Social Security: Investing the surplus in marketable securities

It is human nature to look for the easy solution.  My kids do it.  Our politicians do it.

It is one thing when my kids believe the tooth fairy will fix their cavities.  It is another thing when politicians try to convince the public at large that there is no shortage of ways to reduce the growing gap between the projected revenue and expense of Social Security.

There is no free lunch anywhere in the system. If, for example, you remove the maximum taxable wage cap, the system will generate more revenue. At the same time, the change will make it harder to raise revenue for other governmental needs, such as paying down our debt. Increasing payroll taxes is a political statement that Social Security is relatively more important than other governmental priorities.

The Center for Retirement Research at Boston College released a study that suggests it has identified the free lunch solution for Social Security. They believe that we can solve the financial gaps by investing some of the existing surplus in marketable securities.

The research reached an astounding conclusion:

At the 50th percentile of outcomes, equity investing has the potential to maintain a healthy Trust Fund ratio through the 75- year period.

The concept holds the appeal of the easy solution. If we were just smarter about the way we handle the existing resources of the system, all of the difficulties in the program would melt away.

Is it possible? Maybe. The Social Security Administration (“SSA”) doesn’t belief so. Its research suggests that investing 40 percent of the surplus in marketable securities will increase the exhaustion point by a total of 1 year, rather than 75. So success isn’t a sure thing.

The success, or failure, of this concept largely rests upon the investment returns generated by the Trust Fund. Typically, the baseline for most of this type of research is based on historic market returns.

This theoretical assumption isn’t a realistic expectation. Social Security’s revenue is correlated to wages which is correlated to the stock markets. The connection means that Social Security will statistically overbuy market tops and under-invest in market bottoms. It is a statistical anti-dollar cost averaging concept.

Secondly, the index return does not incorporate the cost to buy and sell the security. This problem is largely overlooked today because capital inflows of the typical index fund are sufficient to meet redemptions.

That will not be the case with Social Security. The investment redemptions of Social Security will be priced at the bid.  The size of these redemptions may well move the market down as the government sells its positions. A theoretical return of the index never prices in the spread.

The paper from CRR looks at the returns of the Wilshire 5000, an index that includes highly illiquid stocks. One example is Acme Corporation, ACU, a $20 stock which trades with a spread of $0.50 on an average daily volume of 2000 shares. In other words, the loss starts at 2.5 percent and rises as the price of the stock falls.

This solution does not fix Social Security.  It redistributes the allocation of associated risk. Investing the surplus in marketable security lowers the risk of insolvency by investing in assets with higher returns that introduce credit risk that isn’t present today’s portfolio.

This concept introduces the possibility that Social Security will be adversely affected by a credit market disruption. That risk will be borne progressively by future workers. The possibility that a credit event will occur over the next 10 years is less than over the next 50 years. In this respect, the policy option is no different from the standard line that we will tax future workers more.

Redistributing risk might be a good idea. It isn’t a good idea to base that decision on market returns that Social Security will never achieve.

Youth, 401Ks, and Fees

One problem that Boomers face today is not paying attention years ago to the cost of retirement savings. Years ago, while workers were enjoying tax-deferred savings, no one told about the leak in the boat, fees.

One of the things that surprised me was the difference between the performance of my retirement account and the company stock which was the largest component.  What happened?  Fees.

Fee structures have changed since I wrote this piece in 2013, but the average guy who is now approaching retirement paid a breathtaking amount in fees. 

Getting anyone to listen to a piece on retirement planning is difficult on a good day, and almost impossible when the audience is younger Americans. But the topic isn't as irrelevant as many young people think, because retirement planning isn't just about you — it is a family issue. The news about retirement planning isn't good, either, according to this report by the think tank Demos, "Broke Boomers and the Coming Crisis of Elderly Poverty." While you may have heard that the problem is that we don't save enough, the larger problem is the way we save.

For most Americans, their largest expense in retirement planning — Social Security — will lose money. Behind Social Security, many Americans use 401Ks to create the personal savings accounts that Social Security will augment. The problem is that the 401K can also be a money loser, with trade-offs that few understand.

401Ks have a place in an investment portfolio, but you should understand the rules before you invest
through one. 401Ks are not tax-free accounts. They are tax-deferred. Tax-deferred means that you are trading the tax rate today for one that is unknown in the future. You will pay tax on the income at some point.

For money deposited today, that trade is largely a bad decision. The current tax structure is historically favorable, particularly for lower-wage Americans. According to the CBO, people in the lowest quintile of income pay about a 1% effective tax rate on income. In fact, many Americans pay 0% for long-term capital gains. So passing income through a 401K can create a needless tax liability where there was none.

Furthermore, few people consider the tax consequences of 401Ks, as evidenced by participation in Roth-401Ks. One reason that people do not follow these accounts closely is because these accounts reserve wealth for far in the future. Separately, employers pay employees to make the mistake. Some employers offer 100% matches of your contributions. Employees see that match as doubling their money. 

How can free money go wrong? Fees. Fees hit younger Americans harder because the fees accrue over a longer period of time. How much are fees? Consider accounts earning 5% real (roughly an average rolling 40-year return). A dollar invested in 45 years without fees is worth more than $9. Two dollars invested in a 401K subject to 2% fees grows to about $7.50.  The 100% match does not even cover the fees if you are 30 or under.

