The Demise of Social Security

By Richard Glickman and Charles Comer

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MAY 2006 - After reading in the August 2005 CPA Journal (“Social Security: Safety Net in Need of Repair”) that “Even if no changes are made in the law governing Social Security, the Trust Fund will be able to pay promised benefits until 2042,” we were so startled that we checked our files.

Before he left office in 2005, Douglas Holtz-Eakin, the sixth director of the Congressional Budget Office, disagreed, saying: “The Trust Fund has no real economic resources ... The key moments for Social Security are in 2016. Cash-flow benefits will equal cash-flow payroll taxes, and then after that, the Social Security Administration [SSA] will have to come back to the rest of the budget for additional resources to pay promised benefits.” So 2042 is 25 years late.

Let’s go back to the roots of the Social Security system. In the initial collection year of 1937, the Social Security trustees reported receipts of $267,261,811. That money, which became the Social Security Trust Fund, was invested in a special 3% U.S. Treasury Bond maturing June 30, 1941.

The Trust Fund’s Surplus Has Become the Treasury’s Problem

Over the past 20 years, the Social Security Trust Fund has built up a large surplus. That surplus is projected to grow still larger until about 2016 or 2017, when the nation’s demographics will shift because fewer workers will be “contributing” and more beneficiaries (retirees, spouses of workers, etc.) will be receiving Social Security checks. At that point, benefits paid out will exceed Social Security tax revenues coming in, and the SSA will have to begin to draw down the Trust Fund surplus. The problem is simply that, over the years, the surplus has been invested in U.S. government securities, specifically in special-purpose bonds as required by law. So the Trust Fund doesn’t have a problem, but the U.S. Treasury, having spent the money it borrowed, will have to come up with new cash to redeem the bonds held by the Trust Fund, currently estimated at $1.7 trillion.

That entire amount won’t be needed on January 1, 2017. In fact, initially the benefit outflow will only slightly surpass the tax inflow, so the drawdown from the surplus will be small. But as the years go by, the demographics are projected to shift still further. Roughly two workers for every one retiree is the forecast for the year 2030. In 1950, the ratio was 16 to one. Fewer tax-paying workers will be supporting the ever-growing number of retirees, who are likely to be living longer and collecting their Social Security checks longer. The initial cash outflow trickle will grow to a torrent, and the U.S. Treasury will have to fund it.

Problem 1: Pay-As-You-Go

In 1983, the trustees explained that the Social Security program is “essentially on a pay-as-you-go basis. The Trust Funds serve as a contingency reserve to absorb temporary fluctuations in income and outgo.… The Trust Funds are invested in U.S. government securities. After about the year 2020, outgo will exceed income thus creating substantial deficits.”

That forecast appears to have been pretty accurate. We are much closer to 2020 today, and the forecast is that income may be less than outgo as soon as 2017. The American Association of Retired Persons (AARP) concurs, having stated on its website that there will be insufficient “cash” to meet statutory needs.

So the issue isn’t a Social Security problem, it’s a U.S. government problem, which means it’s a problem for the nation’s taxpayers. To satisfy their constituents, the members of Congress, with the complicity of the President, have for decades been spending beyond their willingness to tax the public, borrowing the difference between receipts and expenses. The Social Security Trust Fund is just the largest of the government’s many lenders, accounting for approximately 22% of the $7.6 trillion in the Treasury’s cumulative borrowing as of December 31, 2004.

In their 1994 Report, the Trustees of the Fund explained another problem:

Trust fund assets are generally invested in special Treasury securities so that the excess of cash receipts over expenditures are borrowed from the Trust Funds by the General fund of the Treasury and used to help meet various Federal outlays. These securities are backed by the full faith and credit of the U.S. government, the same as other public-debt obligations of the U.S. government.… The redemption of a Treasury security held by the Trust Fund requires that the Treasury transfer cash—obtained from another revenue source, such as income taxes or borrowing from the public—to the Trust Fund.

