Social Insurance, Trust Fund Runoff, and Federal Debt

28 Thursday Apr 2022

Posted by pnoetx in Deficits, Social Security

Tags

Anti-Deficiency Act, Charles Blahous, Deficits, DI, Disability Income, Discretionary Budget, entitlements, Federal Reserve, Fiscal Inflation, Fiscal Tiger, Hospitalization Insurance, Joe Biden, Mandatory Spending, Medicaid, Medicare Part A, Medicare Part B, Medicare Part D, Medicare Reform, Medicare Trust Fund, Monetization, OASI, Old Age and Survivorship Income, Pay-As-You-Go, payroll taxes, SMI, Social Security Reform, Social Security Trust Fund, Student Loan Forgiveness, Supplementary Medical Insurance

The Social Security and Medicare trust funds are starting to shrink, but as they shrink something else expands in tandem, roughly dollar-for-dollar: government debt. There is a widespread misconceptions about these entitlement programs and their trust funds. Many seem to think the trust funds are like “pots of gold” that will allow the government to meet its mandatory obligations to beneficiaries. But, in fact, the government will have to borrow the exact amounts of any “assets” that are “cashed out” of the trust funds, barring other reforms or legislative solutions. So how does that work? And why did I put the words “assets” and “cashed out” in quote marks?

The Trust Funds

First, I should note that there are two Social Security trust funds: one for old age and survivorship income (OASI) and one for disability income (DI). Occasionally, for summary purposes, the accounts for these funds are combined in presentations. There are also two Medicare trust funds: one for hospitalization insurance (HI – Part A) and one for Supplementary Medical Insurance (SMI – Parts B and D). The first three of these trust funds are represented in the chart at the top of this post, which is from the Summary of the 2021 Annual Reports by the Boards of Trustees. It plots a measure of financial adequacy: the ratio of trust fund assets at the start of each year to the annual cost. The funds are all projected to be depleted, HI and OASI much sooner than DI.

Fund Accumulation

The first step in understanding the trust funds requires a clearing up of another misconception: the payroll taxes that workers “contribute” to these systems are not invested specifically for each of those workers. These programs are strictly “pay-as-you-go”, meaning that the payroll taxes (and premiums in the case of Medicare) paid this year by you and/or your employer are generally distributed directly to current beneficiaries.

Back when demographics of the American population were more favorable for these programs, with a larger number of workers relative to retirees, payroll taxes (and premiums) exceeded benefits. The excess was essentially loaned by these programs to the U.S. Treasury to cover other forms of spending. So the trust funds accumulated U.S. Treasury IOUs for many years, and the Treasury pays interest to the trust funds on that debt. On the upside, that meant the Treasury had to borrow less from the public to cover its deficits during those years. So the government spent the excess payroll tax proceeds and wrote IOUs to the trust funds.

Draining the Funds

The demographic profile of the population is no longer favorable to these entitlement programs. The number of retirees has increased so that benefit levels have grown more quickly than program revenue. Benefits now exceed the payroll taxes and premiums collected, so the trust funds must be drawn down. Current estimates are that the Social Security Trust Fund will be depleted in 2034, while the Medicare Trust Fund will last only to 2026. These dates are reflected in the chart above. It is the mechanics of these draw-downs that get to the heart of the first “pot of gold” misconception cited above.

To pay for the excess of benefits over revenue collected, the trust funds must cash-in the IOUs issued to them by the Treasury. And where does the Treasury get the cash? It will almost certainly be borrowed from the public, but the government could hike other forms of taxes or reduce other forms of spending. So, while the earlier accumulation of trust fund assets meant less federal borrowing, the divestment of those assets generally means more federal borrowing and growth in federal debt held by the public.

Given these facts, can you spot the misconception in this quote from Fiscal Tiger? It’s easy to miss:

“In the cases of Social Security, Medicare, and Medicaid, payroll taxes provide some revenue. Social Security also has trust funds that cover some of the program costs. However, when the government is short on funds for these programs after getting the revenue from taxes and trust funds, it must borrow money, which contributes to the deficit.”

This kind of statement is all too common. The fact is the government has to borrow in order to pay off the IOUs as the trust funds are drawn down, roughly dollar-for-dollar.

