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The Dreaded Social Security Salvage Job

24 Friday Mar 2023

Posted by Nuetzel in Privatization, Social Security

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Angus King, Bernie Sanders, Bill Cassidy, COLAs, Discretionary Spending, Donald Trump, Entitlement State, Federal Asset Sales, FICA Tax, George W. Bush, Insolvency, Internal Rate of Return, Joe Manchin, John Kennedy, Lump-Sum Payouts, Medicare, Mike Pence, Non-Discretionary Spending, OASDI, Opt-Out, Paygo, Payroll Tax, Present Value, Private Accounts, Privatization, Redistribution, Robert Shiller, Seeking Alpha, Social Security, Social Security Trust Fund, Todd Henderson, Universal Basic Income

Government budget negotiations never fail to frustrate anyone of a small-government persuasion. We have a huge, ongoing federal budget deficit. Spending’s gone bat-shit out of control over the past several years and too few in Congress are willing to do anything about it. Democrats would rather see politically-targeted tax increases. While some Republicans advocate spending cuts, the focus is almost entirely on discretionary spending. Meanwhile, the entitlement state is off the table, including Social Security reform.

Fiscal Indiscretion

Sadly, non-discretionary outlays (entitlements) today make a much larger contribution to the deficit than discretionary spending. That includes the programs like Social Security (SS) and Medicare, in which spending levels are programmatic and not subject to annual appropriations by Congress. When these programs were instituted there were a large number of workers relative to retirees, so tax contributions exceeded benefit levels for many decades. The revenue excesses were placed into “trust funds” and invested in Treasury debt. In other words, surpluses under non-discretionary SS and Medicare programs were used to finance discretionary spending!

The aging of Baby Boomers ultimately led to a reversal in the condition of the trust funds. Fewer workers relative to retirees meant that annual payroll tax collections were not adequate to cover annual benefits, and that meant drawing down the trust funds. Current projections by the system trustees call for the SS Trust Fund to be exhausted by 2035. Once that occurs, benefits will automatically be reduced by roughly 20% unless Congress acts to shore up the system before then.

A Few Proposals

I’ve written about the need for SS reform on several occasions (though the first article at that link is not germane here). It seems imperative for Congress and the President to address these shortfalls. By all appearances, however, many Republicans have put the issue aside. For his part, Joe Biden has apparently accepted the prospect of an automatic reduction in benefits in 2035, or at least he’s willing to kick that can down the road. He has, however, endorsed taxes on high earners to fund Medicare. Senator John Kennedy (R-LA) suggests raising the retirement age, or at least raise the minimum age at which one may claim benefits (now 62). Senators Bill Cassidy (R-La.) and Angus King (I-Maine) were working on a compromise that would create an investment fund to fortify the system, but the specifics are unclear, as well as how much that would accomplish.

Meanwhile, Senator Bernie Sanders (S-VT) proposes to expand SS benefits by $2,400 a year and add funding by extending payroll taxes to earners above the current limit of $160,000. Senator Joe Manchin (D-WV) has endorsed the latter as a “quick fix”.

There is also at least one proposal in Congress to end the practice of taxing a portion of SS benefits as income. I have trouble believing it will gain wide support, despite the clear double-taxation involved.

Then there are always discussions of reducing benefits at higher income levels or even means-testing benefits. In fact, it would be interesting to know what proportion of current benefits actually function as social insurance, as opposed to a universal entitlement. The answer, at least, could serve as a baseline for more fundamental reforms, including changes in the structure of payroll taxes, voluntary lump-sum payouts, and private accounts.

More Radical Views

There are a few prominent voices who claim that SS is sustainable in its current form, but perhaps with a few “no big deal” tax increases. Oh, that’s only about a $1 trillion “deal”, at least for both Medicare and SS. More offensive still are the scare tactics used by opponents of SS reform any time the subject comes up. I’m not aware of any serious reform proposal made over the past two decades that would have affected the benefits of anyone over the age of 55, and certainly no one then-eligible for benefits. Yet that charge is always made: they want to cut your SS benefits! The Democrats made that claim against George W. Bush, torpedoing what might have been a great accomplishment for all. And now, apparently Donald Trump is willing to use such accusations to damage any rival who has ever mentioned reform, including Mike Pence. Will you please cut the crap?

