Arnold Kling  

Social Security Arithmetic

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Tyler Cowen points to the Bruce Webb comment on Brad DeLong's post on Social Security. Webb says, in part

If privatization will work, it won't be necessary. If privatization will be necessary it won't work. And exactly no one has provided numbers that prove any different.

I may be putting words in Webb's mouth, but I think that what he is saying is that if productivity growth is high, then privatization will not be necessary, because Social Security will be solvent with a relatively small tax increase. On the other hand, if productivity growth is low, then stock market returns will be low, and in that sense privatization will not work.

I think that there are two scenarios under which Social Security will be insolvent even if productivity growth turns out to be at or slightly above the standard forecasts. Under one scenario, Medicare costs grow as projected, and because Medicare tax rates rise, labor supply declines. Under another scenario, longevity increases faster than the actuaries project. Under either scenario, the ratio of retirees to workers rises too quickly, and Social Security collapses.

However, I would not try to argue with Webb that under my two scenarios privatization solves the problem. On the contrary, I have always disagreed with the hypothesis that shifting more money into stocks is going to bail out Social Security. To me, privatization means making people more responsible for saving for their own retirement, and I think that the most straightforward way to do that is to adjust the retirement age to reflect the longevity increases that have taken place since the 1930's and then index the retirement age going forward.

Another benefit of privatization, which I thought that Brad DeLong endorsed, is that it might constrain the political tendency to promise a free lunch. His latest post (on which Webb comments) appears to take the opposite position.

in the end a lot of people will hit 70 having drained their Social Security private account dry. The rest of us will then have to decide whether to let them starve on the street, or tax ourselves a second time to give them Social Security benefits. As Dick Schmalensee says, "You have to ask yourself not just, 'Is this good policy?' but 'Will this still be good policy after Congress does its worst to it?'"

I guess I would rather give people their money, let them make mistakes, and take a chance on how Congress decides to deal with those mistakes. If we are lucky, the set of people who makes big mistakes and comes whining to Congress about it will not be large. Instead, to not allow private accounts amounts to pre-emptively giving everyone's money to Congress, which raises the potential for mischief by at least an order of magnitude.

For Discussion. What myth about Social Security poses the largest barrier to a reasonable discussion of policy?

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CATEGORIES: Social Security

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The author at LazaX in a related article titled Privatization of Social Security, and why not to do it writes:
    I have been following discussions about economics and privatization of Social Security. What might be a streight forward economics, it was a revelation to me that Social Security is no better and no worse economically after being privatized. (In short,... [Tracked on October 18, 2004 4:30 PM]
The author at Right Mind in a related article titled Social Security Privatization writes:
    TITLE: Social Security Privatization URL: IP: BLOG NAME: Right Mind DATE: 10/21/2004 07:19:41 PM TITLE: Social Security Privatization URL: IP: BLOG NAME: Right Mind DATE: 10/21/2004 07:19:41 PM [Tracked on October 21, 2004 7:19 PM]
COMMENTS (8 to date)
Eli writes:

Deftly passing over your "for discussion."

One problem with what Webb says is that the current law would not allow us to out-produce the Social Security shortfall. Social Security payments are indexed to wages, not prices, so if productivity rises, so does the liability.

This could be fixed relatively simply by Congress, but I'm sure lots of fear-mongers would scare the old folks by calling it a "cut" in Social Security.

joe shropshire writes:

If a privatized system is going to perform about as well (not much better, not much worse) than the current system, then it seems to me that Webb's argument cuts both ways, and DeLong's second comment, "The rest of us will then have to decide whether to let them starve on the street, or tax ourselves a second time to give them Social Security benefits", will apply to the current system in due course.

Bill Fellers writes:

Other than those old people that never reproduced, why should "We" care more for the welfare of a poor, old person than their own children? My wife and I both agree that we'd take our parents into our home if necessary. Why shouldn't others? The "rest of us" idea is stupid. Doesn't he mean roughly 51% of us? The minority is always jerked around by the majority. Which is what the founding fathers were trying to prevent, before politicians, judges, interest groups, etc. decided that the Constitution doesn't mean what it says. Also, why is it more moral to steal from young folks (making them partial economic slaves), thus making it much more difficult for them to save for their own retirement, than let old people suffer poverty, particularly those that are impoverished by their own stupidity?

