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.