The System

The thing to remember about SS is that it is currently structured as a pay-as-you-go (PAYGO) system, despite the fact that benefits are defined like many creaky private pensions of old. SS benefits in each period are paid out of current “contributions” (i.e., FICO payroll taxes) plus redemptions of government bonds held in the Trust Fund. Contributions today are not “invested” anywhere because they are not enough to pay for current benefits under PAYGO.

The Trust Fund was accumulated during the years when favorable demographics led to greater FICO contributions than benefit payouts. The excess revenue was “invested” in Treasury bonds, which meant it was used to fund deficits in the general budget. It’s been about 15 years since the Trust Fund entered a “draw-down” status, and again, it will be exhausted by 2035.

SSA Says It’s a Good Deal

A participant’s expected “rate of return” on lifetime payroll tax payments depends on several things: lifetime earnings, age at which benefits are first claimed, life expectancy at that time, marital status, relative earning levels within two-earner couples, and the “full retirement age” for the individual’s birth year. Payroll tax payments, by the way, include the employer’s share because that is one of the terms of a hire. A high rate of return is not the same as a high level of benefits, however. In fact, relative to career income, SS has a great deal of progressivity in terms of rates of return, but not much in terms of benefit levels.

The Social Security Administration (SSA) has calculated illustrative real internal rates of return (IRR) for many categories of earners given certain assumptions. (An IRR is a discount rate that equalizes the present value (PV) of a stream of payments and the PV of a stream of payoffs.) The SSA’s most recent update of this exercise was in April 2022. The report references Old Age, Survivors, and Disability Insurance (OASDI), but the focus is exclusively on seniors.

Three basic scenarios were considered: 1) current law, as scheduled, despite its unsustainability; 2) a payroll tax increase from 12.4% (not including the Medicare tax) to 15.96% starting in 2035, when the Trust Fund is exhausted; and 3) a reduction in benefits of 22% starting in 2035.

The authors of the report conclude that “… the real value of OASDI benefits is extraordinarily high.” This theme has been echoed by several other writers, such as here and here. This conclusion is based on a comparison to returns earned by investments that SSA judges to have comparably low risk.

I note here that I’ve made assertions in the past about relative SS returns based on nominal benefits, rather than inflation-adjusted values. Those comparisons to private returns might have seemed drastic because they were expressed in terms of hypothetical future nominal values at the point of retirement. The gaps are not as large in real terms or if we consider SS returns broadly to include those accruing to low career earners. Medium and high earners tend to earn lower hypothetical returns from SS.

A Mixed Bag

SSA’s calculated IRRs are highest for one-earner couples followed by two-earner couples. Single males do relatively poorly due to their higher mortality rates. Low earners do very well relative to higher earners. Earlier birth years are associated with higher IRRs, but these are not as impressive for cohorts who have not yet claimed benefits. The ranges of birth years provided in the report make this a little imprecise, but I’ll focus on those born in 1955 and later.

Of course the returns are highest under the current law hypothetical than for the scenarios involving a benefit reduction or a payroll tax hike. The current law IRRs can be viewed as baselines for other calculations, but otherwise they are irrelevant. The system is technically insolvent and the scheduled benefits under current law can’t be maintained beyond 2034 without steps to generate more revenue or cut benefits. Those steps will reduce IRRs earned by hypothetical SS “assets” whether they take the form of higher payroll taxes, lower benefits, a greater full retirement age, or other measures.

The tax hike doesn’t have much impact on the IRRs of near-term retirees. It falls instead on younger cohorts with some years of employment (and payroll tax payments) remaining. The effect of a cut in benefits is spread more evenly across age cohorts and the reductions in IRRs is somewhat larger.

With higher payroll taxes after 2034, the average IRRs for birth years of 1955+ range from about 0.5% up to about 6.25%. The returns for single females and two-earner couples are roughly similar and fall between those for single males on the low end and one-earner couples on the high end. In all cases, low earners have much higher IRRs than others.

The reduction in benefits produces returns for the 1955+ age cohorts averaging small, negative values for high-earning single men up to 5.5% to 6% for low-earning, one-earner couples.

But On the Whole…

The IRR values reported by SSA are quite variable across cohorts. Individuals or couples with low earnings can usually expect to “earn” real IRRs on their contributions of better than 3% (and above 5% in a few cases). Medium earners can expect real returns from 1% to 3% (and in some cases above 4%). Many of the returns are quite good for a safe “asset”, but not for high earners.

Again, SSA states that these are real returns, though they provide no detail on the ways in which they adjust the components used in their IRR formula to arrive at real returns. Granting the benefit of the doubt, we saw persistently negative real returns on a range of safe assets in the not-very-distant past, so the IRRs are respectable by comparison.