A second mistake in the quote above is that federal borrowing to pay excess benefits after the trust funds are fully depleted is not really assured. At that time, the Anti-deficiency Act prohibits further payments of benefits in excess of payroll taxes (and premiums), and there is no authority allowing the trust funds to borrow from the general fund of the Treasury. Either benefits must be reduced, payroll taxes increased, premiums hiked (for Medicare), or more radical reforms will be necessary, any of which would require congressional action. In the case of Social Security (combining OASI and DI), the projected growth of “excess benefits” is such that the future, cumulative shortfall represents 25% of projected benefits!

Again, the mandatory entitlement spending programs are technically insolvent. Charles Blahous discusses the implications of closing the funding gap, both in terms of payroll tax increases or benefit cuts, either of which will be extremely unpopular:

“How likely is it that lawmakers would immediately cut benefits by 25% for everyone, rich and poor, retiring next year and beyond? More likely, lawmakers would phase in reforms gradually, necessitating much larger eventual benefit changes for those affected—perhaps 30% or 40%. And if we want to spare lower-income individuals from reductions, they’d need to be still greater for everyone else.”

It should be noted that Medicaid is also a budget drain, though the cost is shared with state governments.

Discretionary vs. Mandatory Budgets

When it comes to federal budget controversies, discretionary budget proposals receive most of the focus. The federal deficit reached unprecedented levels in 2020 and 2021 as pandemic support measures led to huge increases in spending. Even this year (2022), the projected deficit exceeds the 2019 level by over $160 billion. Joe Biden would like to spend much more, of course, though the loss of proceeds from his student loan forgiveness giveaway does not even appear in the Administration’s budget proposal. Biden proposes to pay for the spending with a corporate tax hike and a minimum tax on very high earners, including an unprecedented tax on unrealized capital gains. Those measures would be disappointing in terms of revenue collection, and they are probably worse for the economy and society than bigger deficits. None of that is likely to pass Congress, but we’ll still be running huge deficits indefinitely..

In a further complication, at this point no one really believes that the federal government will ever pay off the mounting public debt. More likely is that the Federal Reserve will make further waves of monetization, buying government bonds in exchange for monetary assets. (Of course, money is also government debt.) The conviction that ever increasing debt levels are permanent is what leads to fiscal inflation, which taxes the public by devaluing the public debt, including (or especially) monetary assets. The insolvency of the trust funds is contributing to this process and its impact is growing..

Again, the budget discussions we typically hear involve discretionary components of the federal budget. Mandatory outlays like Social Security, Medicare, and Medicaid are nearly three times larger. Here is a good primer on the mandatory spending components of the federal budget (which includes interest costs). Blahous notes elsewhere that the funding shortfall in these programs will ultimately dwarf discretionary sources of budgetary imbalance. The deficit will come to be dominated by the borrowing required to fund mandatory programs, along with the burgeoning cost of interest payments on the public debt, which could reach nearly 50% of federal revenues by 2050.

Conclusion

It would be less painful to address these funding shortfalls in mandatory programs immediately than to continue to ignore them. That would enable a more gradual approach to changes in benefits, payroll taxes, and premiums. Politicians would rather not discuss it, however. Any discussion of reforms will be controversial, but it’s only going to get worse over time.

Political incentives being what they are, current workers (future claimants) are likely to bear the brunt of any benefit cuts, rather than retirees already enrolled. Payroll tax hikes are perhaps a harder sell because they are more immediate than trimming benefits for future retirees. Other reforms like self-directed Social Security contributions would create better tradeoffs by allowing investment of contributions at competitive (but more risky) returns. Medicare has premiums as an extra lever, but there are other possible reforms.

Again, the time to act is now, but don’t expect it to happen until the crisis is upon us. By then, our opportunities will have become more hemmed in, and something bad is more likely to be promulgated in the rush to save the day.

If You’re Already Eligible, Your Benefits Are Safe

06 Tuesday Nov 2018

Posted by pnoetx in Medicare, Social Security

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Asset Sales, COLA, Defined Benefits, Defined Contributions, Entitlement Reform, Federal Borrowing, Medicare, Medicare Advantage, Pay-As-You-Go, Paygo, payroll taxes, Social Security, Social Security Trust Fund, Swedish Public Pensions

I’m always hearing fearful whines from several left-of-center retirees in my circle of my acquaintances: they say the GOP wants to cut their Social Security and Medicare benefits. That expression of angst was reprised as a talking point just before the midterm election, and some of these people actually believe it. Now, I’m as big a critic of these entitlement programs as anyone. They are in very poor financial shape and in dire need of reform. However, I know of no proposal for broad reductions in Social Security and Medicare benefits for now-eligible retirees. In fact, thus far President Trump has refused to consider substantive changes to these programs. And let’s not forget: it was President Obama who signed into law the budget agreement that ended spousal benefits for “file and suspend” Social Security claimants.