The Trust Fund has not set aside a pile of cash or gold to pay out to retirees. The Trust Fund consists of pieces of paper representing promises by the U.S. government to pay itself (the Social Security Trustees, agents for another U.S. government entity) approximately $1.7 trillion.

After 2017, in order to pay retirees their Social Security benefits, the U.S. government will have to raise cash by:

  • Borrowing it;
  • Raising taxes;
  • Printing trillions of dollars of paper money (thereby destroying the currency’s value);
  • Selling $1.7 trillion of U.S. assets;
  • Changing the Social Security system; or
  • All of the above.

The Social Security system was designed to operate on a pay-as-you-go basis. When the pay-as-you-go approach fails in approximately 2017, the nation will face Problem 1.

Problem 2: Insufficient Cash

The second issue is that there is no cash in the till to pay the Social Security beneficiaries after 2017 or 2018. It is amazing that intelligent readers of SSA reports really believe that the so-called “Trust Fund” consists of cash that the SSA will be able to use to pay beneficiaries. Prior years’ trustees knew that “cash” was an issue.

The real story is that the size of the Social Security Trust Fund is irrelevant. The U.S. government has the same few options that we just described whether the Social Security Trust Fund has a zero balance or a $1.7 trillion paper balance, because in 2017 or 2018, the government will need to find the cash to pay Social Security benefits to the extent that they exceed Social Security tax revenues.

Legally, the Trust Fund has assets of $1.7 trillion, and this is the confusing part to many noneconomists. However, former President Clinton said: “These Trust Fund balances … do not consist of real economic assets that can be drawn down in the future to fund benefits.… The existence of Trust Fund balances, therefore, does not by itself have any impact on the government’s ability to pay benefits.” This is very clear. If the Trust Fund had hard assets, such as gold, those assets could be used to pay benefits to retirees.

Problem 3: Where to Invest Retirement Funds?

Because Congress was concerned with preserving the resources needed to ensure that beneficiaries actually collect, initially it required that the Social Security Trust Fund be invested only in special-purpose U.S. government securities. During the Great Depression of the 1930s, this seemed the most prudent approach, and the Trust Fund was seen as a contingency to absorb temporary fluctuations in collections. The early aversion to financial risk has led to the current problem of too low a return being earned on investments of the Social Security funds. The system put in place in the 1930s made economic sense at the time. Now we see that it will no longer be operative after approximately 2017.

At the inception of Social Security, Congress determined that the surplus funds should earn a return of 3% per annum, and over the years two problems have arisen with respect to the investment returns. In some years, inflation at varying rates has eroded any real return on the Trust Fund’s “investment.” In other years, when the SSA needed to invest its excess reserves in these special-purpose Treasury Bonds, the ceiling on the national debt inhibited the sale of bonds to the Trust Fund.

Potential Solutions

Keeping an open mind, we the authors ask: What are equitable ways to fix the system and possibly improve it?

The world has changed so significantly since 1935 that we believe it is time to revisit the design of the Social Security system. In the mid to late 1930s, other than certain government workers, people generally did not have pensions. The social safety net created made economic sense in the simpler world of the 1930s, but may no longer be the optimal approach. The SEC had just been created. Mutual funds were in their infancy. Portable IRAs, 401(k)s, and 403(b)s did not yet exist. The development of investment theory was in its infancy. In 1937, Benjamin Graham and David Dodd had just published their seminal work on investing, Security Analysis. Mathematician Harry Markowitz, who subsequently won the Nobel Prize in economics, had not yet developed the theory of “efficient” investing, the modern portfolio concept of “diversification” to minimize portfolio investment risk.

Mitigating the Social Security Shortfall

Suggestions for ameliorating the Social Security Trust Fund shortfall raise complex new issues.