Qualifications

There are many assumptions in the SSA’s analysis that might be construed as drastic simplifications, such as no divorce and remarriage, uniform career duration, and no relationship between earnings and mortality. But it’s easy to be picky. Many of the assumptions discernible from the report seem to be reasonable simplifications in what could otherwise be an unruly analysis. Nonetheless, there are a few assumptions that I believe bias the IRRs upward (and perhaps a few in the other direction).

In fact, SSA is remarkably non-transparent in their explanation of the details. Repeated checking of SSA’s document for clear answers is mostly futile. Be that as it may, I’m forced to give SSA the benefit of the doubt in several respects. One is the reinvestment of cumulative remaining contributions at the IRR throughout the earning career and retirement. A detailed formula with all components and time subscripts would have been nice.

… And Major Doubts

As to my misgivings, first, the IRRs reported by SSA are based on earners who all reach the age of 65. However, roughly 14% – 15% of individuals who live to be of working age die before they reach the age of 65. Most of those deaths occur in the latter part of that range, after many years of contributions and hypothetical compounding. That means the dollar impact of contributions forfeited at death before age 65 is probably larger than the unweighted share of individuals. These individuals pay-in but receive no retirement benefit in SSA’s IRR framework, although some receive disability benefits for a period of time prior to death. It wouldn’t bother my conscience to knock off at least a tenth of the quoted returns for this consideration alone.

A second major concern surrounds the method of calculating benefits and discounted benefits. SSA assumes that benefits continue for the expected life of the claimant as of age 65. If life expectancy is 19 years at age 65, then “expected” benefits are a flat stream of benefit payments for 19 years. Discounting each payment back to age 65 at the IRR yields one side of the present value equality. This constant cash flow (CCF) treatment is likely to overstate the present value of benefits. Instead of CCFs, each payment should be weighted by the probability that the claimant will be alive to receive it with a limit at some advanced age like 100. CCF overcounts present values up to the expected life, but it undercounts present values beyond the expected life because the assumed CCF benefits then are zero!! Weighting benefit payments by the probability of survival to each age produces continuing additions to the PV, but increasing mortality and decaying discount factors become quite substantial beyond expected life, leading to relatively minor additions to PV over that range. The upshot is that the CCFs employed by SSA overstate PVs by front-loading all benefits earlier in retirement. For a given PV of contributions, an overstated PV of benefits requires a higher (and overstated) IRR to restore the PV equality, and this might be a substantial source of upward bias in SSA’s calculations.

Third, when comparing an SS “asset” to private returns, a big difference is that private balances remaining at death become assets of the earner’s estate. Meanwhile, a single beneficiary forfeits their SS benefits at death (except for a small death benefit), while a surviving spouse having lower benefits receives ongoing payments of the decedent’s benefits for life. This consideration, however, in and of itself, means that private plans have a substantial advantage: the “expected” residual at death can be “optimized” at zero or some higher balance, depending on the strength of the earner’s bequest motive.

Finally, in a footnote, the SSA report notes that their treatment of income taxes on Social Security benefits for claimants with higher incomes might bias some of the IRRs upward. That seems quite likely.

It would be difficult to recast SSA’s report based on adjustments for all of these qualifications. However, it’s likely that the IRRs in the SSA report are sharply overstated. That means many more beneficiaries with medium and higher earnings records would have returns in the 0% to 2% range, with more IRRs in the negative range for singles. Low earners, however, might still get returns in a range of 3% to 5%.

The SSA analysis attempts to demonstrate some limits to the risks faced by participants, given the scenarios involving a payroll tax increase or a benefits reduction in 2035. Nevertheless, there are additional political risks to the returns of certain classes of current and future retirees. For example, payroll taxes could be made much more progressive, benefits could be made subject to means testing, or indexing of benefits could be reduced. In fact, there are additional demographic risks that might confront retirees several decades ahead. Continued declines in fertility could further undermine the system’s solvency, requiring more drastic steps to shore up the system. As a hypothetical asset, by no means is SS “risk-free”.