Both Social Security (SS) and Medicare are technically insolvent and reform of some kind should happen sooner rather than later. It does not matter that their respective trust funds still have positive balances — balances that the federal government owes to these programs. The trust fund balances are declining, and every dollar of decline is a dollar the government pays back to the programs with new borrowing! So the trust funds should give no comfort to anyone concerned with the health of either of these programs or federal finances.

Members of both houses of Congress have proposed steps to shore up SS and Medicare. A number of the bills are summarized and linked here. The range of policy changes put forward can be divided into several categories: tax hikes, deferred benefit cuts, and other, creative reforms. Future retirees will face lower benefits under many of these plans, but benefit cuts for current retirees are not on the table, except perhaps for expedient victims at high income levels.

There is some overlap in the kinds of proposals put forward by the two parties. One bipartisan proposal in 2016 called for reduced benefits for newly-eligible retired workers starting in 2022, among a number of other steps. Republicans have proposed other types of deferred benefit cuts. These include increasing the age of full eligibility for individuals reaching initial (and partial) eligibility in some future year. Generally, if these kinds of changes were to become law now, they would have their first effects on workers now in their mid-to-late fifties.

Another provision would switch the basis of the cost-of-living adjustment (COLA) to an index that more accurately reflects how consumers shift their purchases in response to price changes (see the last link). The COLA change would cause a small reduction in the annual adjustment for a typical retiree, but that is not a future benefit reduction: it is a reduction in the size of an annual benefit increase. However, one Republican proposal would eliminate the COLA entirely for high-income beneficiaries (see the last link) beginning in several years. A few other proposals, including the bipartisan one linked above, would switch to an index that would yield slightly more generous COLAs.

Democrats have favored increased payroll taxes on current high earners and higher taxes on the benefits of wealthy retirees. Republicans, on the other hand, seem more willing to entertain creative reforms. For example, one recent bill would have allowed eligible new parents to take benefits during a period of leave after childbirth, with a corresponding reduction in their retirement benefits (in present value terms) via increases in their retirement eligibility ages. That would have almost no impact on long-term solvency, however. Another proposal would have allowed retirees a choice to take a portion of any deferred retirement credits (for declining immediate benefits) as a lump sum. According to government actuaries, the structure of that plan had little impact on the system’s insolvency, but there are ways to present workers with attractive tradeoffs between immediate cash balances and future benefits that would reduce insolvency.

The important point is that enhanced choice can be in the best interests of both future retirees and long-term solvency. That might include private account balances with self-directed investment of contributions or a voluntary conversion to a defined contribution system, rather than the defined benefits we have now. The change to defined contributions appears to have worked well in Sweden, for example. And thus far, Republicans seem more amenable to these creative alternatives than Democrats.

As for Medicare, the only truth to the contention that the GOP, or anyone else, has designs on reducing the benefits of current retirees is confined the to the possibility of trimming benefits for the wealthy. The thrust of every proposal of which I am aware is for programmatic changes for future beneficiaries. This snippet from the Administration’s 2018 budget proposal is indicative:

“Traditional fee-for-service Medicare would always be an option available to current seniors, those near retirement, and future generations of beneficiaries. Fee-for-service Medicare, along with private plans providing the same level of health coverage, would compete for seniors’ business, just as Medicare Advantage does today. The new program, however, would also adopt the competitive structure of Medicare Part D, the prescription drug benefit program, to deliver savings for seniors in the form of lower monthly premium costs.”

There was a bogus claim last year that pay-as-you-go (Paygo) rules would force large reductions in Medicare spending, but Medicare is subject to cuts affecting only 4% of the budgeted amounts under the Paygo rules, and Congress waived the rules in any case. Privatization of Medicare has provoked shrieks from certain quarters, but that is merely the expansion of Medicare Advantage, which has been wildly popular among retirees.

