October 21, 1998

Social Security
by Al Levit (alanl@ix.netcom.com)

Part 3: Fixing Social Security

Now that we've explored what Social Security provides, how it's funded, and the basic mathematics of the problem, we're ready to look at a few proposals for fixing it. One of the most popular proposals, and the first one we'll examine, is to replace Social Security with some sort of defined-contribution system.

Such a system was proposed by 5 of the 13 members of the Social Security Advisory Council. Under this arrangement, existing retirees and those near retirement (e.g., over age 55 at transition) would receive roughly the same Social Security benefits promised today. But for younger people, Social Security would be divided into two parts:

1. A defined benefit portion providing the same disability and survivor benefits available today. In addition, this portion of Social Security would guarantee a minimum level of income at retirement. This part of Social Security would be financed by the 5% Social Security payroll tax that employers currently pay for retirement benefits, plus the 1.2% payroll tax that employers and employees each pay to provide disability and survivor benefits.

2. A defined contribution portion made up of a new IRA-style individual account for each person. Currently, the Social Security payroll tax on employees is 6.2% of payroll. Since 1.2% of that tax is being used for the defined benefit portion above, the remaining 5% we are currently paying into Social Security is available for new IRA accounts. This means that we would be and could be saving over 80% of our Social Security taxes in new IRA-type accounts -- invested in the best-performing long-term vehicle available to us, our public stock markets.

In addition, the defined benefit portion would provide higher benefits for those of us caught up in the transition (i.e., between ages 25 and 55 when the new system goes into effect), since there won't be time for the IRAs to take full effect.

This opportunity to start saving 80% of Social Security taxes in a new IRA seems almost too good to be true. Not surprisingly, though, there are a few potholes on this road. And the biggest one of all is what we in Fooldom like to call...

The $2.4 Trillion Problem!

This minor little matter has to do with the nature of Social Security's funding, or lack thereof, that we covered in Part II. As I explained, most of the Social Security taxes that active employees pay right now goes to current benefits for retirees. It is immediately transferred over into payments to current retirees. A small portion goes to fund baby boomer benefits, although even that is debatable. In any case, steering those taxes towards active employees' IRA accounts would take the money out of current retirees' pockets, and that wasn't part of the deal outlined above. Instead, a new source of funds is needed to pay the liability for the benefits to current retirees, to active employees over age 55, and to cover the "transition babies."

At its peak, this deficit is projected to reach $2.4 trillion. Sorry, that's not a typo, that's trillion, as in $2,400 billion, as in $2,400,000 million. As in 12 times the net worth of Microsoft. It's a very big number. In order to get out of this hole, some have proposed that we all pay an additional 1.52% pay tax for the next 70 years to pay off this "transition deficit." And there may be some times during that period when the Social Security Trust Fund has to borrow to pay benefits. But at the end of the period, the system should be stable, and we should all have nice Social Security IRAs to boot.

Such a system has a lot of appeal, but it does require that we dig even deeper into our pockets going forward than we are already. Of course, that pain doesn't mean that we shouldn't start the process; it took a couple generations to dig ourselves into this hole and it may take two generations to dig us out of it. We have to start sometime, and the longer we wait the more painful it will be when we finally bite the bullet.

You should also keep a couple of other concepts in mind when you're thinking about Social Security IRAs.

1. Our emphasis on equity investment in Fooldom is very much contrary to the norm. One of the biggest problems that 401(k) plans have had is that their participants have invested too conservatively, often with 1/3 or more of the accounts in money market funds, and much of the rest of it in underperforming mutual funds. Safety, not steady performance, is their priority -- due primarily to our nation's lack of education on personal finance and investing. Now, I would expect this problem of conservative investing to be just as bad with Social Security IRAs, in the short term. In the long term, though, I'm very optimistic about the power of Foolish education on the Internet -- our ability to work together here to make the smartest long-term decisions possible.

2. All of the proposals that I've seen for Social Security IRAs have talked about limited investment choices. There is some question whether any equity investment should be allowed, under the theory that the government should not control private corporations. Even if that opinion doesn't hold, the best a Fool can probably hope for is an index fund. Of course, as a manager of the Cash-King Portfolio, I'm hoping T. Rowe Price gets in on that action!

Changes to the Existing System

Whether or not we move to an IRA-type system, there will be proposals to make several changes to the current benefit structure. A few of the more popular proposals are:

1. Means Testing

Social Security is unique among transfer payments in that retirees receive benefits regardless of their income level. Proposals to change this have been made in the past, but they've never been passed (the powerful American Association of Retired Persons has always presented fierce opposition).

The closest that Social Security ever came to so-called "means testing" was in 1989, when Medicare was expanded to provide increased benefits. Those benefits were to be paid by increasing income taxes to the 40% of Medicare recipients who actually paid income taxes. The original legislation was very popular, but when the financing method became widely known, there was a popular uprising and the taxes and associated benefits were repealed.

As Social Security is now again being debated, proposals for means testing are being resurrected. Remember this: Under the current Social Security system, the 6.2% of pay that is taken each year from employees earning the minimum wage can get distributed as Social Security benefits to a millionaire. It's difficult for this Fool to justify this.

Taking the extreme to prove my point, should Warren Buffett get Social Security checks throughout his retirement? Applying means testing to eliminate benefits for the top few percentiles of wealth in this country is just plain common sense.

2. Lifting the Wage Base

Each year Social Security stops collecting taxes after an employee's earnings reach a certain level. In 1998, that level -- called the Social Security wage base -- is $68,400.

Read that sentence again. Did you know that was true, Fool?

Yep, it is. At a certain salary level, the government doesn't ask individuals to contribute any more. And so, our nation's wealthiest employees contribute a much smaller percentage of their income to Social Security than do employees with average or below-average income. That's called a regressive tax. In the words of our proverbial great grandpappy, "It just don't make no sense."

One way to start answering our $2.4 trillion problem is to apply the same tax rate to all wage earnings, regardless of the income level. Michael Eisner should keep paying Social Security taxes all year, just like the rest of us -- not just through the first $68,400 of his salary. That's the way taxes were meant to work, no?

3. Increasing the Unreduced Benefit Age

In 1983, changes were made to raise the age for unreduced Social Security benefits to 67 for people born after 1959. Proposals have now been made to raise the age all the way to 70.

4. Changing the Method to Determine the Cost-of-Living

The recent changes to the cost-of-living adjustment that have been adopted will help to dig us out of our $2.4 trillion hole.

5. Expanding the Program

Social Security taxes are mandatory for most private workers, but many state and local employees are exempt. Making Social Security mandatory for all employees, including state and local employees, would help reduce the unfunded liability by bringing more contributions into the system. Like most things in Social Security, the existing proposals almost always include grandfather clauses for existing state and local employees who are not covered by the system, so it is only new hires that would be included. Even so, the benefit to the Social Security system from forcing all new state and local employees into the system would be substantial.

Hey, we're all in this together, right?

6. Investing the Trust Fund in Stocks

This is both the most promising change and yet the most difficult to accomplish. It's the most promising because it'll have the most profound effect of all on reducing the Social Security deficit. Yet, it will be the most difficult to accomplish for at least two political reasons:

1. A short-term fear of the stock market that some politicians are trapped in. After all, politics is often a business with a very short-term orientation.

2. The fact that equity investments would bring to an end the double-counting of the Trust Fund assets as deficit reduction assets. Alas, the budget surplus would disappear overnight. Hey, our leaders can't let that happen. If they were leaders, though, perhaps they would. Accountants certainly would.

Next -- One actuary's opinion on Social Security