Better Returns

Now let’s consider returns earned by private assets, which represent investments in productive capital. For stocks, these include the sum of all dividends and capital gains (growth in value). For compounding purposes, we assume that all returns are reinvested until retirement. Remember that private returns are much less variable over spans of decades than over durations of a few years. Over the course of 40 year spans (SSA’s career assumption), private returns have been fairly stable historically, and have been high enough to cushion investors from setbacks. Here is Seeking Alpha on annualized returns on the basket of stocks in the S&P 500:

“… the return on the S&P 500 since the beginning of valuation in 1928, is 10.22%, whereas the inflation-adjusted return on the market since that time is 7.01%…”

That real return would generate benefits far in excess of SS for most participants, but it’s not an adequate historical perspective on market performance. A more complete picture of real returns on the S&P, though one that is still potentially flawed, emerges from this calculator, which relies on data from Robert Shiller. The returns extend back to 1871, but the index as we know it today has existed only since 1957. The earlier returns tend to be lower, so these values may be biased:

Real stock market returns over rolling 40-year time spans varied considerably over this longer period. Still, those kind of stock returns would be superior to the IRRs in the SSA report going forward in all but a few cases (and then only for low and very low earners).

Most workers facing a choice between investing at these rates for 40 years, with market risk, and accepting standard SS benefits, uncertain as they are, couldn’t be blamed for choosing stocks. In fact, if we think of contributions to either type of plan as compounding to a hypothetical sum at retirement, the stock investments would produce a “pot of gold” several times greater in magnitude than SS.

However, we still don’t have a fair comparison because workers choosing a stock plan would essentially engage in a kind of dollar-cost averaging over 40 years, meaning that investments would be made in relatively small amounts over time, rather than investing a lump-sum at the beginning. This helps to smooth returns because purchases are made throughout the range of market prices over time, but it also means that returns tend to be lower than the 40-year rolling returns shown above. That’s because the average contribution is invested for only half the time.

To be very conservative, if we assume that real stock returns average between 5% and 6% annually, $1 invested every year would grow to between $131 – $155 after 40 years in constant dollars. At returns of 1% to 2% from SS, which I believe are typical of the IRRs for many medium earners, the cumulative “pot” would grow to $49 – $60. Assuming that the tax treatment of the stock plan was the same as contributions and benefits under SS, the stock plan almost triples your money.

Dealing With the Transition

Privatization covers a range of possible alternatives, all of which would require federal borrowing to pay transition costs. Unfortunately, the Achilles heel in all this is that now is a bad time to propose more federal borrowing, even if it has clear long-term benefits to future retirees.

Todd Henderson in the Wall Street Journal suggests a seeding of capital provided by government at birth along with an insurance program to smooth returns. Another idea is to offer an inducement to delay retirement claims by allowing at least a portion of future benefits to be taken as a lump sum. If retirees can privately invest at a more advantageous return, they might be willing to accept a substantial discount on the actuarial value of their benefits.

In fact, there is evidence that a majority of participants seem to prefer distributions of lump sums because they don’t value their future benefits at anything like that suggested by the SSA analysis. In fact, many participants would defer retirement by 1 – 2 years given a lump sum payment. Discounts and/or delayed claims would reduce the ultimate funding shortfall, but it would require substantial federal borrowing up front.

Additional federal borrowing would also be required under a private option for investing one’s own contributions for future dispersal. The impact of this change on the system’s long-term imbalances would depend on the share of earners willing to opt-out of the traditional SS program in whole or in part. More opt-outs would mean a smaller long-term obligations for the traditional system, but it would be hampered by a costly transition over a number of years. Starting from today’s PAYGO system, someone still has to pay the benefits of current retirees. This would almost certainly mean federal borrowing. Spreading the transition over a lengthy period of time would reduce the impact on credit markets, but the borrowing would still be substantial.

For example, perhaps earners under 35 years of age could begin opting out of a portion or all of the traditional program at their discretion, investing contributions for their own future use. Thus, only a small portion of contributions would be diverted in the beginning, and amounts diverted would contribute to the nation’s available pool of saving, helping to keep borrowing costs in check. By the time these younger earners reach retirement age, nearly all of today’s retirees will have passed on. Ultimately, the average retiree will benefit from higher returns than under the traditional program, but since they won’t be (fully) paying the benefits of current or near-term retirees, the public must come to grips with the bad promises of the past and fund those obligations in some other way: reduced benefits, taxes, or borrowing.

Another objection to privatization is financial risk, particularly for lower-income beneficiaries. Limiting opt-outs to younger earners with adequate time for growth would mitigate this risk, along with a reversion to the traditional program after age 45, for example. Some have proposed limiting opt-outs to higher earners. Bear in mind, however, that the financial risk of private accounts should be weighed against the political and demographic risk already inherent in the existing system.

