Cato Institute FAQ on Social Security
Basic argument for changes to Social Security:
I. Current system is a transfer payment scheme lacking a sound rationale
II. Current system will create disproportionate problems for current and future youth, if left as-is
III. Alternative retirement plans like 401(k) and thrift plans are already very popular
IV. Contrary to claims, implementing private accounts does not create net costs to other taxpayers
V. A perpetually self-funding plan does do something to address the solvency problem
VI. “Transition costs” said to come from private accounts are actually due to current system and have nothing to do with private accounts
VII. Private account “risks” have been unconscionably distorted
VIII. Risks associated with government promises are greatly underestimated
IX. Defined contribution accounts provide more significant liberty to choose
These arguments in more detail:
A. There are plain demographic reasons the system is projected to be unable to pay benefits at current formula.
1. Social Security involves today’s active workers paying for the retirements of today’s retirees.
2. When Social Security was started, there were 16 active workers paying in for every retiree.
3. In the future, there will be about 1 or 2.
4. The benefit formula is increasing above inflation, but this isn’t enough to cause the problem; the demographic shift (ratio of retired to working persons) is what is forcing the problem
B. Debate isn’t whether system is expected to go broke, but more of a question of when
1. Under current projections, we will be dipping into the so-called “trust fund” by 2018
2. The term “trust fund” to refer to what happens to surplus social security taxes is a government-coined code word for the utter lack of a real fund – a stack of IOU’s from the government that are put in place when the government takes money out of the Social Security program to spend it elsewhere. To call this a “fund," as though it were some sort of independent account, is dishonest or inept accounting on par with Enron and WorldCom. By no sleight of hand can one entity meaningfully spend and save using the same money at the same time, but this is what is implied by calling the government holding its own debt an investment in a fund. Putting a treasury bond in an account after spending the money gotten for borrowing it is like a husband pawning his wife’s necklace and then leaving her a note saying that he spent the money but promising he will collect money from her to buy her another necklace back in the future – it's not much of a "fund."
4. The system is projected to fall short on payments by 2042 or 2052, so people working at that time will have to pay bigger taxes, cut other government spending, or take benefit cuts to continue the system in its current form.
C. The difference in projections as to when it goes broke isn’t much of an excuse to procrastinate
1. Uncertainty about risk does not mean no action should be taken. It’s somewhat like saying that because you don’t know whether you would live four years or six years by not treating your cancer, there’s no need to go to the doctor.
2. The longer the problem is postponed, the more concentrated the consequences are likely to be on specific generations.
III. Alternative retirement plans, like 401(k) plans, IRAs, and thrift plans are already very popular
A. These all involve private retirement savings accounts, and they are not causing the sky to fall.
B. The vast majority of medium or large-sized companies offer these plans.
C. Unlike traditional pensions, a variety of risk tolerances can be suited using different types of investments (e.g. money market, bonds, stock funds)
A. What one can get out of the account (mutual funds) is exactly the value of what will be in the account.
B. This is just because the account can buy the stock or bond funds itself with the money and just give you back the very same stock / bonds (now worth more money) at retirement.
C. Everything paid out of the accounts is purchased with the payroll contributions.
D. The administrative overhead costs under this system should be no higher than under the current Social Security system (comparable to a 401(k) or thrift plan).
V. A perpetually self-funding plan does do something to address solvency problem
A. Even moderate commentators will suggest that “private accounts” and “the solvency problem” are two separate things
B. This is not so; replacing underfunded benefits earned in the future with benefits that can always be fully paid from future contributions does improve overall solvency (not to say that this is the only possible way to do so)
C. What it does not do is pay off the future costs that have already been created by the current Social Security arrangement (see below)
VI. “Transition costs” said to come from private accounts are actually due to current system and have nothing to do with private accounts
A. Even conservative commentators discuss a “two trillion dollar transition cost”
1. The "transition cost" refers extra cash that be needed to pay shorter-term Social Security benefits if Social Security taxes funded the benefits of those earning the taxes.
