No free lunch on Social Security

Over at the Daily Caller, my friend Bill Shipman writes of Ernie the Electrician and what he discovers about investing his Social Security dollars in personal accounts:

Ernie started working in 1966 at age 21. He made $6,900 his first year, and just average wages thereafter. But he was frugal, for his parents taught him to save no matter what. So he saved every year the same amount he paid in Social Security taxes that he assumed were set aside for his retirement.

Skipping through the math, Ernie looks at what he earned on his investment versus what he'll get from Social Security. Lo and behold, there's a big difference.

Ernie was shocked. Even after including the stock market crash of 2008, he could take out $37,000 in 2011, and increase it every year for 25 years by 3.0 percent, the historical inflation rate. Or he could buy an annuity providing a comparable benefit. Of course he could take out less, so as to leave some assets for his children. Or he may want to hedge whether he'll live longer than 91.

I've written a fair bit on market returns and Social Security accounts, so I don't disagree too much on the basic calculations here. Yes, investing in markets has been a great deal in the past. Of course, we don't know whether it will be a great deal in the future. Maybe average returns in the future will be lower, and maybe the year-to-year risks won't work in our favor.

But there's a more important point here, which is that you just can't switch from paying into Social Security to paying into a personal account. There's still Grandma's check to be paid and so the "deal" for switching has to include that. Once you factor these in, the argument that personal accounts are a better deal basically falls apart.

According to Social Security Administration, there are about $20 trillion in Social Security benefits that have been earned but not yet paid out. These include benefits to current retirees as well as to people still in the workforce. Let's say that we'll honor these benefits, but everyone will switch over to personal accounts and not earn future benefits. To pay off everything that's owed over the next 100 years would require a tax of around 6.2 percent of payroll.

So you've got two options:

1. Invest your full 12.4 percent Social Security tax in a personal account, in which case you're very likely to receive more than Social Security has promised you. But you're also paying the 6.2 percent "transition tax," so overall you're not necessarily better off and quite likely worse off.
   
2. Invest only 6.2 percent of your wages in a personal account, which ensures that your total payment going forward isn't more than you're currently paying to Social Security. But even if you get decent returns on your account, the fact that you're paying only half as much in means you'll likely receive less in retirement.
   

I guess you have a third option as well: screw Grandma and don't pay what she's owed. Then you can in fact be better off, but she's worse off.

This gets at one of those weird and not-so-wonderful truths about Social Security, that confused me for a while and continues to confuse others: it both pays a very low rate of return, lower even than risk-free Treasury bonds, and yet it's highly efficient, meaning that you can't make one participant better off without making someone else worse off. Economists call this "Pareto optimality", but it really just means that it's a zero-sum game. The reason the return going forward is so low is that returns in the past were so high. Since Social Security is a transfer system that simply shifts money from Peter to Paul, there aren't many ways to generate superior outcomes for everyone. (There are some fairly technical and probably politically unrealistic things you could do that would be positive-sum, but that's for another day.)

Until you understand Social Security's dual nature, personal accounts seem like a free lunch. Once you do understand this, accounts may still seem like a good idea but you obviously have a lot of other things to consider. Social Security reform will move faster once we start considering them.

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Just say it, Mr. President.

Reuters reports that "Obama backs lifting income cap for Social Security," referencing proposals to increase the $106,800 earnings cap on which Social Security taxes are applied and (although rarely mentioned) Social Security benefits are calculated. At an event on Tuesday in Annandale, Virginia, the president said:

For the vast majority of Americans, every dime you earn, you're paying some in Social Security. But for (billionaire investor) Warren Buffett, he stops paying at a little bit over $100,000 and then the next $50 billion he's not paying a dime in Social Security taxes.

I very much doubt that Warren Buffet has $50 billion of any kind of income, much less that it's earned income (the kind that Social Security taxes). And, in a recent Retirement Policy Outlook, I raise a number of policy issues regarding an increase in the tax max. But it's clear that President Obama would like to increase the tax max.

What's not clear is that he actually "backed" it. I was expecting at some point a punch line like "And so, my fellow Americans, I favor increasing the tax max." (The full transcript of the discussion is available here.) Not with this president, who's very postmodern and subtle. He leaves it to the listener to infer what he wants. Sort of like watching a French movie.

But at some point I can't blame Congressional Republicans—and Democrats, too, for that matter—if they yell out, "Just say it!" Increasing the tax max would constitute a tax increase for the "middle class," defined in the president's terms as those with incomes less than $250,000. Everyone knows that if the President wants to balance the budget without significant reductions in the programs he cares about, he's going to need to increase taxes on people with more modest incomes. If so, there's no time like the present to make that clear.

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Obama in bind over Social Security

With President Obama giving what is touted as a major budget address today, he will have to thread the needle between a public that is demanding leadership on deficit reduction and a Democratic base that is deeply suspicious of his most obvious routes for balancing the budget. This skepticism is reflected in a recent letter to the President from House Democrats arguing against any embrace of the recommendations generated by the Simpson-Bowles fiscal commission, in particular its plans for Social Security reform.

[W]e remain concerned that the Bowles-Simpson proposal may serve as a starting point for budget negotiations. We consider this plan to be flawed in several key areas, especially with respect to its proposed cuts to Social Security Benefits. We believe that any proposal that includes cuts to a popular, fiscally sound program lacks credibility and does not reflect the political center.

