Don’t Touch My Social Security, Unless — Ooo, Yes, Like That. Mmm. Yeah.

Social Security (SS) is a form of economic security for Americans as they move into retirement. It is a social program that provides (mostly) retirement benefits. It functions by giving retirees payments, based on their former earnings, from the revenues generated by today’s workers. This may sound similar to a Ponzi scheme, which is a scheme where incoming investors pay off earlier investors. Unlike a Ponzi scheme, however, SS promises modest gains, doesn’t attempt to mislead investors, and is fundamentally sustainable.

Currently, however, the trust fund that manages this system is in danger of running deficits that will eventually make it insolvent. Below is a summary of the Old Age and Survivors Disability Insurance (OASDI) Trust Fund that is used to manage the retirement benefits portion of SS (there is also a smaller trust fund for Disability Insurance (DI)):

Notice the yellow line. This line represents all the the reserve funds the Trust fund has and, while the Social Security Administration (SSA) does have the authority to pay out of its “reserves,” they are not tangible funds. Reserves are more akin to IOU’s (taking the form of government-backed securities) and the actual revenue that was taken in has already been spent on government operations (cue the Iraq War and Bush Tax cuts discussion). Some might even lament over Al Gore’s “lockbox”, which promised to keep those funds set aside for future generations, but that idea is somewhat misleading since the debt will exist either way. Although, to be fair, compartmentalization does put more pressure on government to develop sustainable systems rather than, say, counting SS revenue as general government revenue so that it looks like you have a giant budget surplus in the year 2000 . . . I digress.

The gray line above is of considerable importance because it measures net revenue. And unless we want to start adding up to $3 Trillion to our national debt, we need to make sure that it stays above zero. So long as it is above zero we can continue to pay off retirees (and fund government).

Social Security administrators pouring over the actual trust funds.

This brings us to an important discussion: What do we do to make sure Social Security remains sustainable? Well, we have some options:

  1. Increase the Social Security Cap: Currently, workers and their employers each pay 6.2% of the worker’s salary into Social Security. That is, until they reached the salary cap at ~$120,000, above which the tax no longer applicable. This cap covers up to about 85% of all employee earnings. Removing the cap, or increasing it, could absolve up to 100% of the projected shortfalls.
  2. Increasing Payments: If the 6.2% were increased to 7.3%, a typical worker and their employer would be subjected to about $500 in additional taxes annually. This would cover the projected shortfall.
  3. Raising the Retirement Age: Currently, retirement benefits can start being collected at 62. Benefits build up the longer one waits (full benefits at 66). Current plans are already in effect to raise these age limits. However, there are options that would extend them even further. Extending full retirement to 70 or indexing it based on longevity are both options that can be expected to cover less than a third of projected shortfalls. Although given that longevity has decreased recently — the later option might not be an option for increasing sustainability (it is, however, sound logic).
  4. Reduce Benefits: A 5% reduction in benefits would cover about 30% of the deficit. Averaging in more working years to the formula used to calculate benefits (currently we use a worker’s 35 highest paid years) would effectively reduce benefits and cover about 20% of the deficit. Decreasing cost-of-living adjustments (COLA) would also also decrease benefits and could cover up to 80% of the shortfall. If we consider that the primary purpose of Social Security is economic security for the elderly then we ought to disregard reduction of benefits. We should do this because currently about 1/3 of recipient households survive on Social Security alone and the average benefits are less than $15,000/yr (less than $11k after medical expenses). When we consider that these are average payments it becomes readily apparent how dire the situation can be for the elderly.
  5. Trust Fund Investments: Currently, the Social Security Administration (SSA) uses the excess revenues to purchase government-backed securities. If we diversified the investments into market accounts we could out-earn those securities and cover up to a third of the deficit. This assumes a 9%+ return and doesn’t account for the additional debt we’d have to take on to make such a move in the market.

The last solution should bring to mind efforts to partially privatize social security in the mid 2000s. Proponents focused on how market returns would largely benefit individuals more than traditional Social Security. Opponents stressed how efforts in other countries, like Chile and England, showed poor or mixed results. I decided to plot 40-year investment yields, which gives one an idea of how an investment will fair over the course of their career, to examine this issue:

Note that projected performance is used after 1975 because there are less than 40 years of data for each point. And notice that as we approach the present there is more variation due to year-to-year market volatility.

