changes are reasonably simple to understand, retain all the best elements of Social Security, and permanently fix the system.

As previously noted, any cure for the system will incur substantial transition costs. This is very close to a physical law, and must be discussed and debated honestly by our politicians. The current surplus is not enough to fully fund our future needs. Indeed, it is small, shrinking and will disappear very shortly. Some substantial additional funding will be required.

Funding the current system

Most Americans favor the current Social Security system and are afraid that the crown jewel of our social programs might be destroyed in a misguided reform effort. The current system, a classic defined benefit formula, provides a floor income that retirees can accurately estimate during their working years. After retirement, they can count on the benefit for life. It is inflation protected and totally immunized from market risk. After all, their rent and market bills are unlikely to fall along with a bear market slump. Additionally, most know and approve of the safety net (transfer payments) that it provides for the most vulnerable members of our country.

Simply funding the system preserves all those virtues. Payroll taxes are first used to pay current beneficiaries, and the rest (surplus) is invested in a balanced globally diversified common fund. The mechanics are like any other defined benefit pension plan. A board of fiduciaries oversees the fund, setting investment policy, hiring and supervising the investment advisor(s), ruthlessly controlling costs, and eliminating conflicts of interest that might jeopardize the welfare of beneficiaries. An independent actuary certifies the soundness of the funding, and the ability of the fund to meet projected cash flows. Independent auditors, trustees, and custodians provide checks and balances. Full attribution reporting of investment results, along with full disclosure of all costs from every source are published providing needed checks and balances along with total transparency.

The common trust fund must not become a source of endless profits for Wall Street’s Robber Barons. While the assistance of brokerage houses might be required to assemble the portfolio, the requirement for competitive and open bidding should keep investment costs below 0.05% for the fund. Failing that, a government sponsored but independent board could invest the funds along the lines of CALPERS.

Benefit payments are not conditioned upon full funding and are not directly linked to market performance. So, individual participants are completely immunized from market risk. The government is still the guarantor of last resort for the benefits. While it is anticipated that the plan will be fully funded over time, any funding over zero is preferable to no funding. Having said that, payroll taxes should be sufficient to cover future funding needs.

The common trust fund is not sub-divided into individual accounts. The individual has no investment control, and no claims other than his projected benefits. This treatment is identical to almost all defined benefit pensions, and the current Social Security System. There is precious little evidence that beneficiaries are ready, willing or able to assume the investment management role, or that they are dissatisfied with a lack of “personal ownership” in the current program.

If implemented in the US, the arrangement would provide an ever growing and permanent pool of capital to fund our economic growth and lower the cost of capital. Over time the Social Security System would become an engine of economic growth rather than a dead drag on the system.

The current Social Security Administration so fairly, efficiently and economically administers benefits that it is the envy of the entire world. No changes would be required to this system by simply funding their mission.

In conclusion, funding the current plan would insure the fiscal integrity of the system while providing additional economic benefits with the least impact on a social program that Americans treasure.

Note: The author is privileged to be the sole investment advisor to the Nation of the Marshall Islands Social Security Trust Fund, which is operated as described above. There are two major differences which must be considered when applying this model to the US. First, the Marshall Islands has no domestic market, so all trust funds are invested outside of the country. And, the difference in scale would allow for far more economical investments in the US. Both these differences would make the model even more attractive here.

Private accounts in a common trust fund

Another viable option to fund Social Security would be to provide for private ownership in the common trust fund without allowing individual investment control.

Payroll taxes are set to closely approximate a “target benefit” plan so that the system is ultimately fully funded on an ongoing basis. These taxes are first divided into an amount necessary to fund current benefits and transfer payments. The balance is invested in a common trust fund as above but sub-divided into individual accounts. At retirement, the balance is applied to fund the social security benefit, and if additional funds exist they may either purchase additional guaranteed benefits, or be refunded over a period of years to the beneficiary. If there is a shortfall, the government makes it up from the general account.

In case of death before retirement, the lump sum could be made available to beneficiaries in lieu of insurance benefits to survivors, opening up the possibility of intergenerational transfer of wealth.

The second approach simultaneously satisfies a “private ownership” requirement while immunizing the beneficiaries against market fluctuations. It generates the same minimum benefits and provides an upside potential if investment conditions are favorable. The common trust fund allows for economical and effective investment without the overhead of the Bush Administration’s privatized accounts.

The current debate more resembles a grade school food fight than an honest discussion of alternatives. It’s time to cool the rhetoric and rise above petty partisan politics to solve a crucial problem facing all Americans.