Social Security remains the most "fixable" entitlement, one where the solutions are well-understood and the ability to split the difference between conservative and liberal approaches is most evident. But that doesn't mean it's going to be easy.

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A good survey article on Social Security reform

Press coverage of Social Security and reform can often be skimpy – a few standard lines, filled in with a few standard quotes from the usual suspects, and that's about it. While I don't agree with everything in Emily Kaiser's long Reuters article on Social Security reform, it's nice to see the issue get the thorough treatment it deserves.

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Ezra Klein’s “Easy Solution” to Social Security reform?

Not so easy. What worries me about folks like Klein isn't that they disagree with me on Social Security – most people probably do, and many have good reasons for doing so. It's that his discussion of Social Security reform seems blissfully ignorant of the sorts of issues that people who are even a smidge to the right of center care about. As much as he confronts the right on policy, I'm not sure how well he really understands where people to the right of him are coming from. And without that, it's tough to think about the sorts of compromises we'll eventually need to make. In any case, check out my discussion of Klein's recent Social Security piece over at AEI's Enterprise Blog.

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The Social Security Mail Bag

As I've mentioned before, I've gotten some not-entirely-supportive responses from seniors with regard to my comments on Social Security COLAs and Medicare Part B premiums – that, in effect, while they think they've been treated badly in recent years, overall they've come out ahead. As I predicted in a recent Associated Press
story, "This will get me hate mail."

And it has, though mostly hate email. But over at AEI's Enterprise Blog, Nick Schulz shows some of the snail mail I've gotten. A letter written by hand conveys so much more feeling than email ever can. Check it out.

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Does Ryan Budget “Fast-Track Social Security Cuts”?

Over at the Huffington Post, Daniel Marans of Social Security Works argues that Rep. Paul Ryan's budget plan – which it could be argued effectively ducks Social Security reform – is actually a fast track to benefit cuts. Marans says that

• "Under Ryan's plan, any year Social Security is not in 75-year balance, the president and Congress would have to legislate changes that bring it to solvency through an "expedited process.'"
  
• "In effect, Ryan would free up Social Security for fast-track cuts by turning it into a regular line budget item. Since Social Security is not part of the general budget, has its own revenue stream, and is forbidden by law from borrowing, it has always been dealt with separately from the rest of the budget. In fact, Ryan had to create a new fast-track process to trigger cuts for Social Security alone, because by law, it is excluded from fast-track reconciliation procedures for the general budget."
  
• "Further, projections of Social Security's solvency change every year, which means that Ryan's plan could force big changes to Social Security based on very short-term variations in the program's finances."
  

This, I think, is representative of the general lack of confidence liberals have in their own position, in that they view pretty much any attempts to reform Social Security as tantamount to cuts in Social Security. Now, I think that Social Security will involve benefit cuts, given that a) people aren't keen on paying more into a program which they regard as insecure and not such a great deal; b) middle and high earning households can make up for future benefit cuts by saving more today; and c) it's much harder for individuals to make up for cuts in future Medicare benefits with additional saving, given the structure of that program.

In effect, all the Ryan budget does is amp up a provision that's already on the books. Under current law, if the trust fund balance falls below 20 percent of annual outgoes, the program's Trustees are required to submit a plan to increase Social Security taxes or reduce benefits in order to maintain the trust fund's solvency. Obviously, once the trust fund balance has gotten that low, the changes necessary to keep the system on track will be severe. Ryan's plan effectively would require the Trustees to issue their recommendations for solvency anytime the program is insolvent over the long-term, meaning a 75-year horizon. This is a very different bar for action by the Trustees, but it serves to involve them – and the administration – in the process of getting Social Security reform moving.

My question is why the Left assumes that a provision requiring the Trustees – all but one of whom are appointed by the President, and most of whom are actual members of the administration – would necessarily mean benefit cuts rather than tax increases? Wouldn't this approach favor the tax-increase approach, given who's in power these days? My gut is that, despite their rhetoric that Americans strongly favor tax increases (usually on other people) over benefit cuts, the Left isn't quite sure that political process will play out that way. And if it won't play out that way even with Democrats in power, I think that undermines their general narrative on where Americans stand on Social Security reform in the context of the other fiscal and budgetary issues we face.

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Could Social Security Buy You Out for 83 Cents on the Dollar?

My AEI colleague Alex Pollock asks that question over at The American.

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Munnell: To cut deficit, look to Social Security

Boston College's Alicia Munnell has a nice piece in the New York Times today looking at ways to fix Social Security. A quick cut:

The task force suggested four major changes: indexing the full retirement age (after it reaches 67) to improvements in longevity; switching to a measure of inflation that grows more slowly than the one now used to calculate Social Security's cost-of-living adjustment; gradually increasing the earnings subject to the payroll tax (and the basis for benefits) to about $180,000 from $106,800 today; and gradually subjecting both employer and employee premiums for group health insurance to payroll and income taxes.

Click here to read the whole piece.

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Agenda for April8 meeting of 2011 Technical Panel on Assumptions and Methods

2011 Technical Panel on Assumptions and Methods

Meeting Agenda

April 8-9, 2011

The meetings will be held in the offices of the Social Security Advisory Board:

400 Virginia Avenue SW, Suite 625, Washington, DC 20024

Friday, April 8, 2011

9:30am-11:00am Complexity Science models

Presentation by Alan Mills, Milliman

11:00am-11:15am Break

11:15am-12:30pm Projecting revenue from the taxation of benefits

Presentation by the Office of the Chief Actuary, SSA

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