Anyway, the largest myth may be just the one that DeLong is propagating: That without Social Security, there will be a bunch of poor old folks on the street. This is bull. The vast majority of all wealth in the US is held by people over 50. The idea that the government should take money from unwealthy young people to transfer to old people with wealth is disgusting. Most older people have money! Social Security is not a pension fund for most, it's inheritance insurance. It is actually a major factor in keeping wealthy families wealthy and poor families poor. Can anyone justify this transfer of wealth to the rich from the poor?

I hate control freaks. They are always justifying theft and coercive "programs" for "moral" reasons.

"The biggest gang I know is called the government. It makes me 1%. It makes me only 1%."

Tom Kaminski writes:

The biggest myth about Social Security is that it is a retirement savings program rather than a set of transfer payments. This myth is perhaps more prevalent among those over 60. But ask any retiree you know, and he'll tell you, "I put my money in all those years when I was working, and now I'm only getting it back." Most of the retirees I know are white and middle class, and none of them is willing to admit that the amount they currently receive exceeds their contributions. They get indignant if you tell them that they are (in effect) on welfare. tk

Bob writes:

While I agree with Tom's post (and others), all focus on the wrong point. The biggest myth is that social security has anything to do with retirement. It has been a vote buying scheme for at least 30 years. Relatively painless rational fixes are widely viewed as needed and possible (medicare is another matter). But nothing will happen until the political calculus changes after enough boomers retire.

This leads to a second myth that politics requires social security be dealt with before the boomers start drawing benefits. Political transfers always go from people who don't notice what they are losing to people who notice what they are getting. This often happens by taking a small (per capita) amount from a large group and giving what then can be a large (per capita) amount to a small group. Social security has been exactly that way. But as that changes with the boomers' retirement, the political will to "fix" things will grow, not shrink.

Boonton writes:
Anyway, the largest myth may be just the one that DeLong is propagating: That without Social Security, there will be a bunch of poor old folks on the street. This is bull. The vast majority of all wealth in the US is held by people over 50.

But there would be a bunch of old people out on the streets. Yea, those over 50 do on average have more wealth than other age groups. So what? On average whites have higher income than blacks but there are plenty of whites poorer than Bill Cosby. Unlike young people you cannot tell the impoverished 70 year old to get a job (barring futuristic advances that turn 70 yr olds into 30 yr olds).

Lawrance George Lux writes:

The greatest myth about Social Security resides in identification of the beneficiaries. Most would claim they are the dear old Elderly. The main beneficiaries are Business interests, to maintain the purchasing power of an increasing number of Households. Almost any Study anyone would care to take would express Senior citizen household expenditures would drop almost 60%, without the monthly SS payments, also the backup Medicare payments. The system is not designed to serve the dear old Grandparents.

Second, SS taxes are taxes--exactly that. Privatization would only insist that taxes be raised in another manner. Some should notice that the SS surplus is currently spent in the General Revenue.

Third, SS and Medicare Service providers have the strongest lobbys in Congress, and Medicare expansion of medical treatments only include expensive, high-Profit procedures. lgl

Daniel K. Robin writes:

My premise is that for a private social security system to work, you must use compound interest to the greatest extent possible ie start at birth.


