Thursday, April 28, 2011

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.


WilliamLarsen said...

Ryan's plan like the big fix of 1983 does nothing, but kick the can down the road another 40 years.

There is no doubt that stocks beat US Treasuries. However, let us not debate different investments, but the same investment, US Treasuries that Social Security uses.

Based on period life tables and the SS-OASI benefit formula, it is calculated that tax rate to support a fully funded SS-OASI program is under 6%. However, the SS-OASI tax is 10.6%.

Why the difference? Why is Social Security always in need of big tax changes? The reason is simple, granny and papa did not pay their fair share into Social Security. Who is responsible for this? Granny and papa voted to either pass Social Security or continue to vote for representatives who kept raising taxes.

We as parents have a fiduciary responsibility to our children to look out for their well being. Granny and papa and our parents failed to do so either through ignorance of greed. Today I would say it is more greed than ignorance given all the information on the subject.

When a person says “We Earned it!” what exactly do they mean?

To me, this phrase is a righteous euphemism for making the more truthful statement: "We were snookered by this Social Security Ponzi scheme, and now we are going to snooker the next generation!"

If Social Security benefits have been "earned" who is obligated to pay benefits to those who "earned" them? Workers? On a regressive tax basis? Why? Why perpetuate a fraud upon the innocent? Who is responsible for bearing the burden of a fraud? The person defrauded? Or an innocent or unborn child?

Keep in mind 1 out of 5 seniors are millionaires. The median income of a senior according to the IRS statistics is $85,000.

My suggestion is not to wait like they have for the past 74 years, but means test it today. Lower the payroll tax by 60% and let our children save, invest and participate in the American Dream.

Arne said...

"The median income of a senior according to the IRS statistics is $85,000."

Acutally it is between $30K and $40K, closer to $30K.,,id=134951,00.html
Table 1.6: All Returns: Number of Returns

Arne said...

Andrew: "The reason the return going forward is so low is that returns in the past were so high. "

The return going forward does not depend on past returns except as it relates to how much income comes from trust fund interest. As we move toward a steady-state pay as you go system with a one year reserve, the return depends on how long people live after retirement and how many die before reaching retirement because that is what determines the ratio of workers to beneficiaries. And W/B is the key.

Andrew G. Biggs said...

Arne: If the trust fund were 'real', then a more moderate return for lower generations would mean a larger trust fund balance and higher returns for future generations (meaning, a longer period that full benefits could be paid without tax increases). If past generations had received only the bond return then the program would be solvent forever and the return going forward would be higher.

Arne said...

The trust fund is a real mechanism for allowing Social Security to have a reserve so that Congress does not have to mess with it on a frequent basis. It is not a fund that holds participants investments. It never has been; was never intended to be. Social Security is pay as you go.

You are correct that if things were different, then they would be different. If SS were an investment, early generations would not have gotten spectacular investment returns and later generations woud get better returns.

Except that the money my parents would have invested would have been used to support their parents instead of being invested and then the money that I "invest" would also have to be lower because I would have to help support my parents. Even though the "return" would be better, the benefit would be smaller.

The "returns" are a result of the structure of SS. The structure of SS is not a result of the "returns".

JG said...

The "returns" are a result of the structure of SS. The structure of SS is not a result of the "returns".

Both the structure of SS and the return from it are the result of past politicians constantly changing it to increase the return to then-voting seniors, circa 1939 to the 1970s -- Samuelson's "Ponzi Scheme that Works" years -- while dropping the cost on later workers ... so the return to today's workers will be negative.