Social Security

Things don't look so good for Social Security reform, and thats a shame. It's a shame because Social Security is broken, and needs fixing. And it's a shame because President Bush may be the last president we have for a while whose actually willing to risk the status quo for real solutions and progress.

Before we talk about Social Security we must set out a few realities--the facts as they are, from which to work. First, there is no 'trust fund' so to speak. Social Security as it stands is just part of the fiscal budget, and not a separate entity. It also has no money. All incoming money is promptly spent on current Social Security beneficiaries. That means that the money each of us pay every paycheck makes a quick u-turn and goes into some retiree's pocket.

And what about these treasury bills we've heard about that are in the fictional trust fund. The Japanese value them. Are they not real money? Well no. They are in effect IOUs. Now the government has a good track record of making good on, and paying for its IOUs, but they do not represent any real asset, at least of the US. Yes I think we will continue to pay out on our IOUs but where does that money come from. It comes from taxes, from you and me. So to the Japanese t-bills are assets, but to Americans as a whole, a t-bill is not an asset but a liability.

Think of it like this (I got this from David Frum). If I write an IOU to John, then John has an asset that he can collect at some future date. If I write and IOU to myself, I have nothing of any value. This is what we have done with Social Security. We have written ourselves a bunch of IOUs, which, to make good on, we will have to fund ourselves, through higher taxes. The only other thing we can do is lower the Value of the IOU, fudging on our initial promise to ourselves.

Another reality is that Social Security payouts are growing in real terms. This is because Social Security benefits are indexed to wages, and real wages continue to grow higher and higher. Initially Social Security was not indexed to anything, and every couple years congress would vote to increase the payments, but this was a problem because benefits were growing much faster than inflation. The solution was to index benefits to inflation. The formula that was initially used however, didn't work and cause huge undue increases in benefits. Finally, for some consistency, benefits were indexed to wages. This, however, means that we will be unable to grow our way out of our Social Security problem, because as the economy grows, wages grow, and Social Security benefits grow as well.

In addition or population pyramid has changed. At one time there were as many as 16 workers supporting one retiree. A decade of two ago 5 workers supported one retiree. Now its 3.3 workers and in the near future it will be less than 3. Fewer workers per retiree + continuously increasing wages (in real terms)= fiscal crisis.

What can be done to fix this mess? If we are to continue as we have with a pay as you go government run system only two things-- raising taxes and/or cutting benefits. Raising taxes not only taxes the worker, who earns and can use the money, it also is a tax on growth. The Social Security tax in general is know contribute to unemployment. Cutting benefits would mean in 2040, cutting as much as 30% of benefits. It would also mean also mean, if you look at Social Security as an investment of money now for future security, those paying in now will be receiving significant negative returns, getting much less out than what they paid in. Undoubtedly some combination of the two will have to be done to make the system solvent.

But there is a third element that would both help (though not fix entirely) solvency, and switch from a pay as you go system to a real system of saving and building wealth: Personal Social Security Accounts.

Much has been made of the transition cost for these accounts, but the transition cost are not new cost that would otherwise not exist, they are benefits we have promised ourselves that will otherwise not be paid unless we get our fiscal house in order. The two trillion dollar transition cost today will compensate for what is 12 trillion dollar promise we've made ourselves for future benefit payouts. It is a very good deal to go from owing 12 trillion dollars to owning 2 trillion dollars.

And yes, these accounts help the solvency of the system. I know that even the Bush administration has said they do not (a huge mistake in my estimation). But this is based on the assumption that personal accounts will get the same returns that a treasury bond gets (about 3 percent a year). But if you stock broker of financial advisor tells you you're only going to get a 3 percent return (really more like 1.5 percent after inflation) you should promptly fire him. Bonds, which are a virtually risk free investment when properly diversified, return 4 or 5 percent. And the stock market averages about 9 percent per year. Its a safe bet that personal account will beat the return that Social Security promises.

If you need an example look at the Thrift Savings Plan, enacted by congress as part of the last Social Security fix in the early '80s. This plan gives government employees the opportunity to invest there Social Security payments in bonds, stocks, treasury bills or any combination of the three they choose. A Thrift Savings Plan participant have to pick the diversified index funds, meaning a person using the plan can't put all his money in one company. Rather he chooses to put his money into thousands of companies, or thousands of bonds, thus ensuring proper diversification. The result is a program that returns an average of 5.9 percent for its participants annually.


These higher returns made possible by investing a portion of Social Security taxes in individual accounts will then compensate for the diminishing returns that will inevitably happen in the government controlled portion of Social Security. In fact if personal accounts are enacted future retirees can look forward to getting more money from Social Security that today's retirees.

In short personal accounts both help fix solvency and the underlying cause of current insolvency, the 'pay as you go' system.