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.

In the discussion of Social Security, little is more unproductive and contentious than the assertion that Social Security is a Ponzi scheme. It marks the point where the discussion stops and the fight begins.

Is Social Security a Ponzi scheme? That entirely depends upon your meaning of the phrase.

If you use the term loosely to describe current investors relying on more future investors, it is. But there are many of these arrangements around if you define the word so broadly. On the other hand, some over-qualify the term to a point where nothing qualifies. 

Let's look at the two people most frequently associated with the concept of a Ponzi scheme: Charles Ponzi for whom the ploy is named and Bernie Madoff, now serving a 150-year sentence for investment fraud.

Who Were Charles Ponzi and Bernie Madoff?

Ponzi sold investors on a complicated investment idea that was guaranteed to make them large returns over a short period of time. Instead, he paid early "investors" with the money eagerly supplied by those who came later — pocketing millions for himself. His ruse lasted only a few months, collapsing under the weight of its own absurdity.

Madoff sold investors on the simple idea of safety, promising stable returns over long periods of time. In reality, he followed Ponzi's example of paying early investors with the money from later investors — pocketing billions for himself. Madoff's scheme lasted decades, and only collapsed amid a black-swan financial crisis during which spooked investors actually wanted to hold their own money.

What Do They Have In Common?

The one thing that these men have in common is that they personally benefited from the transaction. In every dollar invested, there was a substantial probability that a portion of it would wind up in the pocket of the operator. They have little else in common to bind them together in minds of Americans.

Would Social Security Have Made Madoff Proud?

The answer is no. It would have made him angry, period. While there are widely accepted rumors that the government has profited from Social Security, there is no actual evidence of it.

Today, the Social Security Trust Fund holds about $2.8 trillion. That reserve sounds like a lot of profit pocketed by the government until you break it down by source. Most of the sum comes from interest, which is a cost to the government for borrowing money from the program. Since inception, the program has collected about $1.9 trillion in interest and interest on interest. Separately, the government has paid subsidies of more than $600 billion to the system from the General Fund. Thus, virtually everything in the trust fund actually represents a cost to the government.

So What Happened To The Trillions?

Virtually all of the money ever contributed by workers (nearly 99%) has been spent on beneficiaries. Since inception, the program has collected $14.8 trillion in payroll taxes, and has distributed about $14.5 trillion in payments.. In total, the excess contribution borrowed by the government is not enough even to pay for the subsidies that have been made to the system. As a result, the government has lost nearly half a trillion dollars on the program.

Is Social Security Collecting A Fair Return?

Maybe the government benefited from access to the cash. Specifically, some economists argue that the excess cash that accumulated over years enabled the government to borrow at lower rates. In theory, it is possible because Social Security has created an undisputable supply of cash locked into government securities.

On the other hand, the math tends to discount the size of the savings. The interest rate earned on bonds held by Social Security is based on the yield of longer-term maturities traded in the public markets. That rate is applied to whatever cash is available in June of the year. Provided the long end of the yield curve is higher than the short-end, the government isn't making a killing on the program.

Did Early "Investors" Make Money?

Yes, they did. Typically, we hear about Ida May Fuller, the first beneficiary of the program who collected nearly $23,000 over the course of her lifetime against a contribution totaling less than $25.
The lesser-known fact is that she lived nearly triple the time in retirement as an average retiree of that era. Moreover, she had the good fortune to live through a series of expansions to the program via Congressional mandate, which accounted for the vast majority of her returns. As a consequence, it is exceedingly difficult to determine where the pork barrel politics ends and the Ponzi scheme starts.
To illustrate the distinction, the first farmer to receive agriculture subsidies enjoyed tremendous economic gains. Does that make agriculture subsidies a Ponzi scheme?

What Is In A Word?

The label "Ponzi scheme" isn't contributing to an informed discussion about Social Security or its financial challenges. It is a pejorative meant to scuttle the debate. The label offers no solution, and generates a bottomless rabbit hole of pointless bickering.

(Originally published on TheHill.Com)

 

Traditional coverage of Social Security tells voters that if Congress does nothing, the system will continue to pay scheduled benefits for nearly two decades. 

The problem with the analysis is of course that Congress is not in a position to do nothing. It cannot ignore Social Security as the relationship between Congress and the system evolves from private banker to creditor. Over the next 15 years, Congress will have to refinance debt held by the Trust Fund much to the chagrin of those who claim that the Trust Fund doesn't exist. 
 

