Social Security Crash Explained In 4 Simple Steps

When Social Security was created in 1935, the system was designed to be funded by workers not financed by their children. It wasn't a generational-transfer or a Ponzi scheme.  Since that time, the system's finances have deteriorated virtually every year to the point where the financing gap is nearly the size of our entire GDP. So what the hell happened?

How to destroy the future in four easy steps:

1. Give To Voters
The original law included automatic tax increases which would have increased the cost of Social Security to 6% of wages from its 2% base. Over the 1940s, Congress waived every increase, one of which required a Congressional override of FDR's veto. Funding for Social Security did not reach the originally envisioned 6% until the 1960s. Self-employed workers would not pay 6% until the 1970s.
These tax cuts transformed Social Security from a system paid by workers to a system financed by children.

2. Take From Non-Voters 

Once voters did not have to pay for benefits, Congress raised benefits — every election year in the 1950s. Social Security Act Amendments of 1950, 1952, 1954, 1956, 1958 all increased benefits. These increased the value of existing benefits, created new benefits, or expanded coverage to more Americans. The 1950 Amendment raised benefits by 77%, 1952 (12.5%), 1954 (13%), 1956(added disability), 1958 (7%).

A couple retiring in 1960 expected to collect $8 of benefits for every $1 of contribution. Basically, Congress in the 1950s was selling dollars of benefits to voters for little more than a dime. The difference between the cost and the benefit was largely passed on to future generations who had no vote in 1950.

3. Allow The Federal Reserve to Lower Interest Rates At A Cost Of $1.2 trillion of Projected Interest Income (in 2012 alone)

In 2011, projected interest income over the life of the Trust Fund was 3.6 trillion. In 2012, projected interest income over the life of the Trust Fund was 2.4 trillion.
Thanks, Ben Bernanke.

4. Ignore The Problem

Social Security almost reached insolvency in 1983. At that time, Social Security had more than 40 years of promises embedded in a system that did not have a penny to pay them.  The solution to these problems in 1983? Repeat step 1. Repeat step 2. Prepare for step 3. The solution to these problems in 2013? Repeat step 1. Repeat step 2.

Today, Social Security is not much different than spending quarters to buy dimes.  Congress' solution is for us to get our kids to spend quarters to buy nickels.

Does Social Security Contribute To The Deficit

"Social Security has never contributed one cent to the deficit.  Not one cent!"

~Senate Candidate Jeff Merkley

 

Tim Geithner’s dog whistle is back in the news. Over the past two weeks, the discussion about Social Security and the deficit degenerated into a full blown ‘does so’ – ‘does not’ school yard shouting match.  
 

The exchange started when Jeff Merkley, a candidate for Senate in Oregon, blew the whistle, and PolitiFact challenged his statement.  Michael Hiltzik challenged its assessment.  And the dogs were off to the races.

To fully understand the dispute, you have to know that the word deficit has one meaning to Markley and a very different meaning to PolitiFact.  Both sides ignore the most basic facts of the subject, and use words almost assured to mislead just about everyone. It is the circus of extremes, which allows the voter to learn only what he wanted to hear in the first place. 

These participants are more interested in circus than answering the basic question: does Social Security contribute to the overall financial imbalances of the federal government?  Here is the answer.  While Social Security does not count toward the government’s red-ink, it contributes to it significantly.

Merkley’s statement is completely false.  Social Security is not self-supporting as he claims.  It receives by law (Public Law 98-21) annual general fund transfers, mainly the revenue from the taxation of Social Security benefits. This revenue appears on-budget, and is dollar for dollar deficit spending. Over the past three years, Social Security has by law created more than $75 billion of “On Budget” deficit – according to the Trustees.

Yes, Center for Economic and Policy Research is wrong.  Michael Hiltzik is wrong.  Paul Norr, the financial expert who has written extensively about Social Security, is simply uninformed.  These transfers are clearly detailed in the Trustee Reports.  They are outlined in the budget.  But, sound bites are better than facts.

