Social Security: How do you run a retirement system for people who spend like drug dealers?

MIT’s way of reminding the Class of 1982 (average age: 57) that we are going to be dying soon was to schedule Nobel-winning economist Peter Diamond to speak on the subject of Social Security at our reunion dinner.

Why should running a retirement system be challenging? Why not take citizens’ money, save it for them, and give it back to them, plus interest, when they’re old? Singapore does this:

In contrast to the majority of other publicly managed pension schemes, the Singaporean system operates on a fully funded basis. The CPF does not include social risk pooling and redistributive elements. Individuals rely exclusively on defined contribution funds accumulating in individual accounts. The CPF covers private and most public sector employees as well as the self-employed, who may join on a voluntary basis.

This kind of system is bulletproof.

FDR and his fellow politicians in the 1930s couldn’t do this, however, because in order to get votes they wanted to start ladling out the cash immediately, to people who had put next to nothing in. So we tax currently working Americans to pay currently retired Americans. (Essentially everyone born prior to 1940 got more than they put in.) This is sustainable only with either a growing population or a growing labor force participation rate. Despite spreading out the welcome mat for immigrants, our population isn’t growing fast enough to offset increased longevity. Our labor force participation rate is falling as Americans discover the wonders of SSDI and OxyContin and/or collecting child support or alimony. Thus Social Security is always at risk of crisis.

Sometimes the roots of the crisis are easy to understand. Professor Diamond explained that in 1972, for example, Congress approved an inflation indexing scheme for Social Security that the experts in the Nixon Administration knew would “over-index” payments such that recipients would actually be better off in a high-inflation scenario. At least some senators knew this as well. Congress cheerfully passed the scheme into law because everyone knew that the U.S. would never have high inflation rates. By 1977 the system hit a wall and another emergency fix was required in 1983. (Our next scheduled emergency is in 2034 (source), when the trust fund is forecast to run dry and benefits will exceed contributions.)

Why does it matter? There is no law against Americans saving for their own retirement. However, most Americans spend like drug dealers. Presumably part of this is our nature, but we have a lot of structural discouragements to savings. Married with kids? Save and you’ll be punished by colleges in the financial aid process. Getting paid child support or alimony? Savings could be used against you in court; if you’re able to save maybe you don’t need child support and alimony (amounts always discretionary with the judge) at the current levels. Income below the median? Savings could disqualify you from various means-tested welfare programs, such as free or subsidized housing. Want to save up and buy a house? You will just be cheating yourself out of the mortgage interest deduction.

The result is “Among elderly Social Security beneficiaries, 48% of married couples and 71% of unmarried persons receive 50% or more of their income from Social Security.” (source) I.e., a lot of older Americans don’t have significant savings.

Professor Diamond laid out the history of political arguments about how to patch the actuarial holes in the system. He said that, to a first approximation, Democrats always propose higher taxes and Republicans always propose cutting benefits, except on the poorest recipients, for whom Republicans would like to see higher payments. He explained that politicians are never candid (not to suggest that they might lie!) regarding these proposals, e.g., disguising a benefit cut as a delayed cost-of-living increase or an increase in retirement age.

As with most other government programs, it gets sold to the public as a way of taking money from the fortunate to help the unfortunate. Social Security is advertised as “progressive” because people who had a low income get a larger percentage of their contributions back than high-income participants. In fact, this is undone because high-income participants tend to live longer and high-income participants are more likely to have a nonworking spouse who gets a kicker “spousal benefit” (if Nadine Nevermarried and Meredith Married put in the same amount over the same number of years, but Meredith was super attractive and had a boytoy husband at home, Meredith’s household gets about 1.5X the payments from Social Security). On average, Social Security doesn’t do anything to address the income inequality that has come to obsess at least some Americans.

The latest magic for plugging the most obvious holes? Democrats want higher rates on everyone and a special tax on earnings about $400,000 (soak the 1%!). What if the 1% get motivated and, like Eisenhower, manage to convert what would have been regular income into capital gains? That won’t help them because Democrats also want to tax investment income to feed Social Security. Republicans are opposed to these higher taxes, but they can’t just go on TV and shock Americans with “you have to work if you want money.” Diamond said that the likely fix is that Congress will change the law so that Social Security can borrow, like the rest of the Federal Government. If Social Security borrows approximately 100 percent of GDP, the system can keep working for about 75 more years (assuming that there are no advances in medical technology that increase longevity, for example, nor any further withdrawals by Americans from the labor force).