One more possibility for bridging the transition to private, individually-controlled accounts is to sell federal assets. I have discussed this before in the context of funding a universal basic income (which I oppose). The proceeds of such sales could be used to pay the benefits of current and near-term retirees so as to allow the opt-out for younger workers. Or it could be used to pay off federal debt accumulated in the process. The asset sales would have to proceed at a careful and deliberate pace, perhaps stretching over several decades, but those sales could include everything from the huge number of unoccupied federal buildings to vast tracts of public lands in the west, student loans, oil and gas reserves, and airports and infrastructure such as interstate highways and bridges. Of course, these assets would be more productive in private hands anyway.

The Likely Outcome

Will any such privatization plan ever see the light of day? Probably not, and it’s hard to guess when anything will be done in Washington to address the insolvency we already face. Instead, we’ll see some combination of higher payroll taxes, higher payroll taxes on high earners through graduated payroll tax rates or by lifting the earnings cap, reduced benefits on further retirees, limits on COLAs to low career earners, and means-tested benefits. Some have mentioned funding Social Security shortfalls with income taxes. All of these proposals, with the exception of automatic benefit cuts in 2035, would require acts of Congress.

The House GOP Tax Plan’s Disparate Treatment of Income Sources

09 Thursday Nov 2017

Posted by Nuetzel in Taxes

≈ 2 Comments

Tags

Bernie Sanders, Bubble Tax, corporate income tax, Double Taxation, FICA Tax, House GOP Tax Plan, Investment Incentives, Obamacare Surtax, Pass-Through Income, Scott Sumner, Tax Burden, Tax Incentives

Update: In writing the following post, I neglected to devote sufficient attention to the rules that would govern taxation of pass-through income under the House GOP tax plan. Those rules significantly alter some of the conclusions below. Those rules are discussed in a later post: Stumbling Through Pass-Through Tax Reform.

Double taxation of corporate income is a feature of the U.S. income tax code that is partially addressed in the tax reform bill proposed by the House GOP. Corporate income is taxed to the firm and again to owners on their receipt of dividends or when a company’s growth results in capital gains. Ultimately, the total rate of taxation matters more than whether it is implemented as single or double taxation of income flows. However, there is an unfortunate tendency to view corporate taxes as if they are levied on entitites wholly separate from their owners, so double taxation carries a stench of politically sneakiness. It also creates multiple distortions in the decisions of investors and the separately managed firms they own.

Non-corporate income taxation is reduced by the House plan even more substantially than the cut in taxes on corporate-derived income. However, the plan does not reduce taxes on high-earning professionals, many of whom are situated similarly to successful business owners and investors from an economic perspective.

Tax Burdens and Distortions

The federal corporate tax is not borne 100% by shareholders, as discussed in the previous post on Sacred Cow Chips. Some part of the burden is borne by labor via reduced wages. It is difficult to correct for this distortion in terms of calculating an effective marginal tax rate on corporate income. For example, suppose a new 35% tax would reduce corporate income from $100 to $65. The firm finds, however, that it can reduce wage payments by half of the expected tax payment, or $17.50. The firm would now earn $117.50 before tax and $76.38 after tax. Relative to the new level of pre-tax income, the tax rate is still 35%. It is no less than that by way of the reduction in wages, though the impact on the firm’s pre-tax income is mitigated.

The discussion here of tax rates, and even double taxation, is not intended as commentary on tax fairness. It might or might not be fair that the burden of the tax is shared with labor. Instead, the issue is the magnitude of the economic distortions caused by taxes. Tax rates themselves are a reasonable starting point for such a discussion, and they are easy to measure. Lower tax rates beget fewer distortions in economic outcomes than high tax rates. Low rates provide greater incentives to save and invest in productive assets, which enhances labor productivity, wages, and economic growth. Indeed, businesses go to great lengths to avoid taxes altogether, if possible, but typically those are non-productive uses of resources, which demonstrates the very distortions at issue.

Current and Proposed Marginal Tax Rates

Under current law, the top personal income tax rate on dividends is 20%. It is 23.8% if we include the Obamacare surtax. Adding that to the corporate rate yields the effective top tax rate paid by shareholders: 23.8% + 35% = 58.8%. The GOP bill does not alter the 23.8% top rate on dividends or capitals gains. By virtue of the corporate tax reduction, however, the plan would reduce the overall top rate on shareholders to 23.8% + 20% = 43.8%.