2. Purely fiscally, there is no cost created to the taxpayers by putting their own funds in their own accounts (where assets are purchased at market price); thus the origin of these “costs” has been falsely attributed to this activity. The transition cost is the future government taxes that are already required because Social Security was never funded as private pension plans are.
B. The origins of the true costs have been mislabeled; they come from the current program, not the future private accounts
1. The taxes for every generation of active workers directly goes to current retirees.
2. While the connotation of the term may be dismissed, in substance, this is not unlike a Ponzi scheme (early in the system there were surpluses and it was popular; now the program is showing signs of trouble).
3. The “transition costs” are the cash needs that will inevitably come from ending part of the program. They are amounts already owed to current retirees. When Social Security started, it earned, among some, the reputation of “the most successful government program ever.” Early retirees were perhaps persuaded it was such a well-run program because they were getting benefits from younger workers (and had not paid for them themselves). The younger workers paid for the older workers with their “contributions,” which actually paid directly for those old people. As baby-boomers paid for their parents, there was no solvency problem with their parents’ benefits. Nevertheless, many might naturally expect their savings to convert to future benefits for themselves, even though they’ve truly contributed nothing to themselves. When part of the traditional scheme is unraveled, it can be painfully clearer to the current generation paying in to this system that the government doesn’t have their “contributions” saved up anywhere – it went to the previous generation. All the government has is old debt to itself to be repaid by current taxes. That cash obligation is owed regardless of how future benefits are earned; it is already accrued and cannot be avoided by continuing the system.
4. Thus, the transition costs are owed solely to the existing structure - proposed by FDR and continued to date - and the fact that people live longer and don’t have as many kids nowadays.
5. The fact that the “transition costs” would have to be “borrowed for” immediately says nothing about who will actually pay them down or where they came from. It seems the easiest thing would be to spread the burdens of paying down this debt across several generations, but continuing the Ponzi scheme-like structure as-is would become pragmatically unbearable.
A. The state of current financial literacy is pretty bad with respect to stock market performance:
1. This owes largely to lame history secondary textbooks that teach only two days in the history of the stock market – one in 1929 and one in 1987.
2. Teaching the history of the stock market by showing the two worst days of its history is like teaching the history of music by playing a video of first round disqualifications from American Idol, like teaching the history of the automobile by assigning excerpts of Unsafe at Any Speed, like teaching the history of human character by exclusively discussing Jeffrey Dahmer and Josef Stalin.
3. A less taught fact is that $1 invested in S&P 500 stocks in 1925 – before the stock market crash and great depression – would be worth over $3,000 today (about a 10% return). This investment period spans both the 1929 and the 1987 crash; clearly the stocks have created much more wealth than disaster. (See also http://www.duke.edu/~charvey/Classes/ba350/history/history.htm. Note that the same $1 invested in long-term treasury government securities would be worth perhaps $100 by today. Also note that the chart is in logarithmic scale so it visually understates the difference between stock returns and other returns.) Less conservative investments in smaller stocks would be worth around $9,000 by today. A MoveOn.org ad says that private accounts will lead to people having to work through their retirement in the future, but based on what evidence?
4. It’s probably worth a try asking recent high school graduates what they have learned that the stock market has done for the United States. Students will probably say mention “buying on margin” leading up to the stock market crash and the Great Depression and the 1987 crash. The actual overall track record of financial securities is wholly ignored in favor of discussing isolated the bad days on the market (that have actually been far outweighed by good days).
5. When people get more advanced into financial studies than the lousy high school presentation of the stock market, academic scholars discuss "the equity premium puzzle" – essentially wondering why stocks have historically so dramatically outperformed other types of investments in past years. There is no guarantee the future will be like the past, but the same is true of safer-seeming investments than stocks. Much popular commotion about the risks of stock underperformance seems to be founded on little more than that the future could be different from the past.
