Tuesday, November 09, 2004

Social Security - Avoiding Folly

The following question was submitted on Social Security:

"I am not up on this so I won't pretend to be. However, why does allocating some moneys into personal retirement destroy social security? It seems to me that all that is needed are some safety valves (e.g., HUGE penalties for--or flat out prohibitions of--making early withdrawals; limitation to investment in index funds, etc.). Taking money out of SS and letting individuals invest themselves only results, it seems to me, in the individuals reaping the consequences of their own actions. Those who invest wisely (e.g., S&P500 index, with a historic rate of over 10%) will probably kick SS in the pants. Those who do so poorly will be out of luck (hence the need for safety valves). But reallocating some of SS also means that less will be drawn from SS....so how does this result in the funds disappearing in 1/3 the time? Help me out here. "

I am not an expert either, but I'll take a crack at it. On the surface, the idea of creating individual retirement accounts with SS seems like a good one. After all, it is my money isn’t it? The problem is that SS does not accumulate money in your name like an IRA or 401K plan. When you pay SS taxes a large portion of what you pay goes directly to those receiving SS benefits. The rest is replaced with special treasure bonds. SS explains it this way on their web site:

"Presently, Social Security collects more in taxes than it pays in benefits. The excess is borrowed by the U.S. Treasury, which in turn issues special-issue Treasury bonds to Social Security. These bonds totaled $1.5 trillion at the beginning of 2004, and Social Security receives more than $80 billion annually in interest from them. However, Social Security is still basically a "pay-as-you-go" system as the $1.5 trillion is a small percent of benefit obligations."

An analogy (I am really not good with analogies) is a water tank that is being filled at the rate of 2 gallon per minute while an open faucet drains the tank at one gallon per minute. Net, we are filling the tank at one gallon per minute – this is the surplus. As the population ages it is like opening the faucet wider (or adding more faucets) until sometime around the year 2043 we find the tank drained. After 2043 we would need to close the faucet 27% (per worker) to stay even. Individual retirement accounts have the effect of reducing the inflow into the general fund while the amount being taken from the trust remains the same. While the outflow will be reduced somewhat in the future due to the use of SS individual retirement accounts, this will not occur until long after we have drained the fund - remember that the holders of these accounts won't be retiring for some time while we need to fund current retirees today. Rather than draining the fund in 38 years we will do in ½ to 1/3 the time. This means that the benefits will have to either be drastically reduced, taxes will need to go up or the Federal Government will need to start pumping funds into the system (remember they were taking funds out of the system).

The following link is to a reform plan being promoted by the Brookings Institute which, like most things from Brookings, seems well thought out:


P.S. I will drop the heading "stupid pond" and replace it with "Folly" in honor of Tuchman's "March of Folly"


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