Thursday, September 13, 2007

More on Social Security

I was heartened the other day when Joe Biden (D-De) actually recognized the primary issue with Social Security: the trust fund is not a trust. The basic problem with social security is typical of any defined benefit pension.

First, let me go into some terms. When we think of pensions there are two types: defined benefit and defined contribution. Really the word pension conjures up the former to a much greater extent than the latter. A defined benefit pension is something that is decreasingly available but once was the norm. A defined benefit pension is at its name would imply: the benefits are defined. Say I worked for General Motors for 30 years as an arc welder and my final salary was $100,000. GM's defined pension plan as bargained for entitles me to say 65% of my salary from the date of my retirement to death. I would expect that there is some inflation adjustment. Now, General Motors doesn't do this out of the goodness of their heart but rather this is a supplementary form of compensation that comes at the expense of your wages. They are in essence saving and investing on your behalf. Now it sounds like a great deal, and it is for the worker, but it has some overwhelming downsides which is why the defined benefit is today largely extinct. The first basic problem is that a defined benefit pension is not portable, it was intended for an era when workers worked for the same company for their career. The other problem is that you are essentially up a river if your employer has failed to fund the pension fund adequately, this has been a problem for all defined benefit pensions whether they be offered by a private company, Social Security, or your local government (especially local governments).

A defined contribution pension is as its name would indicate: the contributions are defined, not the benefits. The 401(k), 403(b), Traditional IRA, Thrift Savings Plans are all forms of defined contribution pensions. You are able to set aside up to 15% of your pretax income in a tax deferred account and your employer can match up to 6% of your salary in the form of a tax deferred contribution. The virtue of a defined contribution pension is that you can take it with you, at a minimum what you have set aside (typically there is a schedule for the vesting of your employer contribution). The other virtue is that you don't have to worry about your employer inadequately funding it. Its core problem lies in the fact that employee is assuming some of the risk (that said, you don't have to worry about your employer shafting you, so risk is really in the eye of the beholder). How should you invest it? What happens when you retire, do you annuitize or simply draw down periodically?

How does this relate to Social Security? Well, Social Security is a defined benefit pension plan and it suffers the same problem that most defined benefit plans have: it's underfunded. Now, some will contest that the problem does not begin until 2040 when the trust fund is depleted. After all it says so according to the Social Security's Actuarial report. Well yes, and no. The actuarial projections are based on social security claims as payable under law. Right now, payroll tax revenues (the dedicated revenue source for social security) coming in are greater than social security benefits going out. If you account on a cash basis you would then show a surplus. But the problem is with pensions you account on an accrual basis. And there is a compelling logic to this. The revenues that are coming in are not only to cover present liabilities (i.e. Social Security checks being cut today) but also to cover future liabilities incurred today (i.e. to be able to cut Social Security checks to those who are paying payroll taxes now), thus when you prepare a financial statement you are to book the revenues in excess of your present outgoing benefits as a liability. The government doesn't do this. Every year for the past several decades, the congress has taken the surplus revenues from Social Security and uses it to plug in gaps in the General Budget. In return for pilfering the Social Security trust fund the Department of Treasury issues a special bond to the Social Security Administration and these bonds accrue interest. This has the effect of understating the true nature of the Government deficit. The unified deficit (=General Fund deficit + the social security surplus) is a good deal higher than the number the press touts whenever it reports the deficit numbers.

So how does this relate to Joe Biden and Social Security, well Sen. Biden was complaining that every year we raid the trust fund and spend all types of random crap and our day will come a lot sooner than people talk about. Sen. Biden's solution was to "stop raiding the trust fund". Well, congress has had the opportunity to show their restraint and has never been able to do so. Sen. Biden gets two points for honesty if not for the substance of his proposal. The principle virtue of Personal Retirement Accounts, or privatizing a part of Social Security was that while we are still collecting more than we pay out there would have been a mechanism to prevent the Social Security surplus from being frittered away.

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