Thursday, March 27, 2008

The Social Security Money-Pit

Being brought up as a child of the Thatcher government, I've never really considered Britain a socialist country - although that's what it's labelled by many Americans.

It's Anglicised 'socialism' that's proving to be the crux of the upcoming presidential election, with both Barack Obama and Hillary Clinton advocating British-style programs to care for certain American citizens, while John McCain and the Republican party continue to advocate a completely privatized system.

It's a tough sell for McCain & Co. Universal access to adequate health care is clearly the cornerstone of a 'civilised' society and whether you believe in public or private health care, it's difficult to argue that the current system isn't in need of a serious overhaul.

The other 'tough sell' is Social Security. Developed by President Roosevelt after the great depression, Social Security is a mandatory payment by working citizens into a federal fund, which supplies the retired and disabled with a pension.

Many Republicans want this abolished, leaving citizens responsible for paying into their own retirement programs. Most Democrats, on the other hand, want Social Security expanded, to cover more people and offer more benefits.

On the face of it, the Democrats have a much stronger argument. After all, if somebody's paid into Social Security for their entire life, why shouldn't they receive a pension upon retirement? And if a person becomes disabled, isn't it the government's duty to pay their costs of living?

Whatever argument the Republicans come up with to counter this proposal makes them sound callous and uncaring. However, there is one uncomfortable nugget of truth in their argument that Democrats and Liberals are increasingly wary of acknowledging.

Social Security doesn't work.

In theory, Social Security is just a government-funded pension scheme. Workers pay in 12% of their income every paycheque and that money is invested in a 'fund' which generates enough revenue (from interest and investments) to pay for that worker's retirement after thirty or forty years of payments.

It's exactly how a modern day 401k system works - except for a couple of serious issues.

The return on the invested money is considerably less. An average American investing $285,000 dollars into Social Security over the course of his life (about average for somebody earning $60,000 a year) will receive a pension of $2,200 a month upon retirement. If that same $285,000 had been invested in a private high-grade corporate bond, the monthly return could conservatively be estimated at $7,400 a month.

The interest bearing 'fund' has already been spent. Or, at least, that's what Economist Thomas Sowell suggests - arguing that the retirement pensions of the first generation of Social Security contributors is actually being paid for by the contributions of the second generation. The money that should have been in trust - developing interest to pay for future Social Security payments - has actually been borrowed in the form of Government Bonds. This causes a problem when the 'Baby Boom' generation retires and the Social Security contributions of the 'next generation' are only able to cover 75% of the expected costs.

The Money Pit

Social Security Board of Trustees issued their annual report on Tuesday which outlined this exact problem. By 2017, the income from the current Social Security payments American workers make will fall below the cost of the pensions Social Security has promised to pay out.

In short, those of us planning to retire after 2017 will either have to accept a smaller pension payment - or be prepared to pay more taxes.

And if that sounds bad enough, it gets worse. With advances in medicine and science, the demographic gap between retired Americans and working ones is increasing - meaning the diminishing Social Security investment will have to be spread across a widening group of retirees.

It's absolutely unsustainable. In fact, to pay the pensions of retiring Americans at their current rate, Social Security payments will have to be increased by 300%! That means the average working American will see an instantaneous tax increase of 12.4% - and a self-employed American will technically be required to pay an additional 24.8%.

The only other alternative is to pay out less upon retirement - further widening the disparity between private investment (through a 401k scheme) and the money you get back from a lifetime paying into Social Security.

Democrats Lose

Alarmingly, neither Barack Obama nor Hillary Clinton seem to be addressing this alarming issue. In fact, Clinton has made it very clear that she wants to expand both Social Security and Medicare.

On the surface of it, that appeals to a lot of Americans - more pension money. More health care benefits. But it will come at the cost of increasing income taxes - dramatically.

For most working Americans, Social Security is not longer a realistic plan for the future. Unless they invest more of their own money into a private 401k scheme, there will simply not be enough money in the Social Security fund to give them a livable pension.

The Alternative...

For many people - myself included - it would seem to be far more sensible and profitable to take the 12.4 percent paid into Social Security (half by you, half by your employer) and pay it directly into your 401k (where an additional 6% of my income already goes.)

That way, you can maximise the effectiveness of your investment (if the earlier example holds true) winding up with three or four times the monthly pension that you would through Social Security alone.

In addition, if you could invest 12.4% of your income privately, into a 401k that would actually give you a decent return on your money, you might not need to do what millions of Americans (including myself) do and supplement your Social Security retirement 'plan' by investing a further 6% of your income privately. That's 6% to spend elsewhere adding up to thousands of dollars a year.

...and why it's not viable

As rosy as this option sounds, it's not viable for several reasons.

Firstly, and most importantly, the inefficiencies of the current Social Security system mean that our Social Security payments are required to pay for the retiring Baby Boomers. In fact, these payments won't even add up to 73% of the promised payments the Baby Boom generation is expecting - so Social Security payments have to continue - or possibly increase - even though they're not contributing to our future retirement at all!

Secondly, what the Social Security system lacks in return-on-investment, it at least offers in stability (in theory.) Recent financial disasters like Enron and Bear Stearns show that even low-risk investment portfolios do carry some risk. In the private sector, if a lifetime's investment is wiped out overnight, there's nobody you can go running to.
  • That being said, if the government's habit of dipping into the Social Security trust had been copied in a private company, the 'dippers' would be facing lengthy jail-terms, rather than reelection.)
  • That additionally being said, the fact that Social Security is due to go into the red by 2017 suggests that investment in government Social Security is no safer - perhaps even less so - than putting money into a private investment portfolio.)
Thirdly, the mandatory Social Security payments make sure every American worker is investing in their retirement (even if they get terrible return on their investment.) If American workers had 12% of their income freed up in order to invest in their future... who's to say they would?

It's exactly the same problem that plagues the health care system. Almost 50 million Americans are without health insurance - ostensibly because they can't afford it. How long would it be after Social Security was privatised before millions of Americans started claiming they couldn't afford to invest in their pension schemes, either?

Whether or not they can afford healthcare, they can afford to invest 12.4% of their payroll into a pension scheme - they do so already because the Social Security payments are compulsory. But if payroll taxes were abolished and somebody had the option of spending money or not, many would choose not - resulting in a sizable chunk of people descending into poverty when they hit 65.

THIS is the real Achilles heel of privatised Social Security. The fact that some people are far too bloody stupid to actually take it seriously.

So where does that leave us?

Roll the dice. Take your chances. Whichever way you look at it, the future of Social Security is very grim indeed.

Currently, Social Security is a cash-gobbling monster headed directly into debt. In less than a decade, either the Baby Boomers or the American 9-to-5'er (or both) are going to feel a firm fiscal pinch. Somebody is not going to get what they were promised - either in the size of their Social Security cheque or the amount of tax rudely hacked from their paycheque.

The reality is, Social Security no longer offers anybody a secure future. For my generation, Social Security deductions are basically just another form of income tax. We receive no benefit for them whatsoever. Unless we invest the rest of our paycheque into a 401k scheme, there is little hope of ever receiving an adequate pension from Social Security.

Social Security is already effectively privatised.

When are Hillary and Obama going to admit that?


EmmaK said...

I'm afraid that because I am not eligible to vote in the US I can't concentrate too much on the ins and outs of the social security system. I suppose what you are saying is that it doesn't work and needs a radical rehaul?

Roland Hulme said...

Something like that. Or an excuse for an angry mob with flaming torches. They're always good.