How much 401Ks cost depends upon where you work because fees vary from plan to plan.  Brightscope.com, a retirement planning service, projects that workers of Darden Restaurants lose over $200,000 in fees, or up to 21 years of additional work. Demos projects that "over a lifetime, fees can cost a median-income two-earner family nearly $155,000 and consume nearly one-third of their investment returns." Every plan is different, and Brightscope.Com will tell you about the specifics of your plan.

What do you get for the money? Mostly you get the right to not use your money. These accounts require younger workers who tend to be less established to lock up their money for a longer period of time. In the real world, you are supposed to get paid to make extended commitments of capital. For example, the 30-year Treasury bond pays roughly 4% compared to 1% for the one-year bond.  401Ks do not compensate the holder for the commitment.

For millennials, the commitment means that your money is not available when your life changes. Whether it is to start a new business or for health reasons, you will probably need to dip into your savings sooner than you think. Putting your money into a 401K not only exposes your investment to the risk of the market, but makes it certain you'll be assessed penalties for early withdrawal.

For Baby Boomers, forced 401K distributions create the risk of triggering Social Security's means-test. The IRS applies a means-tested clawback of benefits on people who have "substantial" outside income. (In fact, up to one-third of retirees trigger this test). So it is possible that your savings will trigger a negative savings rate.

This isn't to suggest that 401Ks are evil or that anyone is stealing your retirement money. These accounts are a structured investment tool, with costs and rules. If you don't understand the costs and rules, you could pay a severe price.

Social Security is not an anti-poverty program

One of the most pervasive myths in the debate about Social Security promotes the role of the program in the alleviation of poverty.

Common sense should tell us that something is amiss with this endearing myth. Social Security does not pay a penny of benefit based on need.  The system does not even have visibility into need. So at best any benefit that goes to a poor person is more a matter of luck than systemic policy.
The benefit formula of the program is designed to make that outcome less than likely though.  The system allocates benefits based on among other things wages and the number of years worked. So until working a long and productive career causes poverty, Social Security will never be an anti-poverty program.

Some Americans are not even eligible for its benefits. Again, until Social Security is universal, it will never be a safety-net.

Facts support common-sense.  The IRS reports that in 2012 70% of tax returns filed with Social Security benefits triggered rules for filers with substantial outside income.  Pew Research reports that households headed by someone 65 and older have the highest median net-worth of any age demographic.

How is it possible that anyone can confuse a system that actually pays the wealthiest segment of our society based on how much they have earned in the past with poverty alleviation?
The myth largely demonstrates that statistics remain the greatest lie. The statistic starts at the US Census Bureau, with this statement.

"Without adding Social Security benefits to income, the supplemental poverty rate overall would have been 8.6 percentage points higher (or 24.1 percent rather than 15.5 percent). People 65 and older had a supplemental poverty rate of 14.6 percent, equating to 6.5 million. Excluding Social Security would leave the majority of this population (52.6 percent or 23.4 million) in poverty."  ~ U.S. Census Bureau

The factoid subsequently spins out of control on the internet. The natural extension of the raw data is that Social Security is a safety net without which a majority of U.S. seniors would be poor.  The extension of that extension is that without Social Security there would be people starving in our streets when they weren't dying from exposure.

The primary problem with the statistic is that US Census Bureau measures poverty by income.  The fact is that income measures productivity, not poverty.  Income level may cause poverty, but it is not a sensible measurement of it.   Poverty should be measured by net-worth. 

The second problem is that people engaged in the debate about Social Security do not read disclosures.  Both the Social Security Administration and the Census Bureau warn readers that the definition of income excludes a range of revenue on which seniors depend.  Separately the authors provides a disclaimer, cautioning readers that respondents tend to under-report non-wage income.  In other words, Census’s measure of poverty is based on an incomplete and imprecise measure that is known to overstate poverty in the elderly.

The US Census report does not include a disclaimer that should be present.  The IRS tax rules on Social Security benefits for people with substantial outside income create a significant incentive for the elderly to appear poor.  The Congressional Budget Office reports that these tax rates can approach 47%.  These rules are triggered near the poverty line.

The statistics also exclude a significant factor, the cost of Social Security. If we ignore cost, any government program provides poverty alleviation.  For example, pay-outs from the lottery are a great poverty alleviation tool as well.  The reality of the lottery is however that you are spending a dollar to buy a dime.  If we ignore the dollar of poverty, the dime of cure appears to be the greatest social program ever designed to lift people out middle-classdom.

In terms of the cost of Social Security, an average couple retiring in 2010, lost roughly $600,000 in savings over their lifetime funding the retirement of others. Is it reasonable to say that Social Security lifted that couple out of poverty by returning $30,000 in a given year?   If we are going to say that Social Security lifted some millions of people out of poverty, should that figure not be net of those younger Americans who were put into poverty by the system?

Americans really do not need to know the details of how Social Security interacts with poverty.  Voters need to know that someone in Washington is paying attention.  Politicians, pundits, and policy experts have set policy for the program around statistics that they haven’t bothered to fully research, allowing the raison d'etre of the system to drift into a Bizarro social policy skit from Seinfeld.

I have no idea how Social Security interacts with poverty. I am pretty confident that the politicians who quote this data do not either, and I doubt that they care.