Merkley has also used the wrong word. It is possible to say is that Social Security does not “count” toward the deficit. This is very different from saying it does not “contribute”. Count is a very narrow word dealing with what revenue and expense is included in a calculation.  Contribute weighs the changes in the deficit caused by the system as a whole.

Merkley’s statement assumes that Social Security operates in a vacuum, where it has no impact on the economy around it. This assumption reflects more ideology than reasoned deliberation. It isn’t possible to redistribute nearly a trillion dollars of income without affecting the broader economy.  For example, the National Bureau of Economic Research has shown that Social Security encourages people to retire earlier in life which means that older workers are trading an income tax producing job for a tax-free pension.  Lower income tax collection will foster a deficit.

On the other side of the discussion, PolitiFact’s assessment may be even worse. While its rating is essentially correct, the accuracy has more to do with random luck than actual reason.  The piece has a number of fact problems, only one of which is that Markley did not say what PolitiFact has judged.

PolitiFact has substituted its own definition of the word “deficit” in its ruling.  There is more than one equation to calculate the deficit. Merkley is talking about the on-budget deficit.  PolitiFact has validated his statement against a different measure, the unified budget deficit. Mind you, PolitiFact has made this mistake repeatedly.  (PolitiFact New Hampshire, Politifact Georgia, PolitiFact Wisconsin) 

Fact: Since 1984, Social Security Trust Fund has accumulated $2.8 trillion dollars more revenue than it paid out in benefits.

PolitiFact’s reasoning changes the relationship between Social Security and the government. In the unified budget approach, Social Security is a profit center to fund other spending. There is no $2.8 trillion dollar reserve of payroll taxes, nor interest earned.  The money is spent on other priorities with nothing left over.  So PolitiFact is testing Markley’s statement against a measure which specifically excludes revenue dedicated to Social Security.

In PolitiFact’s world, Social Security adds to the budget deficit as soon as the cost of benefits exceeds the revenue collected from payroll taxes and on-budget subsidizes. This line of thinking is the exact reason that Social Security was moved off-budget in the 1983. The National Commission for Social Security Reform argued that “changes in the Social Security program should be made only for programmatic reasons, and not for purposes of balancing the budget.” 

This approach to government is non-sense.  Social Security does not belong in the budget.  The government does not make a profit or loss on Social Security.  The revenue dedicated to Social Security should not be used by bureaucrats to hide spending problems elsewhere in the budget. 

Neither argument is particularly helpful for someone who wants to understand the relationship between Social Security and the overall financial imbalances of our government. That question is never even really discussed.  

2014 Social Security Trustees Report

The Trustees of the Social Security Trust Funds released their report on July 28^th.  The details of the report clearly show that the crisis in Social Security is not only deepening but widening as well.

The conventional measure of the report is the exhaustion point of the Trust Fund, which continues to be 2033. That is the point at which financial consequences start falling on retirees.  That date didn't change, but every other measure of the crisis has changed for the worse. 

The reasonable solvency of the system was reduced over the course of 2013 from 19 years to 18 years.  This reduction means that for the first time in history on average someone retiring today at normal retirement age expects to outlive full benefits.  Anyone who is 48 years old or younger roughly expects to retire after the system pays depleted benefits.  This, believe it or not, is the good news.

The bad news is that the size of the crisis arriving in 2033 is growing rapidly.  The report reveals that the unfunded liabilities now exceed the Gross Domestic Product of the entire county.  The financing shortfall grew by $1.8 trillion.  The growth means that Social Security created more than $2 of broken promises for every dollar that it collected ($855 Billion in 2013). The grand total of unfunded liabilities exceeds all revenue ever collected by the system since its inception.

The other measure of the shortfall, the 75 year financing gap, tells us how much it will cost to kick the can.  This cost rose $1 trillion dollars, again more than the system collected in all forms of revenue. To solve this part of the problem we would have to raise payroll taxes from 15.3% to 18.18% (an increase of 2.88%).  In other words, the nation would need to divert roughly $10.6 trillion away from deficit reduction in order to make the Boomer’s problem an even larger problem for their children.