Both Social Security and Medicare are in desperate need of reform, and while rethinking the fundamental structures of these programs is advisable, the immediate solutions offered tend toward reduced benefits for future retirees, later eligibility ages, and higher payroll taxes from current workers. The benefits of currently eligible retirees are generally “grandfathered” under these proposals, the exception being certain changes related to COLAs and Medicare benefits for high-income retirees. The tendency of politicians to rely on redistributive elements to enhance solvency is unfortunate, but with that qualification, my retiree friends need not worry so much about their benefits. I suspect at least some of them know that already.

You’re Entitled To Better Returns Than Social Security

08 Monday Jan 2018

Posted by pnoetx in Social Security

≈ 1 Comment

Tags

AARP, Baby Boom Retirement, Brenton Smith, CATO Institute, Disability Insurance Fund, Earnings Test, Entitlement Reform, Federal Asset Sales, FICA Payroll Taxes, Insolvency, Lance Robert, Longevity Indexing, Michael Tanner, OASDI, Private Accounts, Rep. Sam Johnson, Social Security, Social Security Trust Fund

It’s one thing for indignant seniors (or anyone nearing retirement) to defend the crappy returns they get on their lifetime Social Security payroll taxes … er, contributions, against the arguments of reformers. It’s another for younger individuals to rant about the threat to the crappy returns they will get while resisting an idea for reform that would almost certainly improve their eventual well-being: privatization. Both of the aforementioned reactions are marked by confusion over the use of the word “entitlement” in federal budgeting, though in another sense, entitlement is manifested in the very defensiveness of the reform critics. At its root, this self-righteous naiveté is a product of ignorance about the program, its insolvency, how its rewards compare to private savings, and longstanding media propaganda favoring big government as grubstaker… because it feels virtuous.

There’s really not much to like about Social Security, though the status quo will always appeal to some.

Insolvency: The trust fund held $2.7 trillion of reserves at the end of 2016, but benefit payments are growing faster than contributions (plus interest on the public bonds held by the fund). The wave of retiring baby boomers and increasing longevity (and a declining number of workers per retiree) are placing a strain on the system. According to the trustees, depletion of the fund will begin in earnest in 2022, and the Old Age Survivors and Disability Insurance (OASDI) fund will be exhausted by 2034. This might be delayed if the economy and employment grow faster than expected. The actuarial deficit through 2091 is $12.5 trillion, as Brenton Smith notes in this post.

The returns are lousy: Two years ago, I posted an examination of the returns earned on Social Security “contributions” in: “Stock Crash at Retirement? Still Better Than Social Security“. The title is an accurate summary of the conclusions.

“Suppose you are given an option to invest your FICA taxes (and your employer’s 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. At the low-end, you might have as little as 4.5 times contributions if the crash is as bad as the market decline of 1929-32. That would be very bad.

But you don’t have that option under current law. Instead, the return you can expect from Social Security will leave you with only 1 to 4 times your contributions — without further changes in the program — based on your current age, lifetime earnings, marital status and retirement age. The latter range is based on the Social Security Administration’s (SSA’s) own calculations, as quoted in ‘Social Security: Saving or Tax? Proceeds or Aid‘ on Sacred Cow Chips.”

Reforms? The prototypical reform proposals always involve cutting benefits or raising taxes in one way or another. No wonder there is so much suspicion among the public! For seniors and near-retirees, the lousy returns noted above are at least fairly certain: generally, reform proposals haven’t applied to those of age 55+. Nonetheless, those projected returns are not a promise. There is a risk that the benefits could be changed or eroded by Congress, as discussed here by Lance Robert. For youngsters, the returns are much more uncertain, and changing the structure of distant benefits is always more politically palatable.

Examples of typical reform proposals include delaying the age at which benefits can be claimed, increasing the income cap on payroll taxes, and changing the way in which benefits are indexed to inflation. Many of the “new ideas” shown at this link are variations on finding additional tax revenue or delaying benefits. Rep. Sam Johnson has proposed a set of fairly conventional reforms, including gradual increases in the retirement age and elimination of the earnings test, so that some income could be earned without reducing benefits. Also, Johnson’s plan would redistribute benefits toward low-income beneficiaries. AARP provides a summary of 12 proposals, one of which is to index benefits for life expectancy at each age: as expected longevity increases, annual benefits would decrease. There are other proposals with a strongly redistribution aspect, such as reducing benefits for those with high lifetime earnings or means-testing benefits.