B. Long-term stock returns, historically, have not been nearly as risky as portrayed
1. Anecdotally, people seem to refer to the prospect that
2. In the vast majority of short-term, 5-year periods, rates of return on the stock market are positive
3. The recent decade's stocks returns are low, but the cumulative track record of stocks is anything but; the 10-year and longer returns on stocks exceed Social Security internal rates of return or bond yields (See http://www.socialsecurity.org/reformandyou/faqs.html)
4. Stock returns certainly vary dramatically in the short run (they are only occasionally negative over 5-year spans), but over a long run, a working lifetime, the “gamble” in a diversified stock market return is perhaps better framed as, “Would your balance be worth five times what you could have gotten contributing the money to conventional Social Security, or fifteen times what you could have gotten contributing the money to conventional Social Security?”
5. It is impossible to find any modern-era working lifetime (i.e., about 35-40 years) in which contributing a working lifetime of payroll taxes to Social Security would exceed the value that would accumulate on stock with the same contributions
6. Yet contrary to actual history, it is a common claim that the stock market is “risky” in some kind of bad way
C. Bonds and other potential investment alternatives vary less than stocks but also be used in defined contribution plans.
1. Bonds or deferred annuities provide more predictable retirement income. People could choose to invest in government debt as well.
2. Some sleep easy with big risk and some more nervous people sweat over much smaller ones; it is paternalistic and naive to treat all people as though they have the same risk tolerances (see below).
A. Government does not have a contractual legal obligation not to, say, reduce the benefits
B. The system is said to provide “guaranteed” life income, but what is the special advantage of this, and what good is a guarantee from a fund that can be rescinded by legislation?
1. Contractually guaranteed life incomes can be purchased with regular dollars anyway (annuities); there is no reason that people cannot purchase guaranteed life incomes in defined contribution or private accounts.
2. Politicians try to sell the notion that the government is somehow offering something greater or special by “providing a life annuity,” but the private entities often do this on their own with little fanfare. It is already not uncommon for people to buy guaranteed life incomes from their retirement accounts.
3. Postretirement spending desires are not always as neat and level as in the formulas of traditional pension programs such as Social Security.
A. AARP ad says, opposing private accounts, “If we wanted to gamble, we’d play slots”
1. Even if gambling were an option, if AARP membership does not want to gamble, no one has to. Participation in proposed account has been voluntary. (The AARP pretends not to understand stock returns. Slot machines by contrast almost always have a negative return, so this seriously calls into question the intelligence or sincerity of current AARP leadership. Could I possibly sound like I’m taking this complex financial debate seriously if I snidely said, “If I wanted to gamble, I’d play Russian Roulette”?)
2. If AARP’s advice is that valuable they can just give that valuable advice to their members. They don’t have to force all of America not to have any choice in the matter.
3. Under current proposals, the choice is only offered to people who are not yet retired.
B. Many politicians are set on imposing a narrow range of unreasonable restrictions on the financial plans of Americans who, in all likelihood, understand their finances much better than the politicians themselves. What leads these politicians to fight for this authority to restrict these individual liberties? Do they know better what investments let people sleep easily at night or have hope for their future?
Appendix: E-mail exchange with David Wessel (of The Wall Street Journal)
On Feb. 10, The Wall Street Journal posted an article by David Wessel about Social Security. This article did expose problems behind the so-called "trust fund," but makes a suggestion that private accounts do not even slightly address the solvency problem. I wrote to him in response to the column. Here is the unedited text of that e-mail:
I enjoyed your aticle regarding
the Social Security 'trust fund,' but I have a question regarding the statement
at the end:
"The private accounts, the personal accounts, do not, in themselves solve the full Social Security problem." They don't, in fact, even narrow the gap between promised Social Security benefits and projected tax revenues.