The media and experts tend to view this process as a seamless transaction that will go unnoticed by the public markets. The reality is that the government will have to borrow more from the public markets at uncertain rates as it competes with private borrowers for cash. This likely means higher rates for both the U.S. Treasury and for private businesses.

The relationship of Congress and the Social Security Trust Fund was largely shaped by the 1983 Social Security Amendments which increased taxes and reduced benefit levels. The combine changes allowed the Social Security system to grow into the largest customer of the US Treasury Department, buying nearly $3 trillion dollars of debt from the government between 1983 and today.

This pool of money largely insulated the government from the reality of borrowing in the public markets. As excess cash from Social Security flowed into government securities, the borrowing cost of the government dropped from 10.8 percent to 2.9 percent.  The latest round of borrowing from Social Security was completed at 2.5 percent.

There is nothing illegal or unreasonable about this relationship.  What is unreasonable is to fail to acknowledge that the relationship is changing, and how the consequences will affect the way we pay for government. 

We are looking at unwinding 30 years of subsidized borrowing over a relatively short period of time. When the Social Security Trust Fund redeems a bond for cash, the Treasury Department must find a source of funds. The government has two options: It can increase taxes in order to buy the debt or sell new debt to a new lender. 
 
This refinancing burden arrives at the exact time that Social Security is reducing its role as the nation's private banker. In short, the best customer of the Treasury is about to become a direct competitor. Consider, if you owned a shoe store, and your best client was leaving you, it would be a worrisome event. The problem in this case is exponentially larger because the best client is leaving you so that he can open his own shoe store next door to yours.

This process is unfolding quickly.  Since 2010, Social Security has largely been a player on the sidelines, financing much of the interest that it charges the government for the use of the money. For the last 5 years, the Trust Fund largely allowed Congress to stand still while the imbalances continue to grow.  Every year from now on, Social Security will provide less buffer between Congress and its profligate ways. 

It would be wonderful if Congress could do nothing.

Social Security Is The Post Office Of The Investment World

Milton Friedman once observed, “If the government ran the Sahara, in five years there would be a shortage of sand.”  He is right.  The government has run Social Security for 70 years, and now there is a shortage of security.   Today more than 80% of Americans believe that Social Security is heading for crisis if the government does not implement a major reform.  So a system that is supposed to provide security, now it only provides uncertainty for the vast majority of Americans.

Friedman’s quip about the Sahara is an amusing look at government.  The comment about Social Security on the other hand is rather frightening.  The difference between these similar outcomes is that few people depend upon sand in the Sahara; where as Social Security has become a sinkhole of dependence with millions dependent upon a system which is comically broken.

Just how broken is the Social Security system?  While people argue about the solvency of the system, the Social Security Trust Fund’s assets are managed with a 70 year-old investment policy that has underperformed the equity markets by nearly 50 to 1 during that time.  As a consequence, we are debating raising taxes which will be subsequently invested in bonds with a yield of less than 2%.

One day, economists will study this comedy because Social Security is the perfect storm of economics.  It blends the inefficiency of monopolies, with the incompetence of government, with the indifference of absolute pricing power.  This concoction isn’t just headed for failure.  It is headed for massive failure.

People tend to think of the Post Office as the poster-child of government ineptitude, but it is well run compared to Social Security.  The reason for its relative success is that the Post Office has to compete with private sector companies.  No one is forced to use the United States Postal Service.  We communicate by phone, email, and best of all private sector mail services which drive innovation into the business model of USPS.

Social Security competes with no one.  It could be the purest monopoly in the world.  While thousands of firms offer investment products, Social Security does not compete with any of them.  Social Security gets more than half a trillion dollars every year regardless of what happens in the outside investment world. 

As a consequence, innovation is driven by managers at the Social Security Administration rather than by market needs.  The Social Security Administration chose to add things like automated check deposit.  But it didn’t have to offer that service.  The Social Security Administration offers a website, but it didn’t have to offer one. 

So how bad is letting government drive innovation?  Only the government could create a retirement tool that is completely insensitive to risk appetite.  Social Security allocates risk in a one-size-fits-all model that is not only expensive but dangerous.  Imagine, the nation is engaged in a discussion about the solvency of a system, which has no way to allocate the risk associated with insolvency.