Better ideas: There are currently some incentives in place for retirees to delay benefits for a few years, and some of the proposals at the “new ideas” link would attempt to strengthen those rewards. Another idea mentioned there is to offer an inducement to delay claims by allowing at least a portion of future benefits to be taken as a lump sum. This is more novel and has greater potential savings to the system in a world with increasing longevity. To the extent that retirees can privately invest at more advantageous returns, they might be willing to accept a substantial discount on the actuarial value of their benefits.

The interests of future beneficiaries would be served most effectively by allowing them to choose between contributing to the traditional program or setting a portion of their contributions aside in a private account. These accounts would give individual workers flexibility over investment direction. As discussed above, better returns than the traditional program can be had with near-certainty given sufficient time until retirement. Michael Tanner at CATO is correct in insisting that workers control their own accounts should they opt-out of the traditional program. And the government itself should stay out of private capital markets.

It is this proposal that is always greeted with the most vitriol by opponents of reform. The very idea of private accounts seems to them an affront. One explanation is the fear of financial risk, but this would be mitigated by limiting the opt-out to younger workers with adequate time for growth. Another explanation is the fear that lower-income beneficiaries would not fare well under this reform. In fact, there is a strong semblance of redistribution in the system’s existing benefit formulas, but these features do not amount to much once adjusted for the differing life expectancies of income groups and the benefits paid to survivors. There is no reason, however, why the private account option would prevent redistribution through the traditional portion of contributions. Moreover, there is value in creating greater transparency when it comes to redistribution, as it promotes more effective scrutiny.

Funding: Unfortunately, the Social Security program has long relied on funding current benefits to retirees with dollars contributed by current workers. This is one of the biggest areas of misunderstanding on the part of the public. Allowing workers to opt-out would improve the long-term benefits received by those retirees, but it would also remove a portion of the funding for current retirees, thus accelerating a portion of the system’s unfunded obligations. A similar acceleration of the funding gap would accompany any reform to discount future benefits in exchange for payment of a lump sums in advance. The tradeoff is favorable over a time horizon lengthy enough to cover the retirement of today’s younger workers, but the near-term shortfall can only be met by reduced benefits, borrowing, or new sources of funds.

Asset Sales: The best option for bridging the funding needs of a 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, however, could be used to pay the benefits of current and near-term retirees so as to allow the opt-out for younger workers. The asset sales would have to proceed at a careful and deliberate pace, perhaps stretching over a decade or more, but those sales could include everything from 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. In 2011, it was estimated that the federal government owned $1.6 trillion worth of liquid assets alone. The value of less liquid federal assets would be in the many trillions of dollars. (Read this eye-opening assessment of federal assets.) Of course, these assets would be more productive in private hands.

Sustainability: The outrage greeting ideas for entitlement reform largely denies the economic reality of inadequate funding. Social Security is just one example of an unsustainable entitlement program. Few participants in the system seem to realize that their benefits are paid out of contributions made by current workers, or that surpluses of the past were simply borrowed by the government and used to fund other spending. It was sustainable only with a sufficient number of contributing workers to support a stable class of retiree-beneficiaries. It cannot withstand an expanding class of longer-living beneficiaries relative to the labor force.

Ideally, reform would address the system’s insolvency as well as the weak returns to beneficiaries on their payments into the system. Self-direction and individual control over at least a portion of invested contributions should be viewed as a long-term fix for both. It will yield much better returns than the traditional system, but for workers this depends on the amount of time remaining until retirement. Young workers can elect to opt-out of the traditional system at little risk because they have the time to invest over several market cycles, but older workers must be circumspect. In any case, it is unlikely that politicians would take the chance of allowing older workers to opt-out, then face a potential backlash after a market downturn.

The insolvency problem, and the short-term funding shortfall created via the opt-out alternative, require hard decisions, but asset sales can bridge a large part of the gap, if not all of it. Lump-sum benefit payments might also be made at a savings, but they would worsen the short-term gap between benefit payments and contributions. In the long-run, the tradeoffs would become more favorable as today’s young workers age and retire with the more handsome returns available via individually-controlled and privately-invested accounts.

Saving Social Security

14 Friday Oct 2016

Posted by pnoetx 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

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.