Borrowing doesn’t seem like the obvious solution to a long-term systemic problem of overspending. Are we going to be way richer than forecast in the future somehow? Have fewer old people around? Nobody seems to think so. However, in Diamond’s opinion, borrowing is the one option that will be palatable to both Democrats and Republicans (and certainly the two parties have cooperated to borrow more than 100 percent of GDP already).

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10 Comments

  1. Anonymous

    June 26, 2017 @ 1:22 pm

    1

    The solution is to have traditional family structure, with grandparents caring for grandchildren and children helping their parent, + personal savings as well as have longer work lifespans. We are banking on productivity growth outpacing retirees expenses, but it surely does not look like it based on growth of real estate and health care prices. Health care seems to be favorite product with highest demand and governments seem mostly promise unlimited access to it but only offer rationing of health care. For example, “Healthcare wait times hit 20 weeks in 2016” (in Canada) http://www.ctvnews.ca/health/healthcare-wait-times-hit-20-weeks-in-2016-report-1.3171718 and it has been going that way in the USA too recently. Of course, in 5 months many retired patients will drop-off but it is not the solution we want.

  2. jack crossfire

    June 26, 2017 @ 1:30 pm

    2

    Savings accounts don’t work like that, even in Singapore. The money is immediately lent out by the private bank to people who put nothing in. Then the government bails out the bank, just like social security. Social security is now paying out half of unemployment insurance, so it’s quite irrelevant. For men who never achieved chick magnet status & thus are experiencing greatly extended lifespan, there is no concept of retirement.

  3. G C

    June 26, 2017 @ 2:25 pm

    3

    If this post is notes from the talk, this was remarkably candid overview of Social Security.

    The point about the incentives not to save (or save little) is a good one. When I lived in Japan, they closed the ATMs on weekends. I don’t think this was because they couldn’t figure out how to keep them running, and very few credit cards, so this seemed like an attempt to depress spending. I saw a lot of “nudging” from the government like this on consumer spending, in the early 1990s.

    Thanks for sharing.

  4. Russil Wvong

    June 27, 2017 @ 4:46 pm

    4

    Mandatory retirement savings schemes are especially useful when you have a population that tends to spend whatever cash they have. (A population that had perfect self-control wouldn’t need the government to take their money away from them and then give it back in retirement.)

    One big challenge in trying to save enough for retirement individually is longevity risk, the risk of outliving your savings. Say average life expectancy at age 65 is 20 years. Unfortunately, because you don’t know how long you’re going to live, you can’t assume that you’ll be dead by 85. So you need to over-save: you need to save enough to take you through to age 95 (adding another 30 or 40% to your savings target), or even longer.

    Singapore’s retirement system doesn’t deal with longevity risk yet – but it looks like Singapore’s planning to add it:

    The government plans to implement a National Longevity Insurance Scheme with compulsory longevity insurance under the umbrella of the CPF. As life expectancy rises, beneficiaries run the risk of running out of savings. Annuities aim to secure lifelong income. Beneficiaries will have to take a part of their Minimum Sum to buy deferred longevity insurance at age 55, which will become payable when the beneficiary turns 85. For the first time, the new scheme contains a risk-pooling element, as premiums are combined in a common pool.

    This is basically what Social Security is – it’s an annuity funded by Social Security contributions and run by the government. Looks like the US is having trouble figuring out how to make it sustainable, but it’s really not that complicated. Canada made its equivalent (CPP) sustainable back in the 1990s.

    The CPP looked to be in fine shape during its early years. From 1966, when it began, until 1982, annual contributions exceeded annual benefits and the plan’s assets accumulated to almost $24-billion. Beginning in 1983, though, contributions fell short of benefits. However, the interest on the $24-billion pot of money (lent to provinces) was sufficient to keep the overall CPP in surplus another 10 years. By 1992, the pool of assets had grown to $42-billion.

