The 3rd-Rail Is Running Out Of Track

Social Security has long been known as the 3rd-Rail of Politics in large part because the program serves an audience with a high rate of voter participation. Politicians have historically avoided the discussion of reform for fear of the consequences at the voting booth.

This political calculus is however changing. The finances of Social Security are such that most Americans now expect to see benefits cut in their lifetime. Separately, there are few options which insulate voters from the impact from the changes necessary to preserve the system.  In short, the 3rd Rail is running out of track.

Earlier this month the Congressional Budget Office ("CBO") released a new projection for the Social Security Trust Funds which suggests that the combined funds will be depleted in 2030. If the Trustees confirm this finding in their 2014 Report on the Social Security Trust Funds, the system will have reached new milestones: a vast majority of voting aged Americans expect to retire after the system is unable to fulfill its promises.

2030 means that someone turning 70 today expects to outlive Social Security's ability to pay scheduled benefits.  Likewise, women who are 72 generally expect to live into the year 2030.  (SSA Life Expectancy Calculator) This projection means that people who are 52 and younger expect to retire after the Trust Fund is exhausted - more than 60% of voting aged Americans.

The demographics of the 3rd Rail were radically different just 5 years ago. In 2009, the Trustees projected that the system's solvency would extend for 28 years.  People who were 52 and older had a reasonable expectation that they would die before the consequences of Social Security would reach the public.  Even the average 40 year-old expected to collect some level of scheduled benefits.

Five years ago a near majority of Americans expected to be completely unaffected by Social Security's unfunded liabilities. The consequences of ignoring these problems fell on a small group of voters who were largely detached from the electoral process.  Five years ago, it paid political benefits to ignore the problem. 

The changing financial picture of Social Security has yet to materialize in polls.  Public confidence in Social Security is about the same as it was 25 years ago.  In 1988, public confidence in Social Security was roughly 49%.  Current polls shows that the figure is roughly 54%.  Even younger Americans have a surprisingly high level of confidence at 45% given that every one of those polled will be less than 45 when the Trust Fund plans to liquidate its last asset.

While the public's confidence in the system hasn't changed much, financials have changed substantially.  In 1988, Social Security was projected to be solvent for more than 60 years.  Today projected solvency is less than 16 years.  The cost to keep the system solvent has nearly doubled over the last 5 years. It is a matter of time before the deterioration of the systems financials begins to alter the how the 3rd Rail influences the nation's politics.

What should trouble everyone who believes in Social Security is the correlation between personal benefits from the system and confidence in the system.  The National Association of Social Insurance concluded from a poll a year ago, "Large majorities of Americans, both Republicans and Democrats, agree on ways to strengthen Social Security — without cutting benefits."  In that poll, 80% of the respondents said : I don’t mind paying Social Security taxes because I know that I will be receiving benefits when I retire - and 48% strongly agreed.

This poll contrasts sharply with a Reason-Rupe poll of younger Americans who are more skeptical that they will receive benefits from Social Security.  That poll found that 73% of this audience supports a new system with private accounts.  The poll further found that nearly half of younger people would replace the existing system even if current seniors had to have their benefits reduced.

According to multiple polls (here is one), people prefer increasing taxes to decreasing benefits. This preference is completely understandable because benefit reductions affect all future benefits where as tax increases cannot be applied to past earnings. The closer one is to benefits, the cheaper a tax solution is to the voter.  CBO for example projected that increasing the payroll taxes to 14.4% would increase lifetime contributions of those born in the 1960s by 6% and those born in the 2000s by 15%. In other words, the greatest impact would fall on those people who are 14 and younger.  Essentially this proposal is based on the idea that our children will pay the taxes that we won't.

Unfortunately, the tax-other-people alternatives are quickly losing the pretense of effectiveness. Advocates of Social Security frequently argue to increase the amount of wages subject to the Social Security payroll tax. In the apex tax solution, proponents suggest completely eliminating the payroll cap.  In 2010, Congressional Research Service projected that completely removing the taxable wage cap would solve 95% of the financing shortfall.  Earlier this month, CBO lowered its projection to 45% of the solution.  The point here is that solving Social Security's financial gaps will involve more and more personal sacrifice.

The dynamics of the 3rd Rail will change as more people start to look at how the exhaustion of the Trust Fund will affect them personally.  Current law would subject nearly all Americans to forced benefits cuts at some point in their life.  The options to preserve the existing system will have larger and larger impacts on the individual, rather than a nameless individual far in the future.

Social Security will always be a political lighting rod because of the amount of money that it controls. The nature of that force will change as the financial imbalances start to fall on current voters.  That change is occurring much faster than most realize.

Privatizing Social Security

“Politics is the art of postponing decisions until they are no longer relevant.”