My beef is - and I will read you next week to see your answer - how is this true in the long run? An funded personal defined contribution plan has no negative gap between the value of the assets and the value of the obligation, because the obligation is only to give people the value of those assets. To me this seems fundamentally different from expecting a smaller number of young workers to pay for a larger number of older ones. No transfer payments are needed just to invest in a savings security paid for on the market like a stock or bond, period, so in the long run the gap between taxes and revenues fails to arise if people go with personal accounts. That is fundamentally different from a program where, say, 12% of all teenager's taxes will go into an agency that will promise to pay everyone above the age of 21 a check of $30,000 every year. Such a program would, obviously, have a demographic mislink between taxes collected and taxes paid - which Social Security's current structure will have in a less dramatic way in the next few decades. Phasing out that kind of program (and replacing it with a solvent funded arrangement) offsets a future solvency problem, so I think it is not correct to say that the accounts "do nothing about solvency," as some say. My understanding is that phasing in personal defined contribution accounts doesn't solve immediately the problem that under Social Security, citizens' "contributions" never funded their own retirement savings, only the previous generation's payouts - and yet any generation that is last under the old system to make those kinds of "contributions" expects to collect nonetheless. Their money has always been owed to them yet never actually set aside for them (confusion arising from the dubiously named "trust fund" notwithstanding), which is a problem that fully using personal accounts would stop instead propagating and escalating for future generations, but does not cure with respect to the current one (or whichever generation chooses to make the reforms). Would you consider that an accurate characterization?
essay - "The Social Security Debate" - http://politics.ryanrenn.com/social_security.htm
This is the response my message received on the pages of the The Wall Street Journal:
Ryan Renn writes:
I enjoyed your article regarding the
Social Security 'trust fund,' but I have a question regarding the statement at
the end: "The private accounts, the personal accounts, do not, in
themselves solve the full Social Security problem." They don't, in fact,
even narrow the gap between promised Social Security benefits and projected tax
revenues. My beef is -- and I will read you next week to see your answer -- how
is this true in the long run?
David Wessel responds:
If you opt for a private account,
you will divert some of your payroll taxes into a private account and you will
agree to accept lower retirement benefits. That by itself won't balance the
system. It's a wash. The system gets less revenue and it promises to pay smaller
benefits. As the president and his aides have explained, it will take additional
across-the-board cuts in future retirement benefits to make the system solvent
over the long haul (or higher taxes, but he is against that.)
My response to this? I think the part of the original message that space did not permit to be quoted tells the story and speaks for itself. To reiterate, Wessel’s claim is that private accounts "don't, in fact, even narrow the gap between promised Social Security benefits and projected tax revenues" (emphasis added). He maintains this position by portraying the private account contributions as offsetting revenue and liability reductions to the system (which is a very misleading way to word it, because just because future taxes are invested in accounts and the benefit payments are distributions from those accounts, does not mean the taxes and payments are no longer "in the Social Security system"). The point is that when liabilities are fully funded by the taxes, the liabilities and revenues created by the system indeed are “a wash,” but they aren't a wash under the current system. (See part IV of my arguments outline.) The liabilities accrued by continuing the current system are projected to exceed the revenue taken in. To the extent the current system is replaced with a system that does not continue to generate liabilities that exceed the value of the future tax revenues, future deficits are avoided.
The pragmatic problems are that, (1) in order not to rock the political boats, the whole system isn’t yet being proposed to be converted to a system where all contributions are a wash, so we can expect some subset of the system to remain insolvent until that happens, and (2) the current system never funded current retirees' benefits, so the government has a generations' benefits of retirement debt already accrued that has to be paid down. There is no way, though, to construe that as a failing of personal accounts, because the underfunded promises of payment that the government has made under the current system would still exist without them. Realistically, in plain English terms, the way out of the current mess is to pay out the people who were never funded under the current system while simultaneously converting the Social Security system to one where every tax payment washes out the government's future liabilities to that person. Converting Social Security to a funded savings account-based plan while paying off the so-called "transition costs" of the plan is doing essentially that with part of the program. Postponing this will succeed only in creating greater pains for future generations.