Can government innovation get worse?  Social Security is supposed to provide insurance, and yet it has no mechanism for price discrimination.  Survivor benefits are difficult to price – so we make them free.  The unhealthy cardiologist with a family of four pays exactly the same rates that a single person does.   According to the Social Security Administration, survivor benefits basically double the cost of benefits - but the benefits are given away for free.

Actually it can be worse still.  The Social Security system cannot invest in higher yielding assets because some critics feel that the financial markets are too risky.  As a consequence, Social Security invests 100% of its excess assets in a single issuer within an asset class that has enjoyed a 30 year bull market.  The issuer is the US government which has Debt/Annual Revenue of more than 500%.  But the financial markets are too risky.

In short, Social Security could be the only retirement product in the world that cannot allocate risk.  It is likely the only insurance product in the world that can’t price risk.  And it has an investment strategy which brings together low returns and maximum risk.  Social Security is broken because there is no private market where innovators can drive incompetence out of business.

In the private sector, profit and loss regulate the decisions of such managers.  Government has no way to incorporate profit and loss into its decision making process.  In the mind of its managers, positive cash flow is profit regardless of what happens to unfunded liabilities.  This is not a joke.   Politicians of both parties generally agree that Social Security has not contributed to the deficit, ie it makes money.   So Social Security will not be a problem until it is a catastrophe.

The consequence of absolute pricing is that no one who runs the system cares about whether the product is any good.  If the system runs out of money, the managers simply raise the price and shrink the box.  In terms of Social Security, raise the price and shrink the box means raising taxes and lowering benefits.  In the last 70 years, we have never had a single discussion about how to fix the system.

Today some actually argue that we should raise taxes and lower benefits because “Social Security is the most successful government program ever.”  It would be funny if millions of people did not depend upon the system.  As a system, Social Security does not attract money well.  It does not manage what resources it has well.  And it does not allocate its resources well to serve its purpose.  Social Security is horribly broken.  Our leaders don’t want to fix a broken system they want to convince us to pay for one.

GOP And The History Of Social Security

For those of you who believe that the GOP hated Social Security since inception, CNN has an interest note in an article :

After Franklin Roosevelt signed Social Security into law in 1935, for instance, Alf Landon, the Republican presidential nominee in 1936, ran on repealing the law. But after Landon won only two states, Wendell Willkie, the GOP presidential nominee in 1940, ran on expanding Social Security. Although Congressional Republicans continued some rearguard actions against the law through the 1940s, the party never again proposed complete repeal.

While Social Security program is a lifeline for millions, the questions about its stability is nearly invisible in the 2018 mid-term elections. Even a subset of the issues should draw-out well thought answers, and yet it does not even draw questions.

• The SSA expects about half of those turning 71 today to be turning 87 when the program would deliver substantial reductions ~ we don’t even know how those cuts would be distributed to the individual.
• For every $1 collected since inception, the program has created $2 of promises that no one expects it to keep. That isn’t a problem with demographics. That is a political program run amok.
• The unfunded liabilities - the generally accepted measure of the program’s brokenness - is growing twice as fast as the GDP. In other words, the hole is growing twice as fast as our ability to fill it.

Even in battleground states, where millions of dollars are chasing voters at the margin, candidates can’t find 20 cents to explain their thoughts on the program’s long-term finances. AARP, a leading seniors advocate, in the state of Florida, a state heavily dependent upon those monthly checks, cannot find a position from either candidate for Senate. The story is the same in NV, AZ, and MO which supposedly might determine control of the Senate.

The GOP almost across the board believes that they are unwilling to change the program for those in or approaching retirement. They are oblivious to the fact that the existing system can’t even provide certainty to those well in retirement. The person who turns 71 today expects to outlive full benefits. If you are going to keep the GOP’s promise, someone has to be willing to talk about the taxes that will be increased.

The Democrats generally believe that we can fix the program by throwing money at the problem. How has that strategy worked over 80 years? Well, every $1 in has generated $2 of failure.

Back to the idea that millions of people depend upon the system today. That dependence will rise as people age. So we are heading to a point the system is apt to break at the peak point of dependence. Instead of a serious discussion, we get a narrative from Washington that might as well start with “Once Upon A Time”.