The income earned by investors in pass-through entities like proprietorships, partnerships and S-corporations is taxed as personal income under current law at rates ranging from 15% to 39.6% (43.4% at the top, including the surtax). Thus, under present law, the owner of a pass-through company is taxed less heavily at the top rate than the owner of a public company (43.4% vs. 58.8%). (I am ignoring the 15.3% FICA payroll tax owed by self-emloyed individuals in proprietorships or partnerships on incomes up to $127,200, and 2.9% above that level. The combined tax rates would be almost equal even if we include the FICA tax.)

The tax on pass-through business income would be reduced under the GOP bill via a cap of 25% on federal business income taxes. Presumably, this cap would nullify the House plan’s “bubble tax” of 6% on personal income between $1.2 million and $1.6 million of income, as well as the Obamacare surtax. Thus, the tax advantage for pass-through entities over corporations would be somewhat wider under the House plan than under current law (25% vs. 43.4%). (The FICA tax on owners of proprietorships and partnerships would not quite equalize the overall marginal tax rates over a certain income range.)

In addition, the House plan rewards the owners of pass-through businesses relative to individuals earning high levels of wage and salary income. If anything, the bill would penalize these individuals. For example, while the owner of a high-earning pass-through would face a 25% tax rate, a high-earning professional or corporate employee would pay the top marginal rate (39.6%) plus the surtax (3.8%) and possibly the bubble tax (6%). This is one reason why Scott Sumner says it looks as if the House plan was designed by Bernie Sanders!

The Upshot

The tax system should be neutral across different sources of income. Divergent effective tax rates on owners of corporations, pass-throughs, and high wage-earning individuals is undesirable and introduces arbitrary elements into private decision-making. If anything, the House GOP tax plan exacerbates those differences. By cutting marginal tax rates, it would reduce the magnitude of business tax distortions both for corporate and pass-through organizations and their owners, but the relative advantage of pass-throughs would increase relative to corporations, and owners of corporations and pass-throughs benefit relative to high-earning individuals. Let’s hope this is fixed as the bill evolves, but more balanced reductions in rates would require higher rates on business owners than contemplated in the current plan.

Saving Social Security

14 Friday Oct 2016

Posted by Nuetzel in Privatization, Social Security

≈ 2 Comments

Tags

Disablity, FICA Tax, Redistribution, Self-Directed Investments, Social Insurance, Social Security, Social Security Privatization, Social Security Returns, Social Security Trust Fund, Survivors' Benefits

madoff

Social Security benefit levels are anything but sure for current workers, given the likelihood of benefit cuts to preserve the long-term solvency of the system. In fact, even without those cuts, Social Security provides very poor yields for retirees on their lifetime contributions. Instead of a tradeoff between risk and return, the system offers bad outcomes along both dimensions: lousy benefit levels that are not at all “safe”.

To get a clear sense of just how bad the returns on Social Security contributions (i.e., FICA tax deductions) truly are, take a look at this Sacred Cow Chips post from late 2015: “Stock Crash At Retirement? Still Better Than Social Security“. According to the Social Security Administration’s own calculations, without any future changes in the program, a retiree can expect to get back 1 to 4 times their lifetime contributions (obviously, this is not discounted). If you think that’s acceptable, consider a real alternative:

“Suppose you are given an option to invest your FICA taxes (and your employer’s [FICA] contributions) over your working life in a stock market index fund. After 40 years or so, based on historical returns, you’ll have stashed away about 12 – 18 times your total contributions (that range is conservative — 40 years through 2014 would have yielded 19x contributions). A horrible preretirement crash might leave you with half that much.“

Allowing workers to self-direct their contributions over a lengthy working life, whether they invest in equities, government bonds, or other assets, holds much more promise  as a way to provide for their retirement needs.

As for risk, projected benefit levels are worse when possible program changes are considered. It’s widely accepted that changes must be made to the way contributions by current workers are handled and how future benefits are determined, or else the system’s value to them will be a greatly diminished. The Social Security Trust Fund, which once funded government deficits via FICA surpluses over benefit disbursements (while the demographics of the labor force allowed), has dwindled, and it has never been invested to earn the returns necessary for long-term solvency. Shall today’s workers face later eligibility? Reduced benefit levels? Or both? Or can we face up to the reality that workers will do better by choosing the way their funds are invested?

