In 2006, at the State of the Union Address, Democrats cheered wildly when President Bush stated that he was unable to privatize Social Security because Democrats wouldn’t support it. Please watch the video here, since it is an image that should be in everyone’s mind as the Social Security system implodes over the next ten to twenty years. If the US had privatized Social Security in 2006 instead of seeing the measure blocked through filibusters and political rangling, those retiring today with $60,000 yearly incomes would have accounts containing about $65,000, even assuming the money were just left in a bank CD. This would be enough money to pay typical Social Security benefits for about four and a half years (assuming payments of $1200 per month), carrying these individuals through to at least age 69 before needing to start paying out cash from the Treasury. Those who are still ten years out from retirement would have $150,000 when they were ready to retire, again if they just put the money away in bank assets like CDs. If they invested instead, they might very well start off retirement with a quarter of a million dollars.
Instead, because the reform effort to privatize Social Security failed, we’ve continued with the public program where money is sent into the Social Security Trust Fund, the trust fund gives the money to the US Treasury in exchange for an IOU, and then the Treasury spends the money. As with any Ponzi scheme, this works fine so long as there are a lot more people paying in than are receiving, but doesn’t work well when there are a lot of retirees compared to the working population. We are about to see the latter case as we see a large Babyboom generation retiring, a smaller population of GenXers, and a large number of GenYers who can’t find jobs and therefore aren’t contributing much to Social Security or the Treasury. The Social Security Trust Fund will need to start cashing in those IOUs soon, but the Treasury may not have the money available to pay the trust fund back because tax revenues will also drop as fewer people are working and more are retired.
Another danger that could quickly cause the Social Security system to collapse is the national debt. Right now the national debt is approaching $18T, more than $10T more than it was just six years ago. Looking at the US Federal budget, one can see that the interest on the debt is about $250 B currently, which is manageable. (Note, this is extraordinary, given that the average middle class tax payment is about $9,000, this means that the taxes from about 28 million people goes just to pay interest on the debt!) Interest rates have been low however, causing this interest payment to be so manageable. If countries decide that the US is no longer a good credit risk, or a group of countries like China decided not to lend to the US anymore, the interest rate could increase rapidly. If it reached 5%, the interest on the debt would become about $900 B, which is more than national defense and equal to all current Social Security payments. It would be very likely that Social Security and a lot of other programs would need to be cut to service the debt if this were to occur. Given that the US government needs to regularly issue new bonds, rather than having rates locked in for a number of years like a home owner, interest rates could rise very suddenly, forcing the government to cut or eliminate Social Security payments. This would cause a sudden crisis for seniors who depend on Socialis Security for a significant portion of their income. If Social Security were a private entity where everyone had their own private accounts, there would be no issue because the money would be residing in private portfolios and not require funding from the Treasury.
Whenever the idea of privatizing Social Security is floated, the standard response is that we’d be “gambling with people’s retirement in the stock market, instead of getting the safe returns from Social Security.” This is asinine, given that the only way for people to lose their retirement savings in the stock market (assuming they were invested in mutual funds that buy a broad range of companies) is if the entire American economy collapsed and didn’t recover. If that were the case, there would also be no tax collections, so there would be no money to pay Social Security benefits. All that using tax revenues to pay benefits instead of having direct investment guarantees is that retirees will get a far lower return than they would have had they invested themselves because any extra revenues generated by Social Security taxes are spent instead of invested.
Note also that if you have people investing in the stock market all of the time through paycheck deductions, people can be pulling the same amount out of the market without prices declining (the current workers are effectively just giving cash to those who are retired in exchange for their shares). This is exactly the same as the current system where current workers pay the benefits of current retirees. The only difference is that you wouldn’t have politicians spending the extra money on pet projects and the money invested could grow as the businesses in which the money is invested grow.
So here is a better way:
1. Require that every worker contribute a specified portion of his/her salary to a private Social Security account through payroll deduction,. The percentages could be the same as are currently required with the public system, but eventually these could probably be lowered since the return will be so much better.
2. For low-income workers, have the government subsidize their contributions to bring them up to a reasonable basic level. A portion of the contributions from higher paid workers could be used to fund this subsidy.
3. Have these funds invested in a total US stock market fund, a total international stock fund, and a total bond market fund. The percentage in each of these funds would depend on stage of life, with more money being shifted into bonds as the worker nears retirement.
4. Make it impossible for any withdrawals to be made from this account until the worker reaches at least 60 years of age. At that point, allow withdrawals based on a 30-year life expectancy (age 90). The worker may also delay payments until a later date and get proportionally larger payments. If the worker dies before the account is exhausted, allow the account to be inherited with the rest of his/her estate. If needed, a tax could be levied against remaining account balances to fund payments to retirees who live beyond the age of 90.
5. If it makes you feel better, create a provision where government payments would be provided to make up for any shortfall between what the worker receives from the account and what he/she would have received from the current Social Security system. I guarantee you that this provision would never be needed, and if it was, there would be no tax money to exercise it anyway, but it would provide as good a “guarantee” as the existing system provides.
But what about people who have paid into the current system and are near or in retirement? How will they receive payments? This is an issue created by the poor design of the current system and is a difficult issue. Really these people are the victims of the Ponzi scheme – the ones left holding the bag when there are no new “investors.” It would not be right to simply cut off payments (even though they have already received the benefits of their money since the government they continued to elect spent the money and they collectively did nothing to stop them.) There is a way to ease the transition, however, from the current Ponzi scheme to the solid system I propose:
Allow each person age 60 and older to voluntarily give up their benefits in exchange for a person of their choice not needing to contribute to the public Social Security system anymore and instead beign able to direct future payments into private accounts. Many retirees with pensions or other retirement savings would no doubt take advantage of this option and exempt a child or grandchild since the amount that they would receive from Social Security would be so little anyway in comparison to a real retirement account. Because more than one worker pays for each retiree, but they would only be exempting a single worker in exchange for not receiving payments, the money being directed to private accounts would be less than the savings made from not needing to pay benefits to the retiree who forego benefits. =Over time, more and more people would be transitioned to the private system, at which point the transition would be complete.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
