The real truth about Social Security

SOCIAL SECURITY manages to be one of the most popular and misunderstood government programmes. It serves two purposes: to provide an income floor which keeps people out of poverty in retirement (a form of insurance), and to replace income from previous work (a forced saving scheme). There may be more efficient ways to achieve these goals, but generally, Social Security does a decent job at both. But there is a stunning amount of ignorance when it comes to its financing. On the right, people like Rick Perry call it a Ponzi scheme based on lies. The left prefers to believe there's nothing wrong with the programme and figures when revenues and the trust fund can no longer cover benefit payments some simple accounting trick will save the day. Both views are wrong and dangerous. Discontinuing the programme and moving to something fully funded would be so expensive as to not be worth the cost. Social Security’s financing problems can be fixed, ideally with some combination of tax increases and progressive benefit cuts. It is a fairly easy fix and the sooner it is done the cheaper it will be. Punting it to the future makes it even more expensive to future generations, and is in my opinion irresponsible, to put it nicely. Social Security is not based on lies either. It is a remarkably transparent system, your benefits are based on your income and the average rate of wage growth. Both of these variables entail some risk. Which is why I found this from my DIA colleague confusing: If you wanted to call Social Security an investment, you would say it is a play on the proposition that America's GDP will continue to grow over the long term. This is the safest play one can imagine making, which is why the returns are so modest. Like any investment, it could go bad. But if it goes bad, if the economy of the United States ceases to grow over the long term, it is inconceivable that any other investment large enough to feed a pension plan covering the entire working population could do better. I assume he’s looking at the optimistic projections from the Social Security Office of the Actuary, where optimism involves people dying earlier and wages increasing enough that the revenue collected covers benefits. There exists a great deal of uncertainty around how the programme will be financed in the future. It does seem probable that taxes and/or benefits will change, which will mean a lower rate of return on your contributions to the programme. I think my colleague is saying that on the off chance that wages grow faster than they have in the past (or retirees start dying earlier) your expected rate of return will not change. But I would not call that a low risk bet. The uncertainty around Social Security makes saving and investing for retirement much more difficult. There is evidence this uncertainty is leading people to hold less risky, and lower yielding, asset portfolios. Also, while I don’t personally consider Social Security a pyramid scheme, it does have that flavour. It is financed as a pay-as-you-go, meaning workers now pay for current retirees. The nature of PAYGO is the later you are born the lower your return on contributions. The figure below gives the money’s worth ratio (roughly a rate of return on contributions—values less than one mean a negative return), by birth cohort for medium earners, assuming benefits could miraculously be paid with no policy change. It also includes the ratios if there were a benefit cut or tax increase to restore solvency. The range of ratios, depending on the nature of reform, suggests risk to me. The low rates of return may be jarring, but keep in mind Social Security fully indexes benefits with inflation and provides some insurance. The design of Social Security is not ideal. But it is not a terrible programme, though it has the potential to be. The sooner each side acknowledges the truth, the better the programme will be.