Stock Crash At Retirement? Still Better Than Social Security

30 Wednesday Dec 2015

Posted by pnoetx in Social Security

≈ 3 Comments

Tags

Economic Policy Journal, Jeremy Siegel, Medicare Returns, payroll taxes, Restricted Application filing, Revocation of Benefits, Social Security, Social Security Administration, Social Security Privatization, Social Security Returns, Social Security Trust Fund

That’s right! Suppose you are given an option to invest your FICA taxes (and your employer’s 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. At the low-end, you might have as little as 4.5 times contributions if the crash is as bad as the market decline of 1929-32. That would be very bad.

But you don’t have that option under current law. Instead, the return you can expect from Social Security will leave you with only 1 to 4 times your contributions — without further changes in the program — based on your current age, lifetime earnings, marital status and retirement age. The latter range is based on the Social Security Administration’s (SSA’s) own calculations, as quoted in “Social Security: Saving or Tax? Proceeds or Aid” on Sacred Cow Chips.

Social Security, billed as the most reliable source of retirement income because it is not dependent on market risk — would almost certainly buy you less than a private investment even when a horrible market outcome is factored in immediately prior to retirement. Keep in mind that this is an unfair baseline for equity investments, because historical returns already factor-in historical market crashes, and we are imposing an extra, instantaneaous crash at the end-point! Note also that the calculations above do not account for ongoing, post-retirement returns in private investments. In view of this comparison, Social Security’s status as an “untouchable” third-rail of U.S. politics is a testament to the economic ignorance of the American voter.

Wharton’s Jeremy Siegel offers perspective at wsj.com based on his own experience in “My Sorry Social Security Return” (gated — Google “wsj Siegel Social Security”). Siegel’s Social Security benefits represent about a third of what he could have earned in private investments; the value of his benefits is also much less than what Siegel would have earned for retirement had those funds been invested exclusively in government bonds, as the Social Security “Trust Fund” does when there are surplus contributions over and above benefits paid. The return Siegel can expect over his retirement years on Medicare taxes paid is similarly bad. Siegel is just the kind of high earner whom many assume Social Security favors.

Even worse, Social Security benefits for future retirees are quite risky, given the long-term demographic changes underway in the U.S. The Social Security system is not solvent. Only recently, we have witnessed the revocation of “Restricted Application” filing for married filers born after 1953. This change can mean a significant reduction in benefits to any married couple, but it may be a more meaningful blow to married filers in the age cohort now approaching retirement or full-filing eligibility. This will not be the last revocation of future benefits, because the system is now “cash-flow negative” (benefit payments exceed payroll-tax contributions) and it will be for the foreseeable future. There will be hikes in payroll-taxes and reductions in benefits down the road.

This post is a follow-up to earlier discussions on Sacred Cow Chips of Social Security’s horrid returns to retirees: “Reform Not: Play Social Security Slots” in October and the link given in the second paragraph (above) from August. The Social Security “Trust Fund” is not an asset with any net value to the economy. Earlier surpluses have been used to fund the government’s general budget, so the SS Trust Fund is not “saving” your contributions in any real sense. Government debt held by the Trust Fund as an “asset” must be repaid to the SS system via future taxes. Some asset for the public!

Privatization of Social Security accounts would offer tremendous advantages over the current, unsustainable program. From the August post:

“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.“

It’s true that a shorter market horizon makes private investment returns more variable. Transitioning to a system of private accounts would involve a risk tradeoff for private accounts that is less attractive than over a lifetime. That makes it important to offer current workers within, say, 20 years of retirement an option of remaining on a defined benefit plan or converting to a private account, or perhaps some combination of the two.

The safety of Social Security benefits is greatly overrated. As a social mechanism for shielding retirees from market risk, it provides even less in exchange for one’s contributions than would a terrible down-market in equities at the end of a working career.

Without Reform, Social Security Is a Game of Chance

25 Sunday Oct 2015

Posted by pnoetx in Social Security

≈ 1 Comment

Tags

Congressional Budget Office, Cost of Living Adjustments, Intergenerational Transfers, Internal Rates of Return, Michael Tanner, Pay-As-You-Go, Social Security, Social Security Privatization, Social Security Trust Fund, Tax Policy Center, The Urban Institute

Social Security does not provide future retirees with a safe “return” on taxes paid into the system on their behalf, given the program’s funding problems. It’s not even clear that it provides a decent return to many current retirees, and it will get worse as younger age cohorts become eligible. Demographic changes worked in the system’s favor in its early years, but no more: the number of eligible retirees is growing faster than the working-age population. This has led to cash flow deficits since 2010 that will widen in the years ahead. The unfunded liabilities of the system are currently estimated to be $26 trillion. The so-called “Trust Fund” for retirement holds about about $2.8 trillion of government securities, but those can’t be “cashed out” without a raid on general tax revenue or new borrowing by the Treasury.