The contributions of today’s workers are paid out directly to current retirees. This practice must be modified, but the nation still faces a large and immediate liability to current retirees. How will it be paid if the system is overhauled to allow self-directed investment alternatives? Current workers must pay for some portion of that liability, but that portion could be phased out over several decades. The transition, however, would initially require additional taxes, borrowing, or voluntary conversion by some retirees to a discounted cash-balance equivalent, much as most private sector defined-benefit pensions have been converted to cash-balance equivalents.

Ultimately, workers should benefit from their own individual contributions. One objection is that self-directied investments and “privatization” of one’s own contributions would cause the system to lose its function as social insurance. Recall, however, that eligibility for benefits requires contributions, so it is not a general program of assistance. Nevertheless, there are several ways in which Social Security fulfills an insurance function. In a strong sense, it provides insurance against the risk of failure to save for retirement. More fundamentally, disabled workers can qualify for benefits, and the dependents of a deceased contributor are also eligible (survivors’ benefits). In addition, the current system provides greater returns to individuals with relatively low contributions. Under self-direction, these features could be retained via minor redistributional elements applied to investment returns, particularly given the superior returns available to equities over periods of sufficient length.

When U.S. politicians discuss the future of Social Security, they usually say they’ll fight against the dark intent of those who wish to take away hard-earned benefits from seniors. This despite the fact that few (if any) observers have suggested cutting benefits for current retirees, or even for those now approaching eligibility. The self-righteous proclamations about protecting retirees are a dodge that avoids the need to take a position on dealing with the system’s insolvency. But an easy answer is available: reform the system by allowing workers to self-direct their contributions into more promising investment vehicles.

Social Security: Saving or Tax? Proceeds or Aid?

17 Monday Aug 2015

Posted by Nuetzel in Big Government

≈ 3 Comments

Tags

CATO Institute, Federal entitlements, FICA Tax, George W. Bush, Lump Sum vs. Annuity, Michael Tanner, Michigan Retirement Research Center, National Bureau of Economic Research, NBER, payroll taxes, Privatization, retirement, Social Safety Net, Social Security Privatization, Social Security Trust Fund, Treasury Special Purpose Bonds, Welfare Payments

SOCSEC Negative Return

In general parlance, an entitlement is a thing to which one is entitled. If you have paid into Social Security (FICA payroll “contributions”), you should feel entitled to receive benefits one day. Why do I so often hear indignant complaints about the use of the term “entitlement” when applied to Social Security and Medicare? I’ve heard it from both ends of the political spectrum, but more often from the Left. It is usually accompanied by a statement about having “paid for those benefits!”. Exactly, you should feel entitled to them. You are not asking society to pay you alms!

Yet there seems to be resentment of an imagined implication that such “entitlements” are equivalent to “welfare” of some kind. That might be because the definition of an entitlement is somewhat different in the federal budget: it is a payment or benefit for which Congress sets eligibility rules with mandatory funding, as contrasted with discretionary budget items with explicit approval of funding. Because payments are based solely on eligibility, Social Security, Medicare and many forms of welfare benefits are all classified as entitlements in the federal budget. Obviously, those complaining about the use of the term in connection with Social Security believe there is a difference between their entitlement and welfare. But as long as they are willing to leave their “contributions” and future eligibility in the hands of politicians, their claim on future benefits is tenuous. Yes, you will pay FICA TAXES, and then you might be paid benefits (alms?) if you are eligible at that time. Certainly, the government has behaved as if the funds are fair game for use in the general budget.

Having made that minor rant, I can get to another point of this post: the Social Security retirement system offers terrible returns for its “beneficiaries”. Furthermore, it is insolvent, meaning that its long-term promises are, and will remain, unfunded under the current program design. However, there is a fairly easy fix for both problems from an economic perspective, if not from a political perspective.

The chart at the top of this post shows that Social Security benefits paid to eligible retirees are less than the payroll taxes those same individuals paid into the system. The chart is a couple of years old, but the facts haven’t changed. It’s boggling to realize that you’ll receive a negative return on the funds after a lifetime of “contributions”. That kind of investment performance should be condemned as unacceptable. However, you should know that the program is not “invested” in your retirement at all! Social Security’s so-called “trust fund” is almost a complete fiction. Most FICA tax revenue is not held “in trust”. Instead, it is paid out as an intergenerational transfer to current retirees. In the past, any surplus FICA tax revenue was invested in U.S. Treasury special purpose bonds, which funded part of the federal deficit. Here is a fairly good description of the process. The article quotes the Clinton Office of Management and Budget in the year 2000:

