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Social Security's Real Problem

Last summer, Congressional Budget Office scored the effectiveness of 30 potential solutions for fixing Social Security. Every solution was either a tax increase or a benefit cutMore recently, the Presidents Financial Commission on Fiscal Responsibility outlined yet more solutions which consisted of benefit cuts and tax increasesIt is a frightening statement on how little our leaders understand the problem

The solvency of the Trust Fund is not the primary problem in Social Security.  The Trust Fund provides very little economic support to the system. According to the Social Security Administration, the Trust earned only 118 billion dollars in 2009 while distributing 686 billion dollars.  The Trust Fund is unlikely to provide even that level of support going forward as the number of beneficiaries increases and maturing capital is redeployed at lower yields.  Social Security is a pay as you go system where the vast majority of the funding comes from payroll taxes.

The question of solvency is really an unavoidable outcome of the real problem in the system.  The real problem is return on contribution ("ROC") which is terrible, particularly for younger workers.  When economic returns are poor, people do not freely participate.  They will evade or avoid the system.  So the ideas of raising taxes and lowering benefits really solves 15% of the solution and puts the rest of the system at risk.

How bad are the returns from Social Security todayLast summer, the government provided a periodic moneys-worth study of the Social Security system, which compares a dollar of contribution with the present value of future benefitsThe report issued in July of 2010 predicts that some workers will get back as little as .45 cents on the dollar

The report paints a rosy picture of the real returns from the system by using assumptions which artificially inflate the ROCThe government study excludes workers who dont collect, and assumes that workers join the work force at 22. This increases the expected return and lowers the total costIt excludes the impact of employer contributions and income taxesSo even on its most favorable terms, Social Security for younger workers isnt terribly different than spending quarters to buy dimes

Washingtons solution to this problem is to get younger workers to spend quarters to buy nickels.  If we continue to lower the ROC of the system, there will come a generation that says no.  They will vote for different priorities, like paying down the deficit.  When that happensthe whole system will collapse in spectacular fashion whether the Trust Fund is solvent or not.  Raising taxes and lowering benefits simply makes the system less stable.

Any solution has to work for all generations, and needs to focus on ROC of the system. A better way to fix the system is to increase the ROC by addressing two basic design flaws in Social SecurityFirst, it has an investment policy that is completely inconsistent with its lofty goals.  Second, the system applies a benefits formula that fails miserably to allocate risk efficiently
 
Today Social Security is a retirement tool which has no sensitivity to risk appetiteIt is a Walmart of risk where one size fits allThis approach to risk virtually assures the Trust of an unfavorable mix of investment returns versus the demand for benefitsWhen benefits cost nothing, beneficiaries of the system demand more benefits.  When risk has no reward, these beneficiaries will shun risk.  As a consequence, the portfolio of Trust is completely mismatched with the goals of the system.

Risk management as we learned in 2008 is the cornerstone of any retirement tool.  Social Security needs to offer a variable benefits which enables the system to distribute the risk efficiently. The system should enable those who wish to have less risk to trade traditional benefits for better security. Separately the solution should also enable those who wish to have better returns to absorb the risk of having the portfolio invested in more productive assets
 
This means that some portion of the Trust Fund needs to be allocated to equity investment.  Some will argue that Americans are not willing to accept market risk in Social Security. To which one can only respond that there is nothing more risky that investing 100% of your assets in a single asset class that has enjoyed a 30 year bull market
 
On a first dollar basis, a portfolio of Treasuries is as safe today as any investment that can be madeIt is backed by the full faith and credit of the United States Government and the capital markets provides sufficient liquidity to sell the asset before maturity.  On a last dollar basis, the portfolio is considerably more risky because the sale of the first dollar affects the sale of the last dollar. The Trust Fund has asset concentrations of 100% in a single asset class and a single issuer.  Adding equity to the Trust Fund portfolio actually lowers the risk because the process trades last dollar risk in Treasuries for risk in equities

In summary, Social Security is in crisis alreadyWashington's approach will only make the crisis worse.  It is only a matter of time and priority before that crisis manifests itself for the voters.  If the working generation decides to allocate the nations tax base to other priorities - say paying down the debt - income taxes go up, FICA taxes go down, and Social Security is re-written on very different terms.