After three years of researching Social Security, I have finally reached the conclusion that privatizing any or all parts of Social Security will not improve the financial prospects of the system as promised by its many proponents. Privatization has fallen victim to the art of politics. It is no longer relevant.

I am completely unpersuaded by the traditional objections to the privatization of Social Security. On the contrary, my concerns deal with whether the change is sound policy. Moreover, I simply don’t believe that it is affordable anymore because of the structural changes to the system which have occurred over the last 10 years.

Privatization does not reform Social Security. Privatization changes the role that Social Security plays in our lives. Privatization would transform Social Security from conceptually old-age insurance to a system of forced savings. These are very different things.

In terms of policy, I do not see the point of changing Social Security from insurance which I can’t buy in the private market to a personal savings account which I already have in abundance. The only proxy in the private market for Social Security is an annuity which is generally expensive to buy.  On the other hand, I have an IRA, ROTH/IRA, 401K, and a SEP.  I do not understand the reasoning behind making Social Security into another flavor of the alphabet soup of retirement planning.

The sell-side of this idea will tell you that not everyone has prepared for retirement.  Ironically enough, this reasoning is an argument for insurance rather than savings.  Savings must cover how long you might live, where as insurance only needs to cover how long you actually do live. (A longer discussion of insurance vs savings is found here.)

The sell-side of this idea will tell you that it is possible to make more money in the stock market than in Social Security. While it is true, the comparison is not honest. Social Security carries legacy costs which cause the poor return. The market does not reflect this financing burden. So the comparison is only valid if the costs of the past go away – they don’t.

What are legacy costs? They are the benefits of existing retirees which are fulfilled with current payroll taxes. If we redirect the payroll taxes of workers from Social Security to private accounts, how will you pay the existing benefits?  Privatization in general replaces the money with subsidies from the General Fund.  In other words, privatization changes the pocket which pays for Social Security.

The consequence of this strategy is clear: higher income taxes or cuts to other government services.  Your income taxes must increase directly proportionally with whatever payroll taxes that go to private accounts because most of the plans that offer an element of personal ownership come with a clause to protect the existing retirees. Since existing payroll taxes will not fully cover the cost of these benefits, the increase in Social Security income taxes will be higher than the Social Security payroll taxes put into your personal account.  Basically your private account is great, but it is likely that the entire balance will be lost to higher Social Security income taxes.

When the sell-side of this idea tells you that the SSA has said that privatization will make Social Security solvent, it is not completely honest.  Generally they point to studies from 2005.  In a different example, JustFacts.Org says, “As evidenced by analyses conducted by the chief actuary of the Social Security Administration and a bipartisan presidential commission, proposals to give Social Security an element of personal ownership are generally structured to strengthen the program’s finances.” The evidence is a proposal scoring completed by the chief actuary in 2008.  The proposal contained a 4.1 trillion dollar subsidy from the General Fund.  If I hand you 4.1 trillion dollars, yes it will strengthen your financial position.

There are two major structural shifts in Social Security that are generally ignored by the sell-side.  First, the imbalances of the system are growing rapidly.  The 2008 study was based on data from year-end 2006.  The short-term financing gap has doubled since that time.  Second, the system stopped generating excess cash in 2010.  So there is no excess cash in the system to invest.

Research from 2005 is at best irrelevant.  According to the Academy of Actuaries, the cost to privatize Social Security is reasonably considered to be roughly $10 trillion, more than double the cost projected in the research from 2008.  The phrase in football is throw where the receiver will be.  The sell-side on this policy is crafting the play around where the receiver was 5 plays ago.

The second shift in the dynamics of Social Security is a little more serious.  In 2005, Social Security created excess cash which was subsequently invested in government securities.  At the time, it was possible to create economic value by investing the excess cash in more productive ventures.  It wasn’t a lot of money, but at least it was real. Today, the system collects less in payroll taxes than it expends in benefits.  Any money that is pulled away from Social Security for more productive ventures, will be offset dollar for dollar with increases in government borrowing from the public markets.  It is a complete wash.

Finally there is the problem that no one discusses: adverse selection. In terms of Social Security and privatization it means that the first people to leave Social Security for a personal account will be the system’s most profitable participants.  In the case of Social Security, the most likely candidate to leave is the single high-wage worker. If this selection process occurs, a transition from Social Security to private accounts will not make Social Security more financially sound.  It will set the stage for an implosion.

This idea may have had some merit 20 years ago, but today it seems to be a questionable policy decision that we can’t afford.  What does the younger American, for example our kids who have no vote in this matter, get for $10 trillion dollars.  They get the privilege to save for their own retirement.

Originally published on FedSmith.Com.