The principals of compound interest should be used to improve any system for social security private accounts. Investing money early in life will generate significantly more wealth than investing a greater amount later. Deposits made early in life can create great wealth for retirement. The current recommendations to replace social security depend upon income to fund the accounts. That starts too late. Using compound interest effectively, we can replace our retirement planning at a fraction of the cost of our current tax and spend system.
THE HIGH COST. In 2002 the government collected $539 billion ($455 billion from payroll deductions, $71 billion in interest on the social security trust funds and $13 billion from the taxation of Social Security benefits) for social security. And nearly everyone agrees that the system is going broke. In 2004, The actuaries for the Social Security Board of Trustees determined that we must have an immediate increase in payroll taxes of 15 percent or an immediate reduction in benefits of 13 percent (or some combination of the two).
It has been estimated that someone born in 2000 making an average wage will receive back a rate of return of less than one percent from social security. Those with shorter life spans are treated very badly. In reality, 14% of all Americans die before the age of 67.
COMPOUND INTEREST. Einstein called compound interest “the most powerful force in the universe” or the “8th wonder of the world.” Compound interest refers to adding interest to your original investment and then earning interest on both. For example $10,000.00 invested at 8% at simple interest for 30 years yields $34,000.00. $10,000.00 invested at 8% compounded monthly for 30 years yields $109,357.30. The great power of compound interest takes many years to work its magic. The spectacular increases in value hardly show up for the first 20-30 years. If you invest the money at birth, you will have an 18-22 year head start on a system that begins to collect money from a payroll tax. Investing money early in life will generate significantly more wealth than investing a greater amount later in life. If the goal is to create the greatest amount of money available at the age of 65, start at birth.
THE CHILD’S IRA PROPOSAL. I propose to replace the current social security system over the next 65 years. There should be mandatory contributions to a “CHILD’S IRA” upon the birth of each child and smaller mandatory contributions for the next four years: 1st year: $5,000; 2nd year: $4,000; 3rd year: $3,000 and the 4th year: $2,000 and the 5th year $1,000.00. Withdrawal from these accounts would not be permitted until the age of 65. At 7% compounded quarterly this would yield $1,248,690.00. Less the cost of administration, the remainder of approximately $1,080,000.00 invested at 4%, would generate income of $3,600.00 per month without using any of the principal.
The individual who makes the contribution should receive a refundable tax credit for the full amount. There are approximately 4,000,000 babies born per year. That means it will eventually cost the U.S. Treasury $60 billion per year, or less than 10% of $619 billion currently collected (assuming the recommended 15% increase) for social security per year.
Most new parents probably don’t have $15,000.00. This is intended to be a government funded program. (Assuming the recipient will pay no social security withholding during his or her life, it would be reasonable for the recipient to pay the government back $15,000.00 from income.) The donor to the CHILD’S IRA will receive a 100% tax credit. If withheld weekly form the donor’s paycheck, the donor will receive a dollar for dollar reduction in taxes. The net paycheck will be the same. Those with little or no income would sign up their children for direct governmental deposit to the child’s private accounts.
THE TRANSITION. How do we move from the current tax and pay system to a “Child’s IRA” system of privately owned accounts? The Cato Institute suggests that each worker born after 1/1/1950 elect to place 6.2% of the first $87,900 into a private account. The Institute for Policy Innovation (IPI) suggests that each worker contribute 10% of the first $10,000.00 of income and 5% of all additional income to a private account. All of their ideas are founded upon the ability of the private accounts to grow over time. All of these proposals are excellent, but each fails to use COMPOUND INTEREST to the greatest extent possible.
The cost and likelihood of success of those ideas would be greatly increased by applying the same principals of compound interest that guided the “Child’s IRA” suggestion. Remember: investing money early in life will generate significantly more wealth than investing a greater amount later in life.
First, disconnect the ties between contributions and income. I call this the IRA syndrom. You can’t make a contribution to a Roth or Traditional IRA without income. Any new system must allow contributions at any time. Contributions at an early age are so important that I would recommend they be tax deductible for any donor as long as the recipient is under the age of 18. Withdrawal from IRA’s & 401k’s should be prohibited or the tax penalty increased substantially.
Second, the Social Security withholding rate for young workers should be higher than for older people. Therefore, workers age 0 to 24 should have 15 percent of their income withheld and deposited into their private account. Every worker age 25 and 34, should have 10% of their income withheld. For workers 35 to 65, use the IPI system, i.e. 10% of the first $10,000.00 and 5% of all additional income.
Assuming median incomes from the US Census Bureau, and assuming a 5% rate of return after expenses, my calculations show that the account would have $715,794.00 at age 65. Those funds invested at four percent would generate $28,631 income per year without touching principle. With a slight revision in the assumptions, placing all deposits from age 18 to 24 100% into the stock market to yield seven percent, the account should have $1,086,351.00 and would generate $43,454 income per year invested at 4% per annum.
CONCLUSION. The current Social Security System is far too expensive and a terrible investment. Who would rationally and voluntarily put their money into something which is likely to return less than 1%? And most important, the system is failing.
Compound interest is one of the true wonders of the world. We can use its powers to replace the Social Security System. Put money away early; keep it there and you will be able to fund all of the retirement you need. We can replace the entire Social Security System for approximately 10% of its current cost and each retiree would have over a million dollars in their own account to provide for themselves.
Use the principles of compound interest in the designs for all public policy. Transition systems for Social Security must encourage withholding money earlier in life. We should end the IRA syndrom. For every $606.00 put into an account at age 10 will mean an extra $1,000.00 of income per year at age 65. Investing money early in life will generate significantly more wealth than investing a greater amount later in life.

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