The report tells us that these broken promises will start falling on people in roughly 19 years.  The Trustees project that there is a 50% chance that the system will pay full benefits through 2032.  It is reasonable today to expect that more than 50% of voting aged Americans will retire after 2032.  Five years ago, a near majority of voting aged Americans expected to be completely unaffected by the shortfall.  Today, it is less than 20%.

Politicians assure us that we have time to fix the crisis.  It is ironic that Time is the one variable that we know with certainty is destructive to Social Security.  The 2014 report tells us that changing the valuation date from 2012 to 2013 meant that the system created $900 billion broken promises.  Another way to look at this problem is if we had diverted every penny spent on the military in 2013 to Social Security, the system would still have been worse off at the end of the year than it was at the beginning.

What should trouble people is that the Congressional Budget Office (“CBO”) provides similar projections on the Social Security system.  Every angle of CBO’s projections provides a more pessimistic forecast for Social Security.  CBO believes the crisis emerging in Social Security will be larger and arrive sooner than the Trustees.  They show that it will affect more people and require greater resources to ameliorate.  So it is possible that the Trustees are too optimistic. 

The problem with this coverage today is that it focuses on the length of the fuse rather than the size of the bomb.

 

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.

Embrace Your Mistakes

Over three years of researching Social Security, I have come to two conclusions. One, Social Security is a vital program.  Two, there is no single force driving that program to crisis faster than the media and the experts that it quotes.

Today, polls show that roughly 80% of the public believe that Social Security is heading for crisis without reform.  Social Security reform has number. That support is however diluted across dozens of ideas by the media which has abdicated any responsibility for educating the voters.

In 2012, there was very little coverage of Social Security in the Presidential campaigns.  During the debates, President Obama stated that Social Security was 'structurally sound'.  The Trustees project that in the 14 seconds that Obama took to say it, Social Security issued roughly $220,000 of additional broken promises.  Both candidates talked about the necessary changes in terms of tweaks.  The Trustees put the cost of these 'tweaks' at nearly 10 trillion in 2013 dollars. The media treated these euphemisms as facts.

Ideology is largely what passes for information in the media.  Recently, on Bloomberg, Barry Ritholtz wrote that small changes to the wages subject to payroll taxes would make Social Security solvent well into the next century. It isn't close to true, and quickly discounted with research from Social Security Administration. 

To his credit, Mr. Ritholtz wrote a correction.  Unfortunately his correction was even less accurate. It introduced a web page from the American Academy of Actuaries that was based on data from 2009.  He doesn't disclose that this data is trillions of dollar out of date.  By profession, Mr. Ritholtz is a money manager.  Do you think he buys and sells companies based on earnings from 5 years ago when the companies which have shown deteriorating financials for nearly 10 consecutive years? 

Bloomberg will tell you that it is not responsible for Mr. Ritholtz's opinion or his research. Mr. Ritholtz in all likelihood will tell you that it is not his responsibility to correct information on the website of the American Academy of Actuaries. The American Academy of Actuaries will likely tell you that people should use the more current webpage on its site. Ironically enough, Mr. Ritholtz original article condemned the lack of accountability in pundits.

And thus the rumor spreads faster than the fact.  News outlets and bloggers pick-up stories from Bloomberg because of its reputation.  Bloomberg trusts Mr. Ritholtz, who seems to have assumed that the American Academy of Actuaries was a reliable source. There is virtually no accountability in the entire process.

None of the characters here are particularly unusual.  Mr. Ritholtz isn't the lone writer using dubious sources.  The American Academy of Actuaries aren't the sole source of noise. The Social Security debate has evolved into a cottage industry of agenda-driven think-tanks pushing a flavor of social policy through Social Security.  Cato Institute pushes privatization.  The Heritage Foundation sells its American Dream.  These groups plus NASI, and CEPR, all make a living selling the noise that has turned the Social Security debate into a shouting match.

