Tuesday, December 22, 2015

Is Social Security a Problem?

In a previous post, we determined that Social Security bears striking similarities to a Ponzi scheme. While this may be regrettable, the mere fact that the system is a Ponzi scheme doesn't give us much guidance on how to move forward. Besides, we accept all manner of seemingly absurd policies that are passed by the government (a Freedom Act that curtails personal liberty, a Bank Secrecy Act that requires banks to keep fewer things secret from the government, a War on Terror that has created more terrorists, etc.). So even if we grant that Social Security is a Ponzi scheme, perhaps it is not unreasonable to ask whether that's really a big problem. That will be the topic of today's post. (And since I can't keep myself to any kind of reasonable word limit on this subject, tomorrow we'll actually discuss possible solutions.)

So, is Social Security a Problem?

Most people probably know that America is experiencing a major demographic shift as its most prolific generation reaches retirement. The unfortunately named Baby Boomers generation includes everyone born between 1946 and 1965 and included 76 million births compared to just 55 million births for the Generation Xers. (And no, I'm not sure who decided to start the alphabetical generations at X. But it was during the Cold War so I assume everyone figured we weren't going to make it to name Z.) Anyway, this population disparity between the Baby Boomers and the generations that followed naturally creates issues for programs like Social Security and Medicare that rely on taxes from younger working Americans to pay benefits to elderly Americans. And that's what we're starting to see.

Before we discuss the numbers, it's important to recognize that a system like this is destined to be unsustainable when it's administered by politicians. If you had to say what single thing politicians are the worst at, planning for the future is probably near the top of that list. It's an obvious point perhaps, but the only time horizon that matters to them is the next election. Raising taxes to pay for future liabilities is going to be extremely unpopular right now. Failing to pay Grandpa a Social Security check in 10 years will be deeply unpopular too, but not for, well, 10 years. By then, you might not even be in office. And even if you wanted to do the right thing, you'd have to make the tax hike case to your voters and mention actuarial estimates and the discount rate and... yawn. Nope, that's a recipe for losing a primary. So we don't raise taxes. And 5 years later, when the crisis is much closer, the required tax increases will be even harder to implement. And so the cycle continues. Completely predictable, and destined for failure.

By and large, this is where we're at with Social Security. For a while now, it's actually been earning surpluses as the taxes collected specifically for Social Security exceed the benefits paid out. But when this happens, the Social Security Trust is required to immediately give that money to the federal government in exchange for a special type of government bond. So technically, the Social Security Trust is owed about $2.8 trillion by the federal government. But since that federal government continues to run deficits every year and only pays debt off by borrowing more, this $2.8 trillion isn't totally a sure thing. If the US had to rapidly increase its borrowings in a given year to start paying this back for Social Security benefits, it's not clear how the markets would react, but there's certainly some risk involved.

For the sake of argument, however, let's assume the $2.8 trillion in intergovernmental debt is rock solid. Unfortunately, that only buys us a few more years of being able to pay the promised amounts. Currently, the overall Social Security system is not running at a deficit; taxes collected and interest income on the debt exceed the benefits being paid out. But by 2019, the Social Security Administration is projecting that the benefits paid will start to exceed all revenue sources. At this point, the system will have to begin calling in its debt from the federal government. This deficit will widen as more people retire, gradually exhausting the current $2.8 trillion in IOU's that it can redeem for cash. Experts disagree on exactly when it will be completely bankrupt, but the Social Security Administration itself thinks it will be around 2034. It's not a question of whether the system is unsustainable, it's just a question of when it will collapse.

Now if that situation sounds a little odd to you, it's probably because the government follows special accounting rules. We alluded to this point in our previous post, but it bears repeating. In accounting, there's a concept of contingent (or uncertain) liabilities. For instance, if a company gets sued for its product failing, there's a chance that it will have to pay out damages. Depending on how likely it is that the company will lose the case (and how certain the amounts involved are), it may need to show a debt on the books. Certainly, if the company has already lost the case and just hasn't paid yet, it would be required to show that it owes the money since, well, it does. It works essentially the same way for pensions. If the Company has legally committed to paying out the amounts, they have to account for them at present value. Think about how absurd the system would be if it worked any other way. If companies weren't required to show pension liabilities on their books, you would soon see every start-up company offering lucrative pensions and lower starting salaries. It would appear as if they had very low expenses and low debt to help them attract investors, but in reality, they are about to become the start-up version of Detroit. And yet, this is precisely what the government is allowed to do. The government doesn't account for future liabilities in its official debt statistics.*

If you'll forgive another analogy, this is also akin to forgetting to mention your mortgage when you apply for credit. And if some distrusting lender was to ask about your mortgage, you could brush it off. Don't worry man, I don't have to pay it off for thirty years. I don't know about you, but my finances would look great if I was able to count my house but not the mortgage that goes with it. And indeed, when you hear someone refer to the national debt, this is the equivalent of what they're referring to: they listed their credit cards but forgot the mortgage.

When we sweep aside the accounting charade and consider what Social Security's financial position would be under grown-up rules, we find that it has $25.8 trillion in unfunded liabilities if the system continues indefinitely under it's current rules. The immediate action required to shore up the system would be a 33% payroll tax increase on all Americans, from 12.4% of all wages up to around 16.3% for the foreseeable future. Although that's pretty harsh, it is doable. But with each passing year of political inaction, the cost of catching up becomes steeper. And with the system so close to collapse and so expensive to preserve, it's worth asking whether we should keep it all. We'll take that question up tomorrow.

*This article makes the point that Social Security benefits are slightly different from pensions because the government has no legal obligation to pay them. It can summarily declare that benefits will stop tomorrow, and no one could do anything about it. However, as a practical matter, Social Security benefits are basically sacrosanct at this point and politicians treat them as such. So while it couldn't force the US into a Detroit bankruptcy situation, it's still a disaster in waiting for all involved.

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