“These balances are available to finance future benefit payments … only in a bookkeeping sense. They do not consist of real economic assets that can be drawn down in the future to fund benefits. Instead, they are claims on the Treasury that, when redeemed, will have to be financed by raising taxes, borrowing from the public, or reducing benefits, or other expenditures.“

Unfortunately, for the past few years, instead of annual surpluses for the trust fund, deficits have been the rule and they are growing. Retiring baby boomers, longer life expectancies, slow income growth and declining labor force participation are taking a toll and will continue to do so. Something will have to change, but reform of any kind has been elusive. An important qualification is that almost any reform would have to be phased in as a matter of political necessity and fairness to current retirees. Unfortunately, just about every reform proposal I’ve heard has been greeted by distorted claims that it would harm either current retirees or those nearing retirement. In fact, leaving the program unaltered is likely to be a greater threat to everyone down the road.

There are three general categories of reform: higher payroll taxes, lower benefits, and at least partial privatization. Tax increases have obvious economic drawbacks, while straight benefit reductions would be harmful to future recipients even if that entailed means testing: the return on contributions is already negative, especially at the upper end of the income spectrum. Michael Tanner discusses specific options within each of these categories, including raising the normal and early retirement ages. None of the options close the funding gap, but at least higher retirement ages reflect the reality of longer life expectancies.

Early in his presidency, the George W. Bush administration offered a reform plan involving no tax increases or benefit cuts. Instead, the plan would have offered voluntary personal accounts for younger individuals. Needless to say, it was not adopted, but it would have kept the system in better shape than it is today. The key to success of any privatization is that unlike the Social Security Trust Fund, workers with private accounts can earn market returns on their contributions, which are in turn reinvested, allowing the accounts to grow faster over time. Tanner notes that 20 other countries have moved to private accounts including Chile, Australia, Mexico, Sweden, Poland, Latvia, Peru, and Uruguay. This sort of change does not preclude a separate social safety net for those who have been unable to accumulate a minimum threshold of assets, as Chile has done. Tanner’s article lays out details of a tiered plan that would allow participants a wider range of investments as their accumulated assets grow.

Economic research suggests that participants do not place a high value on their future benefits. From a 2007 National Bureau of Economic Research (NBER) paper by John Geanakoplos and Stephen Zeldes entitled “The Market Value of Social Security“:

“We find that the difference between market valuation and ‘actuarial’ valuation is large, especially when valuing the benefits of younger cohorts. … The market value of accrued benefits is only 2/3 of that implied by the actuarial approach.“

An implication is that younger workers who have already made contributions could be offered the choice of a future lump sum that is less than the actuarial present value of their benefits when they become eligible. Such a program could cut the long-term funding gap significantly, if the results found by Geanakoplos and Zeldes can be taken at face value, though it could create additional short-term funding pressure at the time of payment.

Qualified support for such a program seems apparent from another 2007 NBER paper by Jeffrey R. Brown, Marcus D. Casey and Olivia S. Mitchell entitled “Who Values the Social Security Annuity? New Evidence on the Annuity Puzzle“. They find that:

“Our first finding is that nearly three out of five respondents favor the lump-sum payment if it were approximately actuarially fair, a finding that casts doubt on several leading explanations for why more people do not annuitize. Second, there is some modest price sensitivity and evidence consistent with adverse selection; in particular, people in better health and having more optimistic longevity expectations are more likely to choose the annuity. Third, after controlling on education, more financially literate individuals prefer the annuity. Fourth, people anticipating future Social Security benefit reductions are more likely to choose the lump-sum, suggesting that political risk matters.“

Moreover, lump sums may offer an additional advantage from a funding perspective: a 2012 paper from the Michigan Retirement Research Center at the University of Michigan by Jingjing Chai, Raimond Maurer, Olivia S. Mitchell and Ralph Rogalla called “Exchanging Delayed Social Security Benefits for Lump Sums: Could This Incentivize Longer Work Careers?” found that “... workers given the chance to receive their delayed retirement credit as a lump sum payment would boost their average retirement age by l.5-2 years.”

Certainly, it would be difficult for private accounts to fare as badly in terms of returns on contributions than the system has managed to date. The future appears even less promising without reform. There are several advantages to privatization of Social Security accounts beyond the likelihood of higher returns mentioned above: it would avoid some of the labor market distortions that payroll taxes entail, and it would increase the pool of national savings. Perhaps most importantly, over time, it would release the assets (and future benefits) accumulated by workers from the clutches of the state and self-interested politicians. They are not entitled to pursue their political ends with those assets; they are yours!

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