Social Security's Investment Shortfall: $8 Trillion Plus — and The Way Forward

The following sections are included:

• CONTENTS

• LIST OF TABLES AND FIGURES

• PREFACE

This study is about one of the world’s largest investment funds, the Trust Fund of the Social Security System of the United States. Hundreds of millions of people have made contributions to it over three quarters of a century. A very large number of the people who have paid into it have also received, or are receiving, retirement benefits, disability payments, or the proceeds from life insurance sent to their next of kin; all others who have made and are making contributions can expect these same types of benefits in the future.

As of December 21, 2010, the Social Security Trust Fund had assets of $2.609 trillion in the form of non-marketable Special Issue Government Bonds and no debts. Of this amount, total inflows to the Trust Fund in the form of payroll taxes exceed benefit payments and administrative expenses in the sum of $1.144 trillion. Consequently, the Trust fund’s accumulation of earnings, in the form of interest income, over its first 74 years of existence, adds up to only $1.465 trillion. As of this writing, the Social Security Trust Fund has never invested a penny in stocks.

The Social Security System of the United States, a child of the Great Depression, dates its birth to 1935. It was controversial then and has remained so in varying degrees ever since. The requirement since 1983 to make 75-year projections of its financial prospects, where demographic changes in the age distribution of the population play a key role, have generated sobering, and in some quarters nearly hysterical, reactions about its sustainability. It is not my intent to review these issues in any detail. Many careful studies of the problems facing Social Security have concluded that they can be solved by relatively minor adjustments. An especially cogent analysis in this vein is provided by Peter Diamond and Peter Orzag in their book Saving Social Security — A Balanced Approach (2004). Their adjustments to revenues and benefits are based on three components: improvements in life expectancy, changes in earnings inequality, and what they call the legacy debt that arose from the early recipients’ relatively large benefits…

The reason for purchasing an insurance policy is to protect oneself or an economic entity from the prospect of future loss. With respect to home, auto, or other property insurance no loss may occur. But if there is damage or destruction, the insured receives a payout in some form as compensation in accordance with the terms of the policy. What the insurance policy provides is a safety net that may or may not end up being needed. The same is true for disability insurance, (discontinued) term life insurance, long-term care insurance, liability insurance, unemployment insurance, as well as event insurance written to protect against terrorist attacks, for example…

Despite being viewed as the most successful of the government’s many programs, Social Security suffers from three serious shortcomings. First, contributions are labeled, and thought of, as a tax rather than as mandatory retirement and insurance contributions which is what they are. Since the contributed funds are invested in Treasury securities, they have all the properties of what we call savings or investments which, like pension funds and personal retirement accounts, are expected to grow over time. In addition, the mindset is often affected by the words used. “Taxes” tend to generate negative reactions while the word “investment” tends to elicit positive connotations…

Pension funds, insurance plans, and individual investors of funds for retirement share a long-term perspective in making their placement decisions. Most if not all of their allocations of capital are invested in stocks and bonds. As we observed in Chapter 1, this is true in countries outside the United States as well although in varying proportions. Historically, British funds have tended to put the highest proportion into equities, while Japan has exhibited among the highest allocations to bonds.

The idea of privatizing Social Security or the minimum safety net in part or in full has a long history but was especially hotly debated after the second Bush administration proposed a partial privatization. To consider the merits or demerits of such a move it will be useful to first briefly review the lessons from the various countries which have implemented, and thus have experience with, privatization of public pension schemes.

The recent period has seen a clamor calling for reform of the Social Security System of the United States. Most proposals (see e.g., Blinder, 2010; Brandon, 2010; Farrell, 2010; Malkiel, 2010; and Peterson, 2010) have called for rather modest changes. The thrust of the present analysis, as is already evident, is that a more comprehensive, yet easily implemented, restructuring is needed.

It is evident that the Social Security Trust Fund is not in the best of hands. It clearly needs to disengage from being a political football. What is required is a change in the mindset that will view Social Security contributions as genuine (passive) investments into a minimal safety-net plan, a plan that can expect above average net-of-fees investment returns for the purpose of funding a combination of inflation-indexed, life-time annuity-based retirement, life insurance, and (when applicable) disability benefits.

The following sections are included:

• EPILOGUE – THE LESSONS

• APPENDIX

• REFERENCES

• ACKNOWLEDGMENTS

• INDEX

• About the Author