The Great Social Security Debate
By Richard P. Halverson

The first time I wrote an article on Social Security was 1981.  The system was facing serious difficulties by the late 1980’s.  I predicted the problem would be solved by using a combination of the following:

·         Payroll tax increases – substantial increases have occurred

·         Delay of benefits – this has occurred

·         Reduction of benefits – arguably they have increased

·         Use of general tax revenue – Social Security taxes have actually been used for general purposes, making the current challenge more difficult

·         Reducing benefits based on private retirement assets – has not occurred yet

As you can see I was only partially correct on what I expected to happen.  There was one prediction where I was totally wrong.  I used terminology suggesting the government would solve the social security problem.  They did not.  They only delayed  the problem.

I was not bright enough in 1981 to think of private accounts.  Private accounts could potentially solve the problem. 

Some Facts

You know the Social Security discussion is highly contentious.  You are being deluged by confusing information from all sides, and it is hard to know what the truth is.  My purpose here is to speak to the issue of private accounts and the safety of investing in stocks for retirement. 

Here are some facts:

·         There is a problem with Social Security.

·         It will take years for the problem to become a “crisis.”  However, when it comes to retirement, anything that is put off is geometrically more difficult to solve in the future.

·         The numbers that reveal this problem are very accurate.  Actuarial statistics are solid.  We know how many people are alive and exactly when they will turn 65.  The biggest risk to the numbers is that medical breakthroughs will substantially increase life expectancy.  Generally that is good, but it is a disaster for the Social Security system because the actuarial statistics are counting on people dying on time.

·         Because of the baby boom and subsequent reduced birth rate we are entering a period when there will be fewer workers supporting greater numbers of retirees.  This can not be avoided.

·         Social Security is a pay-as-you-go system.  The dollars withheld from your paycheck today go to pay the benefits of your retired relatives today, not your benefits tomorrow.

·         Pay-as-you-go retirement systems, including Social Security, are fundamentally unsound.  They are so unsound that Congress has passed very strict laws preventing any private employer from adopting a pay-as-you-go system.  Only Social Security and a few other public systems are allowed to get away with it.

·         Converting to an invest-for-the-future system is expensive in the short run.  It must be phased in over time.

·         Private accounts are a form of invest-for-the-future system.

·         Private accounts offer all the advantages and uncertainties of personal ownership.

·         There are other invest-for-the-future systems that do not involve private accounts e.g. a fully funded national pension system.

·         It is possible to solve (or more likely delay again) the Social Security problem without converting to an invest-for-the-future system.  (See my list at the top and underline the part about tax increases two or three times.)  It is hard for me to comprehend that any well-informed individual or policy maker could seriously prefer a pay-as-you-go system if it is possible to get over to an invest-for-the-future system.  That is exactly like saying, "I always prefer to be in debt and pay for every emergency with my credit card rather than having any savings at all."  People do live like that but nobody prefers to live like that.

Why the Argument?

OK, why are so many well-informed people against the private account proposal?  Most of it can be summed up in one word – politics.  There are some on one side who do not want the other side to get credit.  There are some who do not want to actually solve the problem because they run for re-election all the time on a platform of solving it.  If the problem really gets solved, the problem and the issue go away.  Some simply have no faith in people and private ownership and believe the government knows best.

There are some who might favor an invest-for-the-future system but are deeply concerned about the transition cost.  Again it is like someone living off debt who decides to change and pay down the debt.  He must find the cash flow to keep living and pay down the debt. People worried about the transition cost have a point, except for two things.  First, it gets substantially more costly to convert the longer the conversion waits.  Second, they are not looking at the unfunded liability of the current system.  That liability is far larger than the cost of conversion.

Risk of Stock Market Investing is Low over the Long Term

Finally, we hear some argue that private investing in the capital markets is way too risky for ordinary people.  While it is a fact that private investing carries some risk, the point of this article is that risk is very low.  Please understand these private accounts will operate with many safe guards.

·         People will be required to participate.  Funds will be deducted just like Social Security taxes.

·         No one will be able to concentrate all their investment in a non-diversified risky portfolio.  Many people were burned in their 401Ks when they had most of their money in the company stock and it went south.

·         People will not be able to withdraw the money early and spend it.

·         Stocks will not be the only option.

·         If people are still worried, every model I have seen allows leaving all the money in the current Social Security system as an option.

·         Finally, investing in the stock market over a long period of time generally is not risky and is superior to leaving the money in the current social security system.

For Example

Dealing with Social Security numbers is beyond mind-boggling.  Every person’s circumstances are different.  It is impossible to come up with simple illustrations that apply to everyone.  Let me offer one fairly simple example that will illustrate the point.

Scenario #1 – Existing Social Security.  An individual is retiring at 65½.  He has earned full benefits.  He has worked 40 years and has paid $102,500 into the system.  His annual benefit may be about $21,600.   If he lives to age 75 ½ the value of his benefit is about $220,400.  (Present value at age 65 ½ assuming 3% inflation.)

Scenario #2 – Private accounts.  An individual is retiring at 65½.  All his Social Security taxes of $102,500 have been invested in the stock market.  (This would be 100% privatization, which is not on the table at this time.)  How much will the portfolio be worth?  Probably about $445,500 –more than twice as much as Social Security.  Probably.  Based on simulations of history, the value can range from more than $10,500,000 to $42,000, with the extremes representing about 1 chance in 30,000.  (I do not wish to bore you with statistics.  The analysis is based on randomized total rates of return generated by the Dow Jones Industrial Average during the past 104 years, using statistics from 30,000 Monte Carlo simulations. 104 years covers a lot of good and bad times for the country and ups and downs in the stock market.)

This analysis suggests that in nearly 86% of the scenarios our retiree is better off in the stock market than in Social Security and generally much better off.  That still leaves a 14% probability of being worse off.  If you fear it is just your luck to wind up in the lower 14%, then opt for the traditional Social Security option.  I wouldn’t.  I only wish private accounts had been available when I started working.

We Need to Do Something to Solve the Problem

I truly believe something needs to be done to move Social Security from a fundamentally unsound pay-as-you-go system to a far better invest-for-the-future system.  I like private accounts.  I think ownership is always wise.  America is a nation of ownership.  But if people can’t stomach the risks of ownership in their public retirement system, let’s at least start funding a pension system.  Such a system would offer guaranteed benefits and require the government to invest the money.  Hey – the government requires everyone from IBM to the local school district to invest-for-the-future.  Why not Social Security?