Michael Tanner reveals the absurdity of some of the myths surrounding SS, such as claims that there is “no crisis” (and even more absurdly, that benefits should be expanded), that the Trust Fund will “save” the system, and that SS payroll taxes are “saved” for retirees. They are not saved; it is a “pay-as-you-go” system with current payroll tax collections paid out to today’s retirees. Here is Tanner on the woeful state of the system’s finances:

“According to projections by the Congressional Budget Office, for workers born in the 1980s, there are only enough funds to pay 76 percent of their schedule benefits; for today’s children born in the 2000s, this falls to 69 percent. And, taxes are already so high relative to benefits that young people will receive far less than they could receive if they invested their taxes privately.“

Measuring the return on Social Security (SS) payroll taxes (otherwise known as FICA) is not without controversy. The Social Security Administration (SSA) performs its own analyses of the returns on payroll taxes periodically. They analyze individuals at different income levels for each of four circumstances: single men, single women, one-earner couples and two-earner couples. They do so under different scenarios about future payroll taxes and benefits. The benefits include cost-of-living adjustments. These calculations show that today’s younger workers, singles and high-income workers can expect to receive the lowest returns. According to the most recent report, from December 2014, annual rates of return for those not yet drawing benefits under present law varies from less than 1% to 6.5%. Of course, the promised benefits are not sustainable under present law.

Reforms are not optional, as the program cannot run a deficit under its current authority once the Trust Fund is exhausted. SSA attempts to analyze steps that might close the gap and the impact of those changes on returns to retirees. One scenario involves higher payroll taxes and another lower benefits. These changes reduce the calculated returns in all cases, though even the lowest returns remain positive, if barely. These alternative scenarios involve no changes until 2033, however.

At the time of the SSA report, the most recent Congressional Budget Office (CBO) predicted that the SS Trust Fund would be exhausted in 2033. More recently, the CBO predicted that the fund will run dry in 2029. (The Disability Trust Fund is projected to run dry in 2017.) Therefore, the returns calculated by SSA under the alternative scenarios are over-estimates, since more drastic and earlier measures are required to restore balance. It’s likely that some of those returns would turn negative using SSA’s methodology. And it’s not unreasonable to suggest that reforms, whatever shape they might take, should be implemented sooner than 2029. After all, the need for reforms is well known, and we’re talking about it now! As for the SSA’s alternative scenarios, changes much sooner than 2033 would cause even lower returns.

While the SSA’s effort to provide the estimates is laudable, there are several aspects of the methodology that are questionable. SSA claims that the returns are real (inflation-adjusted) internal rates of return (IRRs), but they do not offer a detailed explanation of the inflation adjustment that must take place after calculating the nominal IRR. Using projected cost-of-living increases to inflate future benefits does not make the calculated IRRs “real”, if that’s what they have in mind. Second, the cost-of-living adjuster is the Consumer Price Index for Urban Wage Earners, which underestimates inflation experienced by the elderly. Third, they do not attempt to account for the probability of death before retirement, which would obviously reduce the return on contributions for single earners.

The “present-law” returns are essentially irrelevant, given the unfunded projected benefits. But the calculations under the alternative scenarios fail on other grounds: they are not “dynamic” in terms of adjusting for the economic impacts of the policy changes. In particular, higher payroll taxes are likely to reduce employment and slow the economy. A slowdown might even lead to additional claims on the system from earlier-than expected retirements. Thus, the higher payroll tax rates used by SSA will not be sufficient to close the gap. Likewise, reduced benefits would have a negative impact on the economy, reducing payroll tax collections. In both cases, dynamic economic effects would cause a wider funding gap; closing it will reduce returns more than suggested by SSA’s calculations.

An analysis by the Urban Institute in 2012 made somewhat arbitrary assumptions about rates of return. They used a 2% real rate of return to compound past contributions and discount future benefits (presumably with no cost-of-living adjustment). Under their assumptions, the value of payroll tax contributions at retirement often exceeds the discounted value of SS benefits for age cohorts turning 65 in 2010 and 2030. That implies that the real IRR must be lower than 2%.