  • Raising Social Security tax rates could be a partial solution. The main problem is reality. Edward C. Prescott, a 2004 Nobel laureate in economics, said, “Taxes distort behavior. From this powerful little sentence comes the key insight that should inform our thinking about setting tax rates. Any tax, even the lowest and the fairest, will cause people to consume less or work less. Taxes that are inordinately high only exacerbate this reaction, and the aggregate accumulation of these individual decisions can be devastating to an economy” (The Wall Street Journal, December 20, 2005). We agree, and we think raising the rates is a poor solution.
  • Raising the retirement age again (but exempting those close to retirement) makes more sense. This step would reduce the number of workers getting benefits, as well as increase the number of workers paying into the system. After all, people are living much longer today than when Social Security was established; it is forecast that in the year 2035, 20% of the population will be over age 65.
  • The federal government has already privatized the pension plans of federal employees. Privatizing the Social Security system so that each beneficiary owns a portable retirement fund is another partial solution. In addition, the federal government would have less ability to spend the funds on other programs. Investment returns would likely increase. Prudent investments with higher returns would provide retirees with greater benefits. Families would take control of their own Social Security tax money.
  • Another possible approach to improving returns, assuming privatization, is to require Social Security account holders to diversify their stock and bond investments directly or indirectly, possibly through indexation or another prudent investment-management technique. There has never been a 20-year period in U.S. history during which one would have lost money in the stock market.
  • Alternatively, statutory controls and restraints could be implemented to prevent people from gambling in the stock market with their privately owned Social Security taxes and potentially obligating the public sector to bail them out. One such control might be to limit individuals’ accounts to investing only in U.S. Treasury securities, thereby containing portfolio risk. Unfortunately, the Treasury’s cash flow problem would still exist, although in a different form and timeline.
  • Adjusting the Social Security inflation indexing formula has particular merit. Starting benefits for Social Security beneficiaries are currently calculated using a wage-inflation index. Per year, this index has grown 1.1% faster than the consumer price index (CPI). Substituting the CPI for the wage-inflation index would result in lower starting benefits for retirees. The Social Security system would pay out lower benefits even as they rise to account for CPI inflation. Again, to be fair, this change should be implemented only for younger people; for example, below age 50.
  • Using a means test to pay Social Security benefits would be perceived as unfair, we believe. Why should the government tell taxpayers during their working lives that they will receive the benefits of the Social Security taxes they are paying and then take the benefits away because the workers were too successful? This appears to be another proposal that would force successful proactive taxpayers to think about not maximizing their income potential or perhaps not reporting all of their earnings to the government.

Are Taxes a Disincentive to Work?

Let’s revisit a real-life economic event from the early 1960s. Four very young, smart, successful businessmen were in the offices of their CPA firm explaining their business. One of them had been a farmer. His current job was to buy farms that the other three assembled to market for commercial real estate developers. They earned millions of dollars each year. During the meeting, one of them said that usually at the end of May each year, they stopped working until the following January. This routine of work and not-work, they explained, was due solely to the fact that by June they each had earned between $1 million and $2 million. At that level, for every dollar they earned they paid more than 80% in income taxes. They reasoned: Why work to keep 20 cents on the dollar? They had already earned more than they needed. So they waited for the next year. That meeting was an epiphany for this author: Taxes clearly are a work disincentive.

How does this event relate to Social Security issues? Clearly, higher taxes, both income and Social Security, are not incentives in our capitalist system. In the words of Edward C. Prescott, “Taxes distort behavior.”

Mend the Safety Net Now

The bottom line: We cannot wait until 2016 to mend the Social Security safety net. We agree with the headline “Social Security: Safety Net in Need of Repair.” More than one change is needed to ensure that the Social Security system will last. Mending it will let taxpayers improve their lives and reduce their reliance on “Big Government.” And Congress will have one less source from which to borrow.


Richard Glickman, CPA, and Charles Comer, CMT, are principals in Family Office Advisors, LLC, a wealth-management consulting firm in New York City. For more information, see www.foallc.com.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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