Let's talk about Social Security.

"Oh, look at that pretty basket! Hey! It's full of vipers!"

I don't really want to talk about Social Security, actually, but I do feel compelled to, since there's a whole lot of chin-wagging going on around the country over whether the Social Security system is in a crisis, whether it's going broke, and whether President Bush's proposal to set up private accounts for individuals is heaven-sent, or a tool of Beelzebub. Basically, it's a question about whether Social Security needs to be reformed.

The question of whether it does is one of mathematics. With lengthening life expectancies, there will come a point in the future when the sums paid into the Social Security system will be less than those that must be paid out. This could happen as soon as 2018, and the reason this will happen, regardless of the timing, is simple demographics.

You know, it's really a pity when a math problem becomes a political issue. Let's defuse the bomb: There is no Social Security crisis. There is a demographic one, and the problem cannot be solved by simply raising Social Security taxes, or by lifting the cap on salaries subject to Social Security taxes. And it certainly cannot be solved by allowing younger workers to set up personal accounts.

What Social Security is NOT
Many people view Social Security as though it were a pension plan, a pool of appreciated assets in which the current beneficiaries and remaindermen have competing but balanced claims on those assets. The beneficiaries hope the payments will be as large as possible, while the remaindermen want the principal as large as possible.

But Social Security was never meant to be a pension. In fact, the tax withholding on your paycheck is called FICA, which stands for Federal Insurance (not investment) Contributions Act. "Insurance" is something specific: a payment you receive if the risk you've insured against comes true. I pay homeowner's insurance now. If I never have to make a claim for loss, I don't have any right to get back all of the money I paid into the system. But if I do suffer a loss, I get a payment back that can be far larger than the amount I paid in.

Isn't it amazing how government takes words and simply destroys their meanings? This past weekend, one of the commissioners of Fairfax County, Va., where I live, said that it was impossible to drop the overall burden of property tax for homeowners because the county had to be able to fund all of its "investments." Now, our county government does a lot of things (too many things, if you ask me), but one thing it does NOT do is "invest." "Fund," yes. "Grant," yes. "Invest?" Heck, no.


If you look at the Social Security website, you'll see that a married couple with one 66-year-old retiring spouse retiring today would receive a maximum of $32,880 per year in Social Security benefits. The maximum that would have been paid over the life of the spouse's employment is about $310,000, so the amount of time before the couple has recouped every penny the working spouse ever put in is less than 10 years. But Social Security guarantees the same rate of payment for life after age 65, so the average retiree is currently receiving substantially more than he or she ever contributed to the plan.

Whether you need it or not
And this money is guaranteed whether you need it or not. Warren Buffett, a not-so-average retiree worth $40 billion -- who runs Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb) and generated nearly $1 billion in trading profits for the firm in 2003 (I guess just to pass the time in his dotage) -- gets a Social Security check. I'm sure he cashes it, but it has exactly zero bearing on his well-being. Ditto Charlie Munger, also worth a multiple of billions and the chairman of Wesco Financial (AMEX:WSC). Ditto a number of people who are among the wealthiest in the world.

Tell me: If Social Security were actually an insurance policy, would these people have a claim?

A secondary problem is the belief that the Social Security fund has substantial assets. It does, in the form of U.S. Treasuries, but these instruments, in the hands of a government body, are little more than an obligation for it to pay itself. It's akin to a person trying to fund his retirement by making out checks to "cash," and then putting them in a lock box. At retirement, he will still need financial assets to fund those checks out of his current cash stream.

But those are structural issues that have been in place since Social Security was founded. Demographic pressures are much newer. In the 1950s, there were more than 10 current workers for each retiree. Within the next decade, that ratio will drop down to 2:1. Were Social Security a pension (it isn't) with substantial assets (not!), this situation could be tenable for a long period of time.

Social Security transfers wealth from current workers to current retirees: Its existing fund is negligible, and it's filled with the only assets Social Security is allowed to carry -- government obligations.

Think of it this way: If you're a retiree, every penny of your Social Security benefits comes from the labor of three current wage earners. Soon it will be two. That means that every two-income household in America will have at least one dependent. That will mean that each working person can expect at least a 50% increase on today's contributions just to keep the program's head above water. We're placing an enormous claim on our (and other people's) children's incomes, since they will be compelled to support us in old age, whether we individually require such assistance or not.

This adds up to a system where the average recipient receives far more than he or she contributes, a system that has no real assets, and one that is dependent upon having enough current wage earners to support retirees, a balance that is quickly eroding as retirees live longer.

But allowing younger wage earners to have private accounts is fraught with problems. Giving employees free rein doesn't make any sense -- since the purpose of Social Security is to care for elderly people who are unable to save for themselves. On the other hand, increasing the level of government control over the stock-picking process, through approved funds or the like, would mean that the government would also control a large portion of the stock in most big American companies. How long, then, before the government would begin exerting its muscle on behalf of its shareholders?

Why the government should not be a portfolio manager
How long before the government starts saying, "Well, we can't have Altria (NYSE:MO) in our Social Security portfolios, because we don't want to be viewed as encouraging smoking"? What about McDonald's (NYSE:MCD)? Think it can't happen? Please, I invite you to regard, then, all of the social, political, and economic causes that the California state pension fund, CalPERS, has taken up over the years. When a political entity is involved, its stewardship concerns cease to be solely fiduciary.

This is a situation that promises to collapse - the math says so. The solution isn't privatization, which will create larger government programs, but rather in a final, honest discussion of what insurance is supposed to do. It protects against disaster.

For you wealthy retirees and near-retirees who believe that I'm suggesting that you're not going to get back what you paid in, BINGO. That's exactly what I am suggesting.

Social Security should return to its real function -- an insurance policy under which anyone whose average income or net assets are higher than some defined level would be ineligible. The timing and terms of this change could be phased in over time. Social Security was meant as a straight collectivist social program, and it would at least remain solvent as such. Such a recognition would be far superior to a situation where the government controls wide swaths of the stock market.

We could also change the definition of retirement age to recognize the longer life expectancy for Americans. But rather than simply name an arbitrary age, we could index it: The date on which you could begin to receive Social Security benefits would be set at, say, 11 years less than the average life expectancy.

Something has to give. We do not yet have a crisis in Social Security, but the math is very, very simple. If we believe as a society that the protection of the weakest is a noble pursuit, then we have to consider changes to the system that guarantee that we can offer such protection. The only real excuse not to do this would be that we'd prefer not to deal with it, and just leave the job of cleaning it up to our children.

See also:

Bill Mann owns shares of McDonald's. The Fool has a strict disclosure policy. Bill wonders whether he can claim his one-third dependent along with his other real dependents for taxes this year.

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