As a hypothetical exercise, if individuals could invest their own payroll contributions over their working lives, significantly better returns could be earned than the IRRs discussed above, even if workers were forced into low-risk investments as they approach retirement. Therefore, the implied value of payroll contributions at retirement inherent in the IRR calculations is far too low. And while the discounting of retirement benefits at a relatively low rate reflects an appropriate conservatism, the level of SS benefits would not be competitive with the dollar returns on safe investments funded by a larger pot at retirement. The IRR calculations show only that the SS program is about as good as stuffing money into a mattress.

Unfortunately, the mattress might burn. The risks inherent in future SS benefits are substantial, and none of the reform alternatives are very popular. Some of the opposition is rooted in unreasonable criticism: No one has suggested programatic changes that would affect the benefits of anyone over the age of 55. Still, cuts in benefits for future retirees, delayed eligibility and higher payroll taxes are not easy sells. Another solution is to phase out the pay-as-you-go system, allowing younger workers the option of a a self-directed account (subject to certain restrictions), including a discounted “cash value” credit as a buyout for previous contributions. This was discussed in a recent post on Sacred Cow Chips.

Social Security is unsustainable and is an inter-generational rip-off in its current, pay-as-you-go form, as younger, less affluent workers subsidize current retirees, who are relatively wealthy as a class. Rather than shutting-down debate over reforms with exaggerated political claims, those interested in assuring a viable public retirement program should consider proposals that would give workers more choice and control, taking advantage of the higher returns available on private investments. Only this type of program can take advantage of the economy’s ability to convert savings into productive investment and real growth. Simple transfers from young to old do not leverage this process, and can never hope to compete with it.

Social Security: Saving or Tax? Proceeds or Aid?

17 Monday Aug 2015

Posted by pnoetx in Big Government

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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

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!

Busted Big Government

01 Monday Jun 2015

Posted by pnoetx in National Debt

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Alan Greenspan, bailouts, Contingent liabilities, Default, Disability Insurance Fund, entitlements, Inflation, Lawrence Lindsey, Medicare, Nicholas Ballasy, Social Security Trust Fund, Taxes

Alan Greenspan says we are “way underestimating” the U.S. national debt. His statements on this point make a great follow-up to last night’s post on bailouts. Here are a couple of recent Greeenspan quotes from an article by Nicholas Ballasy:

“Largely because we are not including what I would call contingent liabilities, that is the issue of, which is answered by a question: what is the probability that in today’s environment JP Morgan would be allowed to default? The answer is zero or less.”

Now, that means that whole balance sheet is a contingent liability. Now to be sure, while it’s contingent, there’s no interest payments but ultimately that overhangs the structure because we have committed in so many different ways to guarantee this, that and the other thing. It’s not only Fannie and Freddie but it’s a whole series of financial institutions and, regrettably, it is also non-financial institutions.”

The bailout barometer I mentioned last night is an eye-opener, but it reflects a very incomplete view of the contingent liabilities faced by the government. Ballasy discusses some massive unfunded liabilities associated with programs like Social Security, which has a trust fund that Greenspan calls “meaningless”:

“The Social Security and Medicare Trustees 2014 annual report said while legislation is needed to address all of Social Security’s financial imbalances, ‘the need has become most urgent with respect to the program’s disability insurance component. Lawmakers need to act soon to avoid automatic reductions in payments to DI beneficiaries in late 2016.’”

Lawrence Lindsey, an economic official in the Bush Administration, says the real national debt is closer to 300 percent of GDP when unfunded obligations for Social Security and Medicare are added. The fast-dissipating disability insurance fund was the subject of another post here two days ago. It is a case study in irresponsible governance. Here is Ballasy with another Greenspan quote:

“According to Greenspan, entitlement spending in the U.S. was 4.7 percent of GDP in 1967 compared to more than 14 percent today. ‘Had we kept it at that level, our productivity would be far higher today. The average wage would be very significantly higher, the standard of living would be higher and what we have to do is think about how we are going to shrink that pie back and, to me, that is the single most important problem that confronts this country,’ he said.“

Shrinking the ongoing flow of entitlements is a tall political order. Avoiding the contingencies that would add to existing obligations calls for economic policies that promote stability, rather than boom and bust cycles that follow misguided efforts to stimulate the economy. Still another matter is to deal with the obligations that already exist. Higher taxes, inflation and default do not represent attractive policy options, but our activist government has placed us squarely in that corner.