Social Security's Real Problem
Apr. 02, 2011 10:41 PM ET2 Comments
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Seeking Alpha Analyst Since 2008
Brenton Smith is a private money manager, specializing in capital preservation. He has worked in financial services for more than 20 years.
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 cut. More recently, the President’s Financial Commission on Fiscal Responsibility outlined yet more solutions which consisted of benefit cuts and tax increases. It 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.
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 today? Last 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 benefits. The 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 ROC. The government study excludes workers who don’t collect, and assumes that workers join the work force at 22. This increases the expected return and lowers the total cost. It excludes the impact of employer contributions and income taxes. So even on its most favorable terms, Social Security for younger workers isn’t terribly different than spending quarters to buy dimes.
Washington’s 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 happens, the 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.
Washington’s 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 happens, the 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 Security. First, 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 appetite. It is a Walmart of risk where one size fits all. This approach to risk virtually assures the Trust of an unfavorable mix of investment returns versus the demand for benefits. When 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.
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 made. It 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 already. Washington'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.
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