With this information, we can examine the differences between using a traditional retirement account and Social Security benefits:

This model assumes a compound annual growth rate (CAGR) of 6% (quite conservative) and no changes to the SSA formulation that is used to calculate benefits. Note that this formulation requires the use of index factors, which account for inflation, and this model uses index factors from the 70s onward. If we assume a CAGR of 9%, which would be more appropriate for someone born in the 1950s, and replicate the index factors used from then onward, a similar result emerges.

It is also important to realize that moving towards traditional accounts leads to increasing volatility. However, responsible management of retirement accounts reduces these risks as accounts transition from high-risk investments (i.e. emerging markets, high/low cap stocks) to low-risk investments (i.e. money markets).

Moreover, based on the figure showing fund performance we can readily see how (high-risk) investments made at the peak of the market, before the 2008 crash, recover to net positive returns in less than 10 years. This gives investors an idea of when they need to start moving their funds to safer investments (and how much to move).

An excellent (and realistic) model for a retirement portfolio is one that creates a nest egg large enough that one can survive on it indefinitely, which is important if we consider that advancements in regenerative medicine may support increasingly longer lifespans. Unfortunately, population-based systems, like Social Security, are fundamentally unable to function in this capacity as they rely on our eventual death.

There is one other thing that is important to note with regards to how traditional retirement accounts perform against Social Security: The losers are those who are most in need! It might be tempting to then suggest making Social Security optional, but Social Security is, effectively, income redistribution. That is, the formula used to calculate benefits necessarily limits returns on those worker’s making more so that those making less can receive more. If Social Security were optional, higher income earners would/should opt out and the trust funds would face shortfalls.

Another concern, which was often cited during the debate over privatization, is administration fees that would crowd out potential earnings. Private firms tend to act in their own self interest and sometimes charge exorbitant fees, which consumers don’t take the care to research and avoid. This translates into retirees losing out on the windfall of earnings they would’ve had in a more idealized model. It defeats the entire purpose of privatization!

One last issue with privatization is the transition period. A quick review of Social Security will show how the first people to take out from Social Security never actually put into the model. Essentially, it would’ve been impractical to solve the near-term crisis involving the elderly being impoverished by having them work another 35 years. So, instead, we crafted a population-based model that would allow us to skip savings in favor of a pay-as-you-go scheme.

There is, fortunately, a solution to all of these dilemmas.

A hybrid model.

Imagine a social security system that transitions slowly, over a 40-year period, to a hybridized model. This model that takes revenue from each individual and parses those funds (increasing up to 1/3) into an individual account and the other part (decreasing down to 2/3) into a public trust. Imagine this transition being funded by a legacy tax that would affect those who benefit most.

Imagine a social security number that actually refers to an account. This account is managed by the federal government or a delegated non-profit agency. The investments are selected from an array of assets that meet certain criteria (i.e. low admin fees). Options could be extended to individuals to empower them with more control (at a cost). For instance, enabling a person to be able to invest more in green companies or divest from purple ones. Payments are made through a schedule that seeks to maximize the well-being of the account holder without compromising the longevity of the account.

Imagine a social security account that has guaranteed returns for investments below a certain threshold. This threshold being where their earnings under an antiquated Social Security account would have exceeded expected market earnings. Based on the chart above, that would mean that someone making less than ~$20k would be invested in (presumably) government-back securities with a guaranteed return rate of 6% or more. These rates would be secured through a progressive, administrative fee made on incomes greater than $100k (capping at ~2%).

Imagine a social security account that would be transferred, upon death, to those who you care about. Or given to charity. Or used to establish a scholarship program that awards the person who can correctly guess the number I am thinking right now(Spoiler Alert: It was Pi).

This hybrid model would also mitigate the potential $45+ trillion dollars that could flood the investment market in a purely private system to about $15+ (roughly equivalent to the equity in today’s NYSE). It might be more appropriate to adjust the transition period or the ratio of private:public so as to better understand how all this equity would impact the market.

Overall, the solution is apparent. It is easy to understand. A hybridized, public-private Social Security system is superior, safer, and more sustainable than a plan that is purely dependent on market conditions or one that is purely dependent on human conditions.

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