    By 1993, however, even that combination of contributions and interest income couldn’t produce enough revenue to cover the stream of pension benefits. The CPP’s chief actuary warned that, without changes, the plan would be in very deep trouble, especially after the baby-boom generation began to hit 65 in 2012.

    The politicians who run the plan — the federal finance minister and his counterparts in the nine provinces that take part (Quebec has its own plan) — moved briskly (for politicians) to act on the actuary’s advice. Beginning in 1998, they jacked up the contribution rate in a series of annual increases that is taking the rate from 6 per cent of defined earnings in 1997 to 9.9 per cent in 2003 and thereafter. The rate this year is 9.4 per cent, split equally between employers and employees.

    It may have lacked imagination, but the fix has certainly worked. In the first year — 1998 — the plan’s total revenue exceeded benefits slightly, and by 2000, contributions alone were high enough to cover all benefits. After falling to $36.5-billion in 1997, the CPP’s assets were approaching $48-billion at the end of 2001.

    Last month, Jean-Claude Ménard, the current chief actuary for the plan, said in a report that the CPP is not only “sustainable over the long term,” but is also strong enough to weather “almost any unforeseen economic or demographic fluctuations” without any further increases in the contribution rate. A decade from now, he figures, the plan’s assets will have climbed to $155-billion. By 2021, when about half the baby boomers will be over 65, the assets will have reached $345-billion.

  5. dean

    June 28, 2017 @ 2:53 pm

    5

    Russil,
    “This is basically what Social Security is – it’s an annuity funded by Social Security contributions and run by the government”
    US Social Security is anything but what it is. FDR Supreme Court ruled that it was illegal for government to setup any insurances, except collecting new generic tax. Historically social security tax was used for anything, not necessary fund social security benefit. This is the original fake news that social security tax was to exclusively fund social security, it was generic tax from the start.

  6. Russil Wvong

    June 28, 2017 @ 3:55 pm

    6

    dean: Are you referring to Helvering v. Davis (1937)?

    There is a Social Security Trust Fund, current balance $2.79 trillion. Unlike the CPP, which invests in all sorts of things (private equity, public companies, real estate), the Social Security Trust Fund can only hold US government bonds.

  7. dean

    June 28, 2017 @ 5:03 pm

    7

    Yes Russil Wvong #6, this one too. It is a generic tax and thus falls under 16th amendment. Otherwise it would be illegal, as was the reasoning of the appeals court. So FDR lawyers stated that it is generic tax in their arguments. Not an insurance! And raised funds can be diverted to other things, and other taxes can be used to populate Social Security Trust Fund (that is my understanding). Not an insurance.

  8. Russil Wvong

    June 28, 2017 @ 6:06 pm

    8

    dean: Just doing some quick Googling, I’m not seeing any references to the 1937 decision preventing the federal government from putting Social Security contributions into the Social Security Trust Fund, and using income from the trust fund to make benefit payments – which is what it does. The only thing missing to make it an annuity is that the contribution and benefit rates have to be adjusted to make it financially sustainable. (The last such adjustment was in 1983, under Reagan.)

  9. CHenry

    June 29, 2017 @ 10:42 pm

    9

    Life expectancy in 1935 was 61 years; today it is 79 years. In addition to the larger cohort of persons surviving to old age today, there are also those whose benefits are paid at much younger ages by way of social security disability income payments, something that did not exist in 1935. The system conceived then was not intended to provide for either a large cohort of survivors or a significant extension of life beyond the age of eligibility or to provide for income to so many people obtaining disabled status, which in many parts of this country has nothing to do with being unable to work rather it is enough to be chronically jobless.

  10. dean

    June 30, 2017 @ 12:20 pm

    10

    Russil 8:
    “I’m not seeing any references to the 1937 decision preventing the federal government from putting Social Security contributions into the Social Security” Yes it does not. But it is not a definition of insurance. It is just a tax,

    “The only thing missing to make it an annuity ”
    You imply that someone has good will to make it real annuity. That’s not the case. And it is politically dangerous, it implies strict caps on benefits. And it is not convenient for authorities, limits ability to manipulate assets as moment requires. And it is dangerous: someone could use it as a collateral for new types of hedge trading, that will emerge after law for using it as a collateral for known types of trading is passed.

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