Social Security And The Safety-Net

One of the more dangerous arguments in the debate about the Social Security system is the growing belief that Social Security is part of a social safety-net that protects the elderly or the poor. The argument is dangerous because it expands the charter of Social Security at a time when the system lacks the resources to serve its primary goal.  

Social Security is supposed to be old-age insurance which provides some financial certainty to people who no longer have a viable option to work. Old age is an uncertainty, one which can create great expense. Insurance spreads the risk of old age across a large population, and concentrates resources on those who incur the cost. Unfortunately, the trustees of Social Security project that even in a good economy the program cannot fulfill that role for people who are 64 and younger.

The argument to broaden the scope of the system has bled into the lexicon of both parties, and become a standard for media analysis of any proposal to reform the system.  The problem here is that there is no basis in the argument. The history of the program does not support the argument. The cashflows do not support the argument. Comically enough, the design of the system makes it uniquely unfit to serve as a social safety net.

Social Security Was Not Originally a Safety Net

The Social Security Act Of 1935 includes many things, some of which deal with needs of the elderly, unemployed, and children.  Separately, it created the Social Security Old-Age Insurance. If Title 2, "TITLE II- FEDERAL OLD-AGE BENEFITS," was intended to provide a safety net for the poor, there would have been no need for Title 1, "TITLE I- GRANTS TO STATES FOR OLD-AGE ASSISTANCE". Title 2 is what created the Social Security Old-Age Insurance program.

FDR structured the law in this way because he did not want his program to be subject to political priorities. Originally, Social Security was supposed to be a self-funded contributory benefits system. FDR referred to these contributions as "politics all the way through. We put those pay roll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits." A social safety net has no rights. It is a political priority. 
AJ Altmeyer, who was the chairman of the Social Security Board said in 1944, rejected the idea that Social Security was a public dole in congressional testimony.

"I believe that I am safe in saying that the people of this country, that the Congress of the United States, and that the members of this Committee favor a system of contributory social insurance for providing protection against the inevitable economic hazards that beset the workers of this country, rather than a Government dole."

Social Security Cannot Serve As a Safety Net

Social Security is uniquely unfit even to play a role in a social safety net. Millions of Americans are not covered by Social Security. Many of them do not qualify because of a spotty job history that created need in the later years of life. So the system excludes those who would need financial support most. Even if everyone were covered, Social Security does not even have visibility into the poverty that it is supposed to alleviate. As a social safety net, the system blindly throws money at people who may or may not be in need at all.  

The Social Security system is highly progressive, in which high-wage earners subsidize those who are lower-wage earners. This makes old-age insurance more affordable for a wider audience.  Yes, the formula rewards people progressively less as they earn more.  Yes, the formulas reduce benefits for people who saved for their own retirement. At the same time, the Social Security system does not pay a penny based on need. 

Social Security's Benefit Formulas Reward Everyone But the Poor 
 
The benefits formula for Social Security has more than 2,000 rules which change the benefits based on whether you have kids or how many times you marry. The benefit formula rewards people for living longer or working longer. The formula allocates the largest amount of resources to people who contributed the most in the past, live the longest, have the most qualifying ex-wives, and have the most children after the age of 65. Nowhere do the formulas base benefits on need.

Social Security pays the most money to someone like Pete Stark. Who is Pete Stark? An ex-Congressman who is wealthy by congressional standards. He is apt to collect the maximum payment allowed by Social Security. He is apt to live longer than most Americans. He married three times, giving the system three potential wives to collect survivor benefits from Social Security. The last wife produced three children all of whom have been eligible for Social Security almost since birth. It is not possible to call a system that lards benefits on someone like Pete Stark a safety net. 

In contrast to the haul of Pete Stark, Social Security will allocate zero resources to people who worked for Central Falls, a small town in Rhode Island which faces bankruptcy. Like many towns and municipalities, Central Falls did not put its employees into Social Security. With their pensions gone in bankruptcy, the people who retired from the city